The Open Economy & Exchange rates

Pure theory of trade 1. Absolute advantage: A country is said to

have an absolute advantage in the production of a good when it is more efficient in the production of that good

Assume each country has equal amounts of resources and devotes half to X and half to Y x y

Country A 20 100

Country B 10 150

Country A has an absolute advantage in the production of X and country B in production of Y.

2. COMPARATIVE ADVANTAGE :Two countries can trade with each other if each specializes in the industry in which it has the lowest opportunity costs. x y

Country A 20 200

Country B 10 150

Country A has a comparative advantage in the production of X and B in the production of Y

Specialization leads to increased total production

A 30 100

B 0 300

Total 30 400

A 35 50

B 0 300

Total 35 350

Instruments of trade policy

o Tariffs: o specific tariffs are a fixed charge for

each unit of good producedo Ad valorem: are levied as a fraction

of the value of the imported goodso Quotaso Export subsidies

Effects of alternative trade policies:

tariffs Exp.sub

quota VER

Producers’ surplus

Rises Rises Rises Rises

Consumer surplus

falls Falls Falls Falls

Govt rev

Rises Falls No change

No change

Total welfare

Falls falls Falls No change

Adjustable peg- where exchange rates are fixed for a period of time but may change

Devaluation: where the Govt re-pegs the exchange rate at a lower level.

Revaluation – re-pegs at a higher level.

Dirty floating- a system where govt intervenes to prevent excessive fluctuations or even to achieve an unofficial target rate

Exchange Rates

Defining Exchange Rate Measuring Exchange Rate

Movements Appreciation/Depreciation of a

currency Exchange Rate Equilibrium Factors that influence Exchange

Rate Movements

Meaning of Exchange Rate and Measuring Changes in Exchange Rates

Value of one currency in units of another currency

A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation.

If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated

If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

Appreciation/Depreciation Percentage change in value US $New Value of Foreign Currency per unit of $ - Old value of foreign currency per $

-------------------------------------------------- X 100

Old value of Foreign Currency per $

Percentage change in value of Foreign Currency

New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency

-------------------------------------------------- X 100

Old value of $ per unit of Foreign Currency

Exchange Rate Equilibrium Forces of Demand and Supply Demand for foreign currency negatively

related to the price of foreign currency Supply of foreign currency positively

related to the price of foreign currency Forces of demand and supply together

determine the exchange rate

Demand for Foreign Currency

Price for Foreign Currency

Units of Foreign Currency (£)

$1.50

$2.00

D

D

50m 75 m

Demand for pounds: 1.The firms, households and govt

who import UK goods 2. US citizens travelling to UK 3. Holders of $ who want to invest

in UK stocks and shares 4. US companies wanting to invest

in UK 5. Speculators anticipating a fall in

dollar price

Supply of Foreign Currency price of foreign currency

Units of Foreign Currency (£)

$1.50

$2.00

50 m 75 m

S

S

Supply of pounds: 1. Importers of US goods into UK 2. UK citizens travelling to US. 3. Holders of pounds who want to

buy financial instruments into US 4. UK companies wanting to invest

in US 5. Speculators anticipating a rise in

the value of dollars.

Equilibrium Exchange Rate Exchange Rate

Units of ForeignCurrency(£)

S

SD

D

$1.6775

Factors that influence the Exchange Rate

Relative Inflation Rates Relative Interest Rates Relative Income Levels Expectations of the Market Political Events Exchange rate is the results of an

interaction of these factors

Relative Inflation High inflation relative to a foreign country,

decline in value of currency Low inflation relative to a foreign country,

increase in value of currency If inflation rates in one country are higher,

there is an increased demand for imported goods and decrease in exports. This increases the demand for foreign currency and reduces demand for local currency – leading to depreciation

Relative Interest Rates High interest rates in home country relative to

a foreign country may cause domestic currency to appreciate

If US Interest rates fall then outflow of dollars leading to increase in demand for pounds and British citizens will not invest in US leading to a fall in supply of pounds. This causes dollar to depreciate

An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign

Relative Income Levels Increase in domestic income relative to

foreign income may lead to a decline in the value of domestic currency– Why?

Imports are a function of income . Hence increasing incomes lead to increase in imports and hence increase in demand for foreign currency. This causes domestic currency to depreciate

Market Expectations Expectations about future exchange rate

changes on the basis of current and future political and economic conditions

1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 – 2001 Weak Dollar today 2005 onwards 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies

Political Events

Fall of Berlin Wall and unification of East and West Germany

Rumors about resignation of Mikhail Gorbachov

Tiananmen Square Persian Gulf War September 11, 2001

Fixed vs flexible exchange rates: Advantages of flexible exchange rates:

Better adjustment mechanism Better confidence No need for central banks to hold money Gains from freer trade Increases independence of policy

Disadvantages: Uncertainty and diminished trade Instability speculation

Fixed exchange rate is maintained by Use of reserves Trade policies Exchange control Domestic macro-adjustments Raising interest rates

Advantages of fixed exchange rates Certainty No speculation Automatic correction of monetary errors Prevents irresponsible macro policies

Disadvantages: Makes monetary policy ineffective

Imbalance persists BOP deficit may hurt the economy Problems of international liquidity

Surplus or a Deficit in the BOP: A deficit in the BOP can have 2

consequences: The country can borrow from

abroad. It may sell its assets To rectify a deficit:

Devaluation/depreciation Import restrictions Domestic deflation to reduce aggregate

demand

Impact of a Devaluation: Increase in exports depends on

Price elasticity of demand for the exportables

Price elasticity of supply in the domestic market

Decrease in imports depend on Price elasticity of demand for imports May result in cost push inflation and

hence a rise in price if exports as well.

J curve: A depreciation leads to at first a

deterioration of the trade balance and then an improvement

Marshall Lerner condition: The sum of proportional change in exports plus the proportional change in imports minus the percentage change in depreciation must be positive

Balance of Payments A record of international transactions

between residents of one country and the rest of the world

International transactions include exchanges of goods, services or assets

“Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations

Double-entry Accounting in the BOP

All transactions are either debit or credit transactions

Credit transactions result in receipt of payment from foreigners Merchandise exports (valued f.o.b.) Transportation and travel receipts Income received from investments

abroad Gifts received from foreign residents Aid received from foreign governments

Double-entry Accounting (Cont’d)

Debit transactions involve payments to foreigners Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government

Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.

Balance of payments: A. Current Account:

Balance of Trade in goods Balance of Trade in services- travel,

insurance and transportation. Balance of trade in goods and services Other income flows

Investment income Transfers, balance( aid, remittances) GNIE

B. Capital Account: 1.Foreign investment FDI and FII 2.Loans and commercial borrowings 3. Banking capital – assets, liabilities and non

resident deposits. 4.Rupee debt service 5. others. Capital account = 1+2+3+4+5

C. Errors and omissionsD. Overall balancesE. Monetary movements- IMF / foreign

exchange reservesbalance in current account + balance in

capital account + monetary movts =0

Real exchange rates:

Relative prices of two currencies after adjusting for changes in domestic prices

RER of $ per pound: = ($/£)(PUK/PUS)

If exchange rate = 3$ per £ RER = 1 if prices in UK and US are 30

and 90 respectively.