International Economics

TOPIC 8
Exchange Rate System and Macroeconomic Policy in an Open Economy PK:ch13,14,17; Part 4 Husted/Melvin:CH.13,18,19,21. Kreinin:ch.11.12.15

Topic 8

Outline

Determination of Foreign Exchange Market Internal and External Macroeconomic Equilibrium Macroeconomic Policies under Certain Exchange Systems

2013/4/12

Foreign Exchange Market

Definition
The marketplace where international currencies trades take place It need not be a collective fair for traders but always integrated by telephones,fax and internet links, each part of the market makes the sun never set(24hours a day): four major markets Huge trading volume (over 4000b per day) USD acts as vehicle currency
3

2013/4/12

Foreign Exchange Market

Transactions Spot transactions: immediate delivery within two business days Forward transactions: dealing on value date basis more than two mature date and at an agreed upon price Swap transactions: converting one currency to another currency which makes up a significant proportion of all foreign exchange trading
2013/4/12 4

Foreign Exchange Market

Transaction Actors include: Commercial banks:interbank trading (Libor) Corporations:across border payments (BOC in NY) Nonbank financial institutions:Funds (Soros Quantum Funds ) Central Banks:intervention/final settlement The Truth is: There is a market, there exists difference under different systems
2013/4/12 5

Why Trade Forex online?

Online forex trading has become very popular in the past decade because it offers traders several advantages: Forex never sleeps Trading goes on all around the world during different countries business hours. You can, therefore, trade major currencies at any time, 24 hours per day. Since there are no set exchange hours, it means that there is also something happening at almost any time of the day or night. Go long or short Unlike many other financial markets, where it can be difficult to sell short, there are no limitations on shorting currencies. If you think a currency will go up, buy it. If you think it will fall, sell it. This means there is no such thing as a bear market in forex you can make (or lose) money any time. Low trading costs Most forex accounts trade without a commission and there are no expensive exchange fees or data licenses. The cost of trading is the spread between the buy price and the sell price, which is always displayed on your trading screen.
2013/4/12 6

Why Trade Forex online?

Unmatched liquidity Because forex is a $4 trillion a day market, with most trading concentrated in only a few currencies, there are always a lot of people trading. This makes it typically very easy to get in to and out of trades at any time, even in large sizes. Available leverage Because of the deep liquidity available in the forex market, you can trade forex with considerable leverage (up to 50:1). This can allow you to take advantage of even the smallest moves in the market. Leverage is a double-edged sword, of course, as it can significantly increase your losses as well as your gains. International exposure As the world becomes more and more global, investors hunt for opportunities anywhere they can. If you want to take a broad opinion and invest in another country (or sell it short!), forex is an easy way to gain exposure while avoiding vagaries such as foreign securities laws and financial statements in other languages.
2013/4/12 7

The Real Value of a Currency: Spot Rate and Forward Rate of Exchange
When and where it will change: the case of Euro in Jan.1,1999 Euro per Dollar Depreciation of Euro 1 S This tells us all things about the determination but nothing of the story!

Appreciation of Euro 1
2013/4/12

D Euro
8

Euro per 1 USD

2013/4/12

USD per Euro:2002-2012

2013/4/12

10

The Real Value of a Currency USD

Officially, the U.S. Federal Reserve Board of Governors effective Forex Rate by using trade weight, issued in 1973 Technically, Market analysis based on market fundamentals and expectations

2013/4/12

11

Market fundamentals
CA balance Real income Real interest rate Inflation rate Consumers preference Productivities change Profitability and venture investment Product availability Fiscal and monetary policy Trade policy
2013/4/12 12

Expectations
News about future market fundamentals Speculative options about future exchange rates

2013/4/12

13

The Equilibrium of Exchange Rate

The Assets-Market Approach
Dollar/Euro Exchange rate Return on Dollar Deposits

E Expected Return on Euro deposits Return rates in dollar term

2013/4/12

14

Foreign Exchange System in History

The Gold standard:1880-1914 ,London The mint parity price (David Hume) Interruption and Recovery of Gold Standard The Gold Exchange Standard:19441973,Bretton Woods system The Floating System: since 1973 Pls check the arrangements of each country with IMF reports
2013/4/12 15

