CFA Level 1 - Global Economic Analysis

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5.1 - IntroductionNow that we have discussed everything you need to know regarding micro and macroeconomics, let's broaden the scope to also include international trade, foreign exchange and the balance of payments.

Understanding how one country's economy and government reacts with other countries' economic activity is important because it helps analysts to determine the strength of economies around the world, as well as exchange rate movement.

TRADING WITH THE WORLDA nation can gain from international trade when:

Its relative costs of producing various goods differ from other nations It specializes in producing goods in which the nation is relatively efficient at producing and uses the

proceeds from its output to produce goods for which it is relatively inefficient.

Note that these costs are relative to a country's opportunity costs. A country could have an absolute advantage in producing (able to produce more) over another country for all goods and still benefit from trade. How nations trade is determined by their comparative advantages.

Benefits of trade include:

Better Quality of Goods - Domestic producers are forced to maintain and/or improve quality due to competition from foreign producers.

Lower Prices Due to Economies of Scale - Because producers have larger potential markets due to international trade, they can sometimes achieve lower per-unit costs with large-scale production. Consumers benefit by being able to purchase the lower-priced goods. Manufacturers often benefit by being able to purchase parts at lower costs.

Better Institutions and Government Policies - Global trade gives government policymakers incentive to create constructive economic policy. A failure to do so, however, will cause capital and labor to flow elsewhere

5.2 - Production Possibility CurvesTo illustrate the benefits of trade, we should look at the production possibility curves for two nations, Great Britain and the U.S. The production possibility curve (or production possibility frontier) shows the maximum possible output of an economy. To simplify things, we will assume that only two goods are produced – wheat and steel.

Figure 5.1: Production Possibility Curves

According to the production possibilities curve shown in the above graphs, the U.S. could produce 50 units of wheat per worker, if it devoted all of its resources to wheat production, and zero units of steel. If all resources were devoted to producing steel, then the U.S. would have 50 units of steel per worker and no wheat. If Great Britain devotes all of its resources to making wheat, it can produce 20 units of wheat, with no steel being produced. If that country concentrates all of its resources on producing steel, then 40 units of steel would be produced per worker, with no wheat production. Please note that the U.S. has an absolute advantage over Great Britain with both products because the U.S. workers are more productive than those from Great Britain. However, this is not important from an international trade perspective.

The domestic exchange rate within the U.S. for the two goods is 1:1; for each unit of steel produced, the U.S. must give up producing one unit of wheat. We could say that the cost of one unit of steel within the U.S., assuming no international trade, would be one unit of wheat. Similarly, the cost of one unit of wheat would be the loss of one unit of steel.

Great Britain would have a different domestic exchange rate. Its production possibility curve implies that the cost of one unit of steel would be one-half of a unit of wheat. The cost of one unit of wheat would be two units of steel. These costs can be obtained by looking at the slope of the production possibility curve.

If the U.S. and Great Britain both operated as autarkies (self-sufficient nations that do not trade), then each country would operate somewhere on their production possibilities curve. The exact point of production would depend on each country's supply and demand for the goods. For example, these points could be 35 units of wheat and 15 units of steel for the U.S., and 10 units of wheat and 20 units of steel for Great Britain, as illustrated in Figure 5.1.

5.3 - Trade Efficiency RuleA general rule of efficiency is that an individual or group should specialize in production activities in which it can operate more efficiently than other entities. This principle is referred to as comparative advantage when discussing international trade theory; it states that the worldwide production output is maximized when each country concentrates on producing goods for which it has lower opportunity costs.

In Figure 5.1, the U.S. is the low-cost producer for wheat, as it only gives up one unit of steel when it produces one unit of wheat. Great Britain is the high-cost producer for wheat, as it must give up two units of steel for each unit of wheat produced. However, Great Britain is the low cost producer for steel, as it gives up only one-half of a unit of wheat for each unit of steel produced. Therefore, the U.S. has a comparative advantage in producing wheat, while Great Britain has a comparative advantage in producing steel. According to the trade efficiency rule, the world will be better off if Great Britain specializes in steel production and the U.S. specializes in wheat production.

An easy way to determine which country has the comparative advantage is to compare the slopes of the production possibility curves. Suppose you have production possibility curves for two countries with product Y and X, and product Y is placed on the y-axis. The country with the most negative slope for product Y will have

the comparative advantage with product Y.

