Disequilibrium Due to Government Regulation

SupplyP

Q

SupplyP

Q

Demand P

Q

Demand P

Q

(A) (B) (C) (D)

Demand Demand Supply Supply

Current Price Current Price Current Price Current Price

Supply Limit

Home Abroad

Home Abroad

Home Abroad

Currrent account = trade balance= net exports

MoneyReal goods and services - imports

Real goods and services - exportsCAPITAL ACCOUNT

Titles to American wealth sold to foreignersUnilateral transfers

Money

Money

Titles to foreign wealth sold to Americans

BALANCE

OF

PAYMENTS

$ in Foreign Exchange Mkt ¥ in Foreign Exchange Mkt

Price of a Dollar Price of Yen

¥/$ $/¥

1

10

100

1000

70 72 74 76 78 80 82 84 86 88 90 92 94 96

Value of the Mexican Peso in $

COUNTRY GDP per Person (1993)U.S. $24,580Canada $18,940Mexico $3,679

Argentina $7,505Brazil $3,528Chile $3,067Cuba $1,959Colombia $1,339

Japan $34,160South Korea $7,368China $1,738Phillipines $791

0

20

40

60

80

100

120

140

160

180

70 72 74 76 78 80 82 84 86 88 90 92 94 96

Unit Labor Costs in Mexico (AER,May 1996

-70

-60

-50

-40

-30

-20

-10

0

70 72 74 76 78 80 82 84 86 88 90 92 94 96

Percentage Change in Value of the Mexican Peso (per $)

-8000

-6000

-4000

-2000

0

2000

4000

6000

70 72 74 76 78 80 82 84 86 88 90 92 94 96

U.S. MerchandiseTrade Balance w/ Mexico

- 8 0 0 0

- 6 0 0 0

- 4 0 0 0

- 2 0 0 0

0

2 0 0 0

4 0 0 0

6 0 0 0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

U.S. MerchandiseTrade Balance w/ Mexico

- 7 0

- 6 0

- 5 0

- 4 0

- 3 0

- 2 0

- 1 0

0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

Percentage Change in Value of the Mexican Peso (per $)

- 8 0 0 0

- 6 0 0 0

- 4 0 0 0

- 2 0 0 0

0

2 0 0 0

4 0 0 0

6 0 0 0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

U.S. MerchandiseTrade Balance w/ Mexico

- 7 0

- 6 0

- 5 0

- 4 0

- 3 0

- 2 0

- 1 0

0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

Cheaper peso means* more imports from Mexico* fewer exports to Mexico==> larger U.S. Trade deficit

- 8 0 0 0

- 6 0 0 0

- 4 0 0 0

- 2 0 0 0

0

2 0 0 0

4 0 0 0

6 0 0 0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

U.S. MerchandiseTrade Balance w/ Mexico

- 7 0

- 6 0

- 5 0

- 4 0

- 3 0

- 2 0

- 1 0

0

7 0 7 2 7 4 7 6 7 8 8 0 8 2 8 4 8 6 8 8 9 0 9 2 9 4 9 6

Percentage Change in Value of the Mexican Peso (per $)

U.S. Surplusesmean Mexicandeficits

Mexican Trade Deficits MUST BE FINANCED with hard currency (U.S. $)

BUT, Greater Demand for U.S. Dollars ($)

MEANS A Higher Value for the U.S. Dollar ($) MEANS

A LOWER VALUE FOR THE PESO

In 1994 the economy is perfectly set up for another devaluationof the Peso

Add the additional fuel of:- An armed insurrection combined with terrorism.- The assasination of the leading presidential candidate.- Political scandals- Kidnappings of prominent businessmen - A fixed nominal exchange rate.- More financial transactions.

Mexico attempted a devaluation of 15% on December 20, 1994

Speculative interests unloading the peso in New York accelerated the decline

0

0.2

0.4

0.6

0.8

1

1.2

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

THE VALUE OF THE YEN ($/yen)

Year

0

0.5

1

1.5

2

2.5

3

75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

THE VALUE OF THE DOLLAR (yen/$)

Year

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

cpi %dPrime

U.S. INFLATION (CPI) & U.S. INTEREST RATES (PRIME RATE)

(% annual change)

Year

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

JapanU.S.