The Result of Exchange Rates Adjustment

Why need an adjustment It will have an adverse economic consequence It will have impact on relative prices of goods and service and in turn on financial assets The extent of casual consequences depends on the response of trade and investment sectors

2013/4/12

16

J-Curve and Foreign Exchange Rate BOP

Time Lag
Long-run Effect

0 Depreciation in Time Path

2013/4/12 17

Restriction on Adjustment
The Elasticity Marshall Lerner Condition E = Q/Pthen Em=Qm/Pm Ex=Qx/Px If Em + Ex >=< 1, The sum is less than 1, Devaluation will cause a deterioration in on nations trade position
2013/4/12 18

Road Map
Devaluation Export price Import price

D/S elasticity Export supply Export receipts

2013/4/12

Import demand Import Expenditures

19

Can We go back to Golden Era?

Rationality It is a market phenomena; impossible to be fixed Reality Orderly international monetary system and stability are not necessarily built on the gold standard
2013/4/12 20

Robert A.Mundell: Optimum Currency Areas

Refers to the best grouping of different countries to achieve some objectives The region is usually characterized by relative costless mobility of productive factors What will he say about Asian optimum currency areas?
21

2013/4/12

Macroeconomic policy in an open economy

Short Run Equilibrium
Exchange Rate Output and Forex DD Money and Forex Exchange Rate

AA Output
2013/4/12

Output
22

Short-run Equilibrium
Interaction of DD and AA
Exchange Rate

Output
2013/4/12 23

Macroeconomic Balance
The notion of Internal and External Exchange Zone 1 Balance Rate
Employment CA+ EB Zone 4 Zone 2 Employment Employment CA+ Zone 3 Employment CA2013/4/12

CAIB Fiscal ease

24

Policy Function
Fiscal Policy Public Expenditure taxation Inflation Unemployment Depression Income distribution Trade deficit Devaluation Capital movement Interest Rate Exchange Rate Monetary Policy

2013/4/12

25

Policy Assignment :Mundells Theory

Macroeconomic policy
Economic situation

Fiscal Policy expansionary Contractive Contractive expansionary

Monetary Policy Contractive Contractive expansionary expansionary

Z1 Z2 Z3 Z4

Unemployment/surplus Inflation/surplus Inflation/deficit Unemployment/deficit

2013/4/12

26

2013/4/12

27

The Plaza Accord

Background: USD depreciation in1980s , Japanese recovery caused other currencies oscillation and trade wars. In 1985 ,G5 hold meeting at Plaza Hotel,the United States, Japan, France, Germany and Britain agreed to the depreciation of the dollar against the Japanese yen and the German mark. Germany and Japan agreed to adopt a more expansionary policy to accelerate their economies.

2013/4/12

28

As a result, Japanese Yen appreciated:

Before the Plaza Accord in Sept.1985, Yen against USD was remianed around 250:1,but afterward Yen appreciated to 120:1 in 1987, almost 50% up during less than 3 years

2013/4/12

29

Targets
Long term Target: cease the burden of U.S. debt service Short term Target: combat protectionism in USA Medium term Target: promote the world economic expansion by stimulating Germany and Japan
2013/4/12 30

Results
G5 had a mean to stable the forex rate; Large interventions introduced since then; G6 met in Paris: Louvre Accord.

2013/4/12

31

Mundell-Fleming Model (1950S) Krugman: The Eternal Triangle 1999

STABILITY OF Exchange Rate Free Mobility of Capital Independence of Monetary Policy Trilemma!

2013/4/12

32

Reading Suggestion
China Daily: articles on RMB IFM: Monetary policies by various nations Chapters covered by this topic

2013/4/12

33

How Financial Crisis occured

The Crash(Documentary Vedio)

2013/4/12

34

Exam Remind
Length: Two Hours Date:Dec.29 or 30, 2012 Content: Choice questions; Essay Questions; Case Study Language: English Textbook/Notebook: not available Dictionary: allowed Teamwork (Y/N): No
2013/4/12 35