Suppose each country specialized in producing the good for which it had a comparative advantage. The U.S. would produce 50 units of wheat per worker and Great Britain would produce 40 units of steel per worker. The combined world output would be 50 units of wheat and 40 units of steel. With no trade, the combined wheat output is 45 units and the combined steel output is 35 units. Clearly the two countries can benefit from trading with one another – the quantity of wheat produced goes up by five units and the quantity of steel produced goes up by five units. Trading offers more efficient production possibilities.

5.4 - Terms of TradeThe next question to determine is what the terms of trade would be. Clearly the U.S. will not accept less than one unit of steel per unit of wheat, as that is the cost if no trade occurs. Also, we know that Great Britain will not accept less than one-half of a unit of wheat for its steel, as that is the cost tradeoff without trade.

The actual terms of trade would need to lie somewhere in between these limits. Suppose Great Britain offered five units of wheat for each five units of U.S. steel. The U.S. would not accept such an offer for its steel production because five units of steel could be traded for five units of wheat internally.

The actual terms of trade will depend on overall world and supply conditions, within the limits just mentioned. However, trade will not occur unless the trade is mutually beneficial.

Suppose the terms of trade settle at 1.5 units of steel per unit of wheat. We can graph a trading possibilities curve and relate that curve to the original production possibilities curve.

Figure 5.2: Trading Possibilities Curve

The slope of the trading possibilities curve will be -1.5 for each country. The original production possibilities curve is shifted to the trading possibilities curve by specializing in the production of the good for which each country has a comparative advantage and by then engaging in international trade. As the possible amount of consumption increases for both countries, they will each enjoy a higher standard of living.

Recall that we assume that without trade, the U.S. will consume 35 units of wheat and 15 units of steel for the U.S and that Great Britain will consume ten units of wheat and 20 units of steel. These points are

shown as Point A in both of the graphs above. With the trading possibilities at -1.5, the U.S. could specialize in wheat production and then trade 12 units of wheat for 18 units of steel. The country would then end up with 18 units of steel, and keep 38 units of its own wheat production. This point is described as Point B in the U.S. graph above. Great Britain could benefit in a similar manner.

Note that the above analysis assumes that relative production costs are constant, which allows for straight lines to be used as a production possibilities curve. In reality, as more and more of a good is produced, relative production costs increase because less efficient resources will be used as production increases. As a result, we expect that production possibility curves will be curved lines. Therefore, specialization will not be an all-or-nothing type of situation. Even if the U.S. is a relatively inefficient producer of steel, some steel production will still occur in the United States. Similarly, while Great Britain will mostly be producing steel, some wheat production will still occur in Great Britain.

Domestic producers of goods that are produced relatively cheaply will be able to get higher prices in the world market. Suppose the U.S. is a relatively efficient producer of wheat. In the Figure 5.3 below, the quantity demanded and the quantity supplied would be equal at domestic price Pdw. However, U.S. wheat producers would prefer to export their goods at the world price Pww. By doing so, they will achieve higher profits. Consumers will lose out because they will have to pay higher world prices.

Figure 5.3: Effects of International Trade on Domestic Supply and Demand

However, for goods produced relatively inefficiently by the U.S., consumers will benefit by paying lower prices. Using shirts as an example, we can see that without international trade, consumers would pay price Pds for shirts. By allowing imports, consumers can pay the lower price Pws. Producers are hurt because they will have to take the lower world price.

Figure 5.4: Effects of International Trade on Domestic Supply and Demand

5.5 - Tariffs and Quotas

TariffsTariffs are taxes imposed on imported goods; they will increase the price of the good in the domestic market. Domestic producers benefit because they receive higher prices. The government benefits by collecting tax revenues. In the graph below, S0 and D0 represent the original supply and demand curves which intersect at (P0, Q0). St  shows what the supply curve is with the introduction of the tariff. The market then clears at (Pt, Qt). Less of the good is produced, and consumers pay higher prices.

Figure 5.5: Effect of a Tariff on a Supply Curve

QuotasQuotas are numerical limits imposed on imported goods. Consumers are harmed by quotas, while domestic and foreign producers benefit by receiving higher prices. In the graph below, the market initially clears at P0, Q0. The supply curve Sd+i0 represents the quantity supplied by both domestic and foreign producers before the imposition of the quota. D0 is the domestic demand curve. After the quota, the supply curve looks like Sd+i1. Both foreign and domestic producers receive higher prices while consumers lose out.

Figure 5.6: Effect of Quotas on the Supply Curve

Voluntary Export Restraints (VERs)These restraints limit the quantity of goods that can be exported from the country to one or more of its trading partners. They are usually "voluntarily" negotiated so that quotas or tariffs are not imposed.

