12&13Econ Gains From Trade Forex 12Jan10 Dist

8/8/2019 12&13Econ Gains From Trade Forex 12Jan10 Dist

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MASTER OF BUSINESS

ADMINISTRATIONJames Cook University Singapore

Lecture 12:

Gains from Trade; ForeignExchange


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CRITICAL THINKING? What factors affect the value

of a countrys exchange rate?

Be familiar with an update on the USD vs

British Pound and assess the implicationsof an appreciating/depreciating on the BOP(particularly the trade and current

accounts)


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EXCHANGE RATES

Exchange Rate (ER)

the price at which the two currenciesexchange

Equilibrium Exchange Rate foreign exchange is bought and sold

on the foreign exchange markets

it is established where the demandfor the currency is equal to its supply


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USD vis--vis foreign currencies

USD1 = (as of 20 Jun 06, as compiled by Spring & Mony, as of 24Oct 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 0.78Indian Rupees 45.806 49.50

Pakistani Rupees 60.406 80.86

Indonesian Rupiah 9,380.7 9,971Philippine Pesos 53.360 48.96

Singapore Dollars 1.5947 1.475

Vietnam Dong 15,988 16,795British Pound 0.622

Cambodian Riels 4,144


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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 whilstM create a supply of currency

Long term capital movements occur.Inward I creates a demand for itscurrency. Outward I creates a supply.

There is an enormous amount ofspeculation in the foreign exchange

markets


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The Equilibrium Exchange Rate

The equilibriumexchange rateoccurs at the

point at whichthe quantitydemanded of a

foreign currencyequals thequantity of that

currencysupplied.


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Determinants ofExchange Rates

Factors that cause a countrys

currency to appreciate ordepreciate are: Tastes

Relative Income Relative Price Levels

Relative Interest Rates

Speculation Others (see next slide)


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FACTORS AFFECTING EXCHANGERATES: 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, naturalcalamities


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FACTORS AFFECTING EXCHANGERATES Strengthening currency

Purchasing Power Parity (PPP)

Economic growth (economic situation) positive economic growth

Interest rates higher interest rates (sothere is inflow of funds)

Current account (CA) CA surplus

Confidence in the economy moreconfidence, currency will strengthen

Political situation - stable

Speculation speculation in favour of theUSD, the USD will strengthen

Market sentiments infavor of the USD

Others (?) -- SARS outbreak, Iraq war, Balibombing, terrorism, natural calamities


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PURCHASING POWER PARITY:A GUIDE

the theory that the exchange rate will adjust so as to offsetdifferences in countries inflation rates, with the result thatthe same quantity of internationally traded goods can bebought at home as abroad with a given amount of thedomestic currency.

an ER of one currency for another which compares howmuch a typical basket of goods in one country costcompared to that of another country.

The Economist publishes yearly its hamburgerstandard 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 thesame in the US as abroad

comparing actual exchange rates with PPPs signals whethera currency is under-or-over-valued

PPP = local price divided by P in US$


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ALTERNATIVE EXCHANGE

RATE REGIMES Exchange rate regimes (the policy rule

describing how government allowexchange rates to be determined) Fixed exchange rates (governments maintain the

convertibility of their currency at a fixed ER. Acurrency is convertible if the CB will buy or sell asmuch of the currency as people wish to trade atthe fixed ER)

Floating exchange rates (when exchange rates floatfreely, there is no government intervention in theforex market and forex reserves are constant. ER isallowed to find its equilibrium level without central

bank intervention using the forex reserves)


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Fixed exchange rates

Fixed exchange rates are normally usedby 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


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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


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Floating exchange rates

Works only if there is enough trade

in a currency to make a viablemarket

Greater freedom for domestic policymay mean poor economic policy hasfewer immediate consequences

Market rates may move erratically


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Certainty

With fixed rates, international

trade and investments become much

less risky, since profits are not

affected by movements in the

exchange market

Little or no speculation

Automatic correction of monetary

errors if CB allows money supply to

expand, resulting in extra demand &lower interest rates, this leads to BOP

deficitPrevents government from pursuingirresponsible macro policies if thegovernment expands AD to gain

popularity, BOP deficit will force the Gto constrain demand

Makes monetary policy ineffective if interest rates are pegged to

world levels & money supply is

infinitely inelastic, CB cannot

control inflation by controllingmoney supply

Fixed rates contradict the objective

of having free market

Inability to adjust to shocks nomechanism to adjust to sudden BOP

crises

Costly to defend / exit under

disorderly circumstances


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Unstable exchange rateSpeculation

e.g., Asian economic crisis

Uncertainty for business

Lack of discipline in economy govt pursuing irresponsibly

inflationary policies & unions may

drive up prices

Cost push inflationary pressuresAbolition of exchange controls

causes capital flights

Automatic correction ER will

move freely to equilibrium

Insulation from external shock

country is not tied to unacceptablehigh inflation as in fixed ER

Govts free to choose their

domestic policy under fixed ER,

government have to deflateeconomy with high unemployment

No problem of international

liquidity & reserves no CB

intervention in the foreignexchange market, no need to hold

reserves


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Impact of a depreciating USdollar

Pros

Exporters can sellabroad more easily

Less competition

for US firms fromimports

Foreign tourism is

encouraged

Cons Higher prices on

imports

Upwardpressure oninflation

Travel abroadmore expensive


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CRITICAL THINKING

What is BOP? Why should a country

have a positive currentaccount balance?

What happens if the

country experiences acurrent account deficit?


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The Balance of Payments

The balance of payments is a summary

of international transactions betweenone country and others over a periodof time.

This summary records the nature andvalue of inflows and outflows of goods,services and financial assets.

(Some slides refer to the data on the Australian Balance ofPayments)


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The current account

The current account records trade ingoods and services. It consists of

balances on: Merchandise trade (goods: agricultural

products; aircraft; computers)

Services (e.g. tourism, education; medicalcare; banking; insurance; logistics)

Income (e.g. dividends and interest

payments) Transfers (private & government transfers)


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The capital account

The capital account records dollar

payments flows of purchases of foreignassets by Australians (or Americans),and of domestic assets by foreigners.

The assets referred to are investmentassets: bonds, securities, property, shares.

Note that any income flowing from theownership of these assets is recorded

as income in the current account.


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Balance of Payments

Balance of payments accounts

sum to zero Current account deficits

generate asset transfers toforeigners

Official reserves


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Current and capital accountoffset each other

The current and capital accounts

should balance (any difference is ameasurement error).

This is because any deficit on the

current account is financed by asurplus on the capital account.

Foreigners accommodate additionalcurrent expenditure by becominginvestors in the country.


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Are current accountdeficits a bad thing?

Australia (or USA) has

experienced a current accountdeficit (CAD) in every year since1960.

This means Australians (orAmericans) spend more than the

income they generate, soforeigners are accumulatingAustralian assets.


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Are current accountdeficits (CAD) a bad thing?

The CAD is not likely to prove a

problem provided overseas funds areused to finance investment goods thatearn income in the future.

The CAD and capital account surplus(CAS) have allowed Australia toachieve higher rates of economicgrowth than would otherwise havebeen possible.


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U.S. Balance of Payments -

2008 (amounts in billions)


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U.S. Balance of Payments:

1980-2008 (amounts in billions)

o trade deficits can decrease value of dollar

decreasing U.S. purchasing power abroado trade deficits can also decrease employment in

domestic industries but are offset by capital inflows

generating employment in other industries


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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)

W k i USD


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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, overallcurrent account is expected to

improve


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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?

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12&13Econ Gains From Trade Forex 12Jan10 Dist