INTEREST RATES (PRIME RATE): U.S. and Japan

(% annual change)

Year

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

U.S.Japan

INFLATION (CPI): U.S. and Japan(% annual change)

Year

0

0.02

0.04

0.06

0.08

0.1

0.12

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

interestinflation

JAPANESE INFLATION (CPI) & INTEREST RATES (PRIME RATE)

(% annual change)

Year

-2

-1

0

1

2

3

4

5

6

7

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

U.S.Japan

REAL INTEREST RATE: U.S. and Japan(% annual change)

Year

-2

-1

0

1

2

3

4

5

6

7

8

76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

Inflation DifInterest Dif.

Difference in U.S. and Japanese Rates (% annual change)

Year

Foreign Price / value of the dollar = U.S. price

1872.55 yen / 220.30 yen = $8.50 1.0 $

U.S. Price * value of the dollar = Foreign price

$8.50 * 400 yen = 3400 yen 1.0 $

Average Profit = Price - Unit cost Price in US $- (Unit cost in Yen/ value of yen)

At 400 yen per dollar$4.50 = $12.00 - (3000 yen / 400 yen per dollar)

At 400 yen per dollar$2.00 = $12.00 - (3000 yen / 300 yen per dollar)

At 400 yen per dollar-$3.00 = $12.00 - (3000 yen / 200 yen per dollar)

Alternative Sources of Telephones: 1981

ROW SOURCE U.S. CANADA JAPAN S. KOREA

1 Price $8.50 C$9.60 Y1806.46 W5888.40

2 Exchange Rate (per $) - 1.20 220.30 701

3 Price (in $) $8.50 $8.00 $8.20 $8.40

4 Cheapest AlternativeSource (in $) $8.00 $8.20 $8.00 $8.00

5 Opportunity Loss(in $) $.50 -$.20 $.20 $.40

SOURCING COSTS REFLECTING CHANGES IN EXCHANGE RATES (per phone)

YEAR U.S. (1)

CANADA (2)

JAPAN (3)

S. KOREA (4)

SAVINGS (5)

1981 $8.50 $8.00 $8.20 $8.40 $.00

1982 $8.50 $7.78 $7.28 $7.86 $.22

1983 $8.50 $7.78 $7.61 $7.40 $.60

Savings From Three Types of Flexibility:I. Opportunity saving buying from Canada instead of the U.S.= 300,000 phones * ($8.50-$8.00 per phone)=$150,000

II. Opportunity saving from one year rather than three year contracts(which allows swithcing to lowest cost producere each year)= 100,000 phones in 1982 * ($8.00-$7.28) + 100,000 phones in 1983 * ($8.00-$7.40) =$132,000

III. Opportunity saving from storing (buying from Japan in 1982 to meet 1983 needs, even after $.07 costs of inventories)=100,000 phones in 1982 * ($7.40-$7.28+.07)=$5,000

TOTAL OPPORTUNITY SAVING = $287,000

INTEREST AND EXCHANGE RATE CHANGESStart: Japanese invest 1000 yen in 1985 at 215.9 yen per dollar with a gauranteed interest rate of 7.97%.

End: Japanese liquidate their investment at 178.55 yen in 1986

Calculation of gain:

1000 yen * 1 *1.0797 * 178.55 = 892.92 yen 215.9

Opportunity loss: Could have earned 1064.7 yen by investing at home.

SAVINGS THROUGH DIVERSIFICATION

YEAR Average Price (1)

Average Saving(2)= $8.50 - (1)

Total Saving over100,000 Phones(3) = (2)*100,000

1981 $8.275 $.225 $22,500

1982 $7.855 $.645 $64,500

1983 $7.8225 $.6775 $67,750

TotalSavings

$154,750

00.77 1.05

3.4 3.75 3.98 4.45 4.565.5

6.02

7.48.26

0

-1.95-3.05

-4-4.6 -5.05 -5.4

-6.37

-7.75

-12.05-12.7

-13.75

-15

-10

-5

0

5

10

Nov\4 Dec\1 \2 \3 \4 Jan\1 \2 \3 \4 \5 Feb\1 \2

SPOT AND FUTURES MARKET PRICES FOR OIL: 1975-76

19761975