Exchange Rate ControlsExchange rate controls set the exchange rate of a nation's currency above the market rate. This makes the nation's exports artificially expensive, which reduces the quantities of the nation's goods that foreigners are

willing to buy. This means that the country's citizens have little foreign currency available to buy imported goods. With exchange rate controls, black markets usually exist where currency exchange occurs at a market rate. Exchange rate controls are declining in popularity, although some developing nations still use them.

"Hidden" MethodsHidden methods of limiting imports include special regulations and licensing requirements that restrict imports. For instance, the Japanese government imposes special quality requirements on food to restrict food imports and protect Japanese farmers.

5.6 - Trade RestrictionsAdvantages and DisadvantagesTrade barriers reduce the possible quantity of goods that can be consumed and produced within an economy. Prices will be higher, and there will be fewer choices with regards to consumer goods.

Beneficiaries of a tariff include the government, which collects the tariff, and domestic producers within the affected industry (or industries). The general public (consumers) loses.

Arguments in favor of trade restrictions include: National Defense - Foreign producers should not be relied upon for production of defense goods, even

if the goods can be produced at a lower cost abroad.

Infant Industries - Start-up industries in a country may not be able to effectively compete against foreign producers because of their small size. An argument can be made that these industries should be protected until suitable economies of scale can be achieved. If the economies of scale are such that the domestic industry achieves a comparative advantage over foreign companies, the temporary protection will help to achieve better economic efficiency

Anti-Dumping - The claim is often made that foreign producers "dump" their goods on the domestic market. The term dumping is applied when foreign producers are thought to be selling goods at prices below their production costs, or below the prices charged in their home market. Retaliatory measures may include the imposition of tariffs, quotas or fines against foreign producers. The fear is that this "unfair" practice will drive domestic producers out of business and that the foreign producers will then impose monopoly pricing. One argument against this fear is that when prices are raised at a later time, domestic producers can reenter the market. Deliberately driving other producers out by selling at a loss usually does not work. Another argument against "anti-dumping" is that the country as a whole benefits when foreign-made goods are sold at lower prices than domestic ones. The reasons for which the prices are lower should not be a primary concern.

Nations often adopt trade restrictions due to: 

Short-Sightedness - In the short-run, the imposition of a tariff may help to preserve jobs in the relevant domestic industry. The effort to avoid unemployment in the affected industry also makes for good politics. However, in the long-run, those workers will find other jobs and the economy will be operating at full employment in a more efficient manner.

Special Interests – Special interests can use their powers to put trade restrictions in place. Although free trade benefits the general public, it does not necessarily benefit all groups within the economy. Management and workers in an industry impacted by foreign goods will not willingly go through dislocation and adjustments (such as retraining) that may be necessitated by foreign competition

Economic Ignorance - Ignorance also contributes to the creation of trade restrictions. Most members of the general public are not aware of the harm created by trade restrictions.

Visibility - The benefits of trade restrictions are large and highly visible for small, select groups of people. The benefits of free trade are dispersed across the general population and are, therefore, harder to see. It is easy to note jobs lost to foreign competition; it is not easy to see that those displaced labor resources will be reallocated to more efficient jobs.

5.7 - International Finance

Law of Demand for Foreign ExchangeThe law of demand for foreign exchange states that, all other factors remaining equal, the quantity demanded of a particular currency will decrease (increase) as the exchange rate goes higher (lower). Demand for a country's currency is derived from the goods or services produced by that country. The purchase of a Japanese car by an American consumer will necessitate the conversion of dollars to Japanese yen. As the exchange rate rises (in terms of Japanese yen), Japanese cars will become more expensive to American consumers, who will in turn buy fewer Japanese cars. The lower demand for Japanese cars will lead to a decreased demand for the yen. If the exchange rate for the yen vs. the dollar goes down, Japanese goods will be cheaper for American consumers. As a result, more Japanese goods will be purchased and more dollars will be exchanged for yen.

Law of Supply for Foreign ExchangeThe law of supply for foreign exchange states that, all other factors remaining equal, the supplied quantity of a particular currency will increase (decrease) as the exchange rate goes higher (lower). U.S. citizens supply U.S. dollars to the foreign currency market when they buy foreign goods or services, or when they purchase foreign assets such as real estate or stocks. As the exchange rate increases (e.g. the price of a U.S. dollar in terms of Japanese yen goes from 100 yen per dollar to 110 yen per dollar), more U.S. dollars will be supplied as U.S. citizens get more value for their "buck".

