MASTER OF BUSINESS

ADMINISTRATION
James Cook University Singapore

Lecture 12:
Gains from Trade; Foreign
Exchange
 CRITICAL THINKING?
„ What factors affect the value
of a country’s exchange rate?

„ Be familiar with an update on the USD vs

British Pound and assess the implications
of an appreciating/depreciating on the BOP
(particularly the trade and current
accounts)
EXCHANGE RATES

„ Exchange Rate (ER)

„ the price at which the two currencies
exchange
„ Equilibrium Exchange Rate
„ foreign exchange is bought and sold
on the foreign exchange markets
„ it is established where the demand
for the currency is equal to its supply
USD vis-à-vis foreign currencies
USD1 = (as of 20 Jun 06, as compiled by Spring & Mony, as of 24
Oct 08)
Jun 2006 Oct 2008
Australian dollars 1.3565 1.52
Swedish Krona 7.3392 7.76
Swiss Francs 1.2403 1.17
Chinese Renminbi 8.0021 6.84
European Euros 0.7957 0.78
Indian Rupees 45.806 49.50
Pakistani Rupees 60.406 80.86
Indonesian Rupiah 9,380.7 9,971
Philippine Pesos 53.360 48.96
Singapore Dollars 1.5947 1.475
Vietnam Dong 15,988 16,795
British Pound 0.622
Cambodian Riels 4,144
EXCHANGE RATES

„ Three reasons why foreign

exchange is bought and sold
„ International trade in goods &
services needs to be financed. X
create a demand for currency whilst
M create a supply of currency
„ Long term capital movements occur.
Inward I creates a demand for its
currency. Outward I creates a supply.
„ There is an enormous amount of
speculation in the foreign exchange
markets
The Equilibrium Exchange Rate

„ The equilibrium
exchange rate
occurs at the
point at which
the quantity
demanded of a
foreign currency
equals the
quantity of that
currency
supplied.
 Determinants of
Exchange Rates

„ Factors that cause a country’s

currency to appreciate or
depreciate are:
„ Tastes
„ Relative Income
„ Relative Price Levels
„ Relative Interest Rates
„ Speculation
„ Others (see next slide)
FACTORS AFFECTING EXCHANGE
RATES:
„ Purchasing Power Parity (PPP)
„ Economic growth (economic
situation)
„ Interest rates
„ Current account
„ Confidence in the economy
„ Political situation
„ Speculation
„ Market sentiments
„ Others (?) -- SARS outbreak, Iraq war,
Bali bombing, terrorism, natural
calamities
FACTORS AFFECTING EXCHANGE
RATES – Strengthening currency
„ Purchasing Power Parity (PPP)
„ Economic growth (economic situation) –
positive economic growth
„ Interest rates – higher interest rates (so
there is inflow of funds)
„ Current account (CA) – CA surplus
„ Confidence in the economy – more
confidence, currency will strengthen
„ Political situation - stable
„ Speculation – speculation in favour of the
USD, the USD will strengthen
„ Market sentiments – infavor of the USD
„ Others (?) -- SARS outbreak, Iraq war, Bali
bombing, terrorism, natural calamities
 PURCHASING POWER PARITY:
A GUIDE
„ the theory that the exchange rate will adjust so as to offset
differences in countries’ inflation rates, with the result that
the same quantity of internationally traded goods can be
bought at home as abroad with a given amount of the
domestic currency.
„ an ER of one currency for another which compares how
much a typical basket of goods in one country cost
compared to that of another country.
„ The Economist publishes yearly its ‘hamburger
standard’ exchange rates for currencies
„ a light-hearted attempt to see if currencies are
exchanging at their purchasing power parity rates,
known as BIG MAC PRICES
„ Big Mac PPP
„ exchange rate that would leave hamburgers costing the
same in the US as abroad
„ comparing actual exchange rates with PPPs signals whether
a currency is under-or-over-valued
„ PPP = local price divided by P in US$
 ALTERNATIVE EXCHANGE
RATE REGIMES

„ Exchange rate regimes (the policy rule

describing how government allow
exchange rates to be determined)
„ Fixed exchange rates (governments maintain the
convertibility of their currency at a fixed ER. A
currency is convertible if the CB will buy or sell as
much of the currency as people wish to trade at
the fixed ER)
„ Floating exchange rates (when exchange rates float
freely, there is no government intervention in the
forex market and forex reserves are constant. ER is
allowed to find its equilibrium level without central
bank intervention using the forex reserves)
 Fixed exchange rates
„ Fixed exchange rates are normally used
by small developing nations to peg to a
key currency
„ For international settlement purposes
„ To stabilize import/export prices with the main
trading partner
„ To reduce inflationary expectations
„ Pegs can be established
„ To a single currency
„ To a trade-weighted basket of currencies
„ To the special drawing right (SDR), a basket
established by the IMF
 Floating exchange rates
„ Currency prices established daily by
an unrestricted market
„ Large foreign exchange reserves are
not needed to defend a fixed rate
„ Rates respond to economic shifts;
payments imbalances are corrected
by rate changes
„ Gives greater freedom to domestic
economic policy
 Floating exchange rates

„ Works only if there is enough trade

in a currency to make a viable
market
„ Greater freedom for domestic policy
may mean poor economic policy has
fewer immediate consequences
„ Market rates may move erratically
¾Certainty
¾With fixed rates, international
¾Makes monetary policy ineffective
trade and investments become much
– if interest rates are pegged to
less risky, since profits are not
world levels & money supply is
affected by movements in the
infinitely inelastic, CB cannot
exchange market
control inflation by controlling
¾Little or no speculation
money supply
¾Automatic correction of monetary
¾Fixed rates contradict the objective
errors – if CB allows money supply to
of having free market
expand, resulting in extra demand &
¾Inability to adjust to shocks – no
lower interest rates, this leads to BOP
mechanism to adjust to sudden BOP
deficit
crises
¾Prevents government from pursuing
¾Costly to defend / exit under
“irresponsible” macro policies – if the
government expands AD to gain disorderly circumstances
popularity, BOP deficit will force the G
to constrain demand

¾Automatic correction – ER will
move freely to equilibrium
¾Insulation from external shock –
country is not tied to unacceptable
high inflation as in fixed ER
¾Gov’ts free to choose their
domestic policy – under fixed ER,
government have to deflate
economy with high unemployment
¾No problem of international
liquidity & reserves – no CB
intervention in the foreign
exchange market, no need to hold
reserves
¾Unstable exchange rate
¾Speculation
¾e.g., Asian economic crisis
¾Uncertainty for business
¾Lack of discipline in economy –
govt pursuing irresponsibly
inflationary policies & unions may
drive up prices
¾Cost push inflationary pressures
¾Abolition of exchange controls
causes capital flights
 Impact of an appreciating US
dollar

„ Pros „ Cons
„ Exporters’
„ Lower prices on products become
foreign goods more expensive
„ Keeps inflation abroad
Imports-competing
down „
firms face price
„ Foreign travel is competition
cheaper „ Travel more
expensive for
foreign tourists
 Impact of a depreciating US
dollar

„ Pros „ Cons
„ Exporters can sell „ Higher prices on
abroad more easily
imports
„ Less competition
for US firms from „ Upward
imports pressure on
„ Foreign tourism is inflation
encouraged „ Travel abroad
more expensive
CRITICAL THINKING

„ What is BOP?
„ Why should a country
have a positive current
account balance?
„ What happens if the
country experiences a
current account deficit?
 The Balance of Payments

„ The balance of payments is a summary

of international transactions between
one country and others over a period
of time.
„ This summary records the nature and
value of inflows and outflows of goods,
services and financial assets.

„ (Some slides refer to the data on the Australian Balance of

Payments)
 The current account
„ The current account records trade in
goods and services. It consists of
balances on:
„ Merchandise trade (goods: agricultural
products; aircraft; computers)
„ Services (e.g. tourism, education; medical
care; banking; insurance; logistics)
„ Income (e.g. dividends and interest
payments)
„ Transfers (private & government transfers)
 The capital account

„ The capital account records dollar

payments flows of purchases of foreign
assets by Australians (or Americans),
and of domestic assets by foreigners.
„ The assets referred to are ‘investment
assets’:
„ bonds, securities, property, shares.
„ Note that any income flowing from the
ownership of these assets is recorded
as income in the current account.
 Balance of Payments
„ Balance of payments accounts
sum to zero
„ Current account deficits
generate asset transfers to
foreigners
„ Official reserves
 Current and capital account
offset each other

„ The current and capital accounts

should balance (any difference is a
measurement error).
„ This is because any deficit on the
current account is financed by a
surplus on the capital account.
„ Foreigners accommodate additional
current expenditure by becoming
investors in the country.
 Are current account
deficits a bad thing?
„ Australia (or USA) has
experienced a current account
deficit (CAD) in every year since
1960.
„ This means Australians (or
Americans) spend more than the
income they generate, so
foreigners are accumulating
Australian assets.
 Are current account
deficits (CAD) a bad thing?

„ The CAD is not likely to prove a

problem provided overseas funds are
used to finance investment goods that
earn income in the future.
„ The CAD and capital account surplus
(CAS) have allowed Australia to
achieve higher rates of economic
growth than would otherwise have
been possible.
U.S. Balance of Payments -
2008 (amounts in billions)
 U.S. Balance of Payments:
1980-2008 (amounts in billions)

o trade deficits can decrease value of dollar

decreasing U.S. purchasing power abroad
o trade deficits can also decrease employment in
domestic industries but are offset by capital inflows
generating employment in other industries
Causes of the U.S. Trade Deficits

There are several reasons for these

large trade deficits:
„ Strong growth in U.S. income that
accompanies economic growth resulting
in increased spending on imported goods
„ Large trade deficits with China have
emerged
„ A declining U.S. saving rate
„ Others? (prices of crude oil; increased
disposable income; improved standard of
living; globalization)
 Weakening USD
„ Impact on Current Account
„ Impact on trade
„ Exports will increase, imports will decrease
„ Impact on services
„ Exports will increase, imports will decrease
„ Impact on trade balance – improve

„ Impact on net investment income

„ Impact on net transfers

„ With exports improving, overall

current account is expected to
improve
 Class Discussion
„ Reasons why the US$ is weakening
„ Budget deficit; trade deficit

„ Expected slow economic growth for the US

„ Expectation that the USD will weaken further

(market sentiments)
„ Governments of many countries shifting their
USD reserves into other currencies (e.g., Euro)
„ Decline in the value of USD denominated assets,
hence, the decline in interest in USD
„ US subprime market; financial crisis (credit
crunch
„ Excessive money supply (printing of money to
finance debts)
„ Inflationary tendencies

„ Huge or ballooning foreign debt

„ Others?