Factors Affecting the Quantity of Demand and Supply for CurrencyThere are two main factors that affect the quantities demanded and supplied for a particular currency:

·Relative interest rates·Expectations concerning future exchange rates

If, for example, interest rates in the United States are higher than those of other countries, foreigners will want to convert their currencies to dollars in order to earn a higher rate of return. Their actions will cause a reduction in the supply of dollars.

Expectations about future exchange rates will also impact current quantities demanded and supplied for currencies. For example, suppose the current exchange rate for euros and dollars is $1.20 per euro and an importer of European goods expects the euro to depreciate next month to $1.1 per euro. That importer will hold off on converting dollars to euros thereby decreasing the current quantity demanded for euros and the quantity supplied for dollars.

How is the Exchange Rate Influenced by Supply and DemandIf the demand for a currency increases (decreases) while the supply remains the same, the exchange rate will rise (decline) to achieve market equilibrium. If the supply of a currency increases (decreases) while demand remains the same, the exchange rate will decline (rise). Exchange rates can be volatile because supply and demand are affected by common factors, such as interest rate differentials and expectations.

5.8 - Purchasing Power Parity and Interest Rate ParityPurchasing Power Parity

Purchasing power parity expresses the idea that a bundle of goods in one country should cost the same in another country after exchange rates are taken into account. Suppose that with existing relative prices and exchange rates, a basket of goods can be purchased for fewer U.S. dollars in Canada than in the United States. We would then expect U.S. consumers to buy those goods in Canada. Even if this is not possible from a transportation or cost viewpoint, some businesses will have an incentive to buy the goods cheaply in Canada and remarket them in the United States. Such actions would cause U.S. dollars to be sold in exchange for Canadian dollars. As a result, the U.S. dollar would depreciate in relation to the Canadian dollar. We would expect the currency depreciation to continue until the bundle of goods costs the same in both countries.

Interest Rate ParityInterest rate parity has to do with the idea that money should (after adjusting for risk) earn an equal rate of return. Suppose that an investor can earn 6% interest with a dollar deposit in a United States bank, or can earn 4% interest with a British pound deposit in a London bank. The investor can earn greater interest income by keeping funds in dollars and, therefore, one might expect all of his investment funds to flow to U.S. banks. However, exchange rate expectations also come into play. Suppose the investor expects the British pound to appreciate at the rate of 2% in terms of the dollar. That investor would then be indifferent to either investment choice, as both are expected to earn 6%.

Why Central Banks Intervene in the MarketSuppose the United States Federal Reserve is interested in the dollar to euro exchange rate. It can directly influence that exchange rate by buying or selling euros with U.S. dollars. If the Fed buys euros with dollars, it will increase the supply of dollars and decrease the supply of euros. This action tends to cause the U.S. dollar to depreciate in relation to the euro.

A central bank will intervene in the foreign exchange market because it wishes to reduce volatility, and/or it has a specific target exchange rate. Suppose the Fed wants the euro and dollar to trade 1:1, with an allowable range of 2% in either direction. If the exchange rate rose to above 1.02 euros per dollar, the Fed would sell dollars; if the exchange rate fell below .98 euros per dollar, it would buy dollars.

5.9 - Foreign Exchange

Direct and Indirect Methods of Foreign Exchange QuotationsWith the direct method of foreign exchange quotation, the exchange rate is expressed as the number of units of the domestic currency needed to acquire one (1.0) unit of the pertinent foreign currency. Within the U.S., this method is also referred to as quoting exchange rates in American (U.S.) terms.

With the indirect method of foreign exchange quotation, the exchange rate is expressed as the number of units of the pertinent foreign currency needed to acquire one (1.0) unit of the domestic currency. In the U.S., this method is referred to as quoting the exchange rate in foreign terms.

Look Out!

Memorize these definitions! Note that the two methods are reciprocals of one another.

Example: Currency ConversionSuppose you are given the direct quote, in U.S. terms, between the U.S. dollar and the euro as:

¬1.00 = $1.2830

The indirect quote between the U.S. dollar and the euro would then be calculated as the reciprocal (1 / 1.2830), and we get the following indirect quote for the U.S. dollar:

$0.7794 = ¬1.00

Suppose you have the following indirect foreign exchange quote for the Japanese yen and U.S. dollar, from a Japanese perspective:

¥109.38 = $1.00

The direct exchange quote for the Japanese yen to U.S. dollar, from a Japanese perspective, will be the reciprocal of (1 / 109.38), and we then get:

$0.009142 = ¥1.00

5.10 - Spread CalculationsCalculating Spread on a Foreign Currency QuoteProfits for currency market dealers are derived from the difference between the bid, which is the exchange rate at which a dealer is willing to purchase a particular currency, and the ask, which is the exchange rate for which a dealer is willing to sell a particular currency.

The difference between the two is called the bid-ask spread. Foreign currency dealers will quote both a bid and an ask for a particular currency. The average of the bid and ask (ask plus bid divided by two) is referred to as the midpoint price. The bid-ask spread is usually given as a percentage and it is calculated as:

Formula 5.1

                       100 × (Ask Price – Bid Price)% Spread=                  Ask Price

Example: Bid-Ask SpreadSuppose that a dealer provides the following quote in the U.S. for euros to      dollars:

                               Bid                Ask

Direct ($/¬)         $0.8038         $0.8041

Answer:Then the bid-ask spread will be 100 × (0.8041 – 0.8038) / 0.8041 =     0.0373%, which is about 4 bps.

Factors Influencing the Size of SpreadsFactors that affect the size of spreads for spot or forward currency exchange rates include: 

Trading Volume - The higher the volume, or the more active a market, the lower the bid-ask spread. Currency Rate Volatility - With higher volatility, currency dealers are exposed to higher risk. Spreads

will increase with higher volatility. Perceived Economic/Political Risks - Risks such as political instability, higher inflation and changing

economic conditions will affect the spreads associated with a particular currency. The higher the uncertainty, the greater the expected spread.

Note that if a dealer has an overly large position in a currency relative to the desired net position, the dealer will alter the midpoint of the spread rather than adjust the spread. For instance, a dealer with a shortage of a particular currency will move the midpoint of the direct quote up. Competition is also an important factor for spreads. A dealer with an overly large spread will not be making trades.

5.11 - Spot Market CalculationsCalculating Currency Cross Rates When Given Two Spot Exchange Quotes Involving Three CurrenciesA currency dealer located in a particular country will usually provide a set of exchange rate quotations between the country's currency and various foreign currencies. The cross-rate between two currencies not explicitly quoted is obtained by getting quotes for each currency in terms of the exchange rate with a third nation's currency. Suppose you are told that the exchange rate of the U.S. dollar per euro is 1.2440 and that the exchange rate for U.S. dollar per British pound is 1.8146. The euro-to-pound cross rate can be calculated as the euro-to-dollar rate multiplied by the dollar-to-pound rate, which is equal to (1/1.2440) × 1.8146 = 1.4587, or ¬1.4587 per British pound. Note that this result is an indirect quote from the viewpoint of a British entity, or a direct quote from the viewpoint of a business whose domestic currency is the euro.

In general, in calculating cross-rates, bid and ask prices will need to be dealt with.

This makes the calculation only slightly more difficult. The following equations should be kept in mind:

Formula 5.2

(FCa / FCb)ask = (FCa / DC)ask ×(DC/FCb)ask

(FCa / FCb)bid   = (FCa / DC)bid  ×(DC/FCb)bid

Where FCa and FCb are the two foreign currencies and DC is the domestic currency.

Similar equations are used when calculating FCb to FCa exchange rates.

Example: Currency Cross Rates and Ask QuotationsVerifications can be made by checking that (FCb/FCa)ask is equal to the reciprocal of (FCa/FCb)bid, and by checking that (FCb/FCa)bid is equal to the  reciprocal of (FCa/FCb)ask.

Suppose you are given the following bid/ask quotations for two foreign currencies against the domestic currency, the U.S. dollar:

                        Bid                      Asked¬ / $             0.9002                    0.9023¥ / $             109.38                    109.40

We want to calculate what the ¥ / ¬ bid and ask quotations will be.

Answer:The ¥ / ¬ bid price will be the number of yen the dealer is willing to pay in order to buy one euro. This transaction would be the equivalent of selling yen to purchase dollars (at the bid rate of 109.38), and simultaneously reselling the dollars to purchase euros (at the ask rate of 0.9023). The bid ¥ / ¬ would be calculated as 109.38/0.9023 = 121.22.

The ¥ / ¬ ask price would be the number of yen the dealer wants to receive in exchange for selling one euro. This transaction would be the equivalent of buying yen with dollars (at the 109.40 ask rate) and at the same time buying those dollars with euros, at the 0.9002 bid rate. The transaction could be expressed mathematically as:

Ask ¥ / ¬ = 109.40 / 0.9002 = 121.53

So the resulting dealer quotation would be:

¥ / ¬ = 121.22 – 121.53

Exam Tip!

You can count on getting questions like these on the exam, so make sure that you are comfortable with these types of questions.

Spot vs Forward Markets Within Foreign ExchangeThere are two types of markets for setting currency exchange rates:

1. The Spot Currency Exchange Market – This market involves trades of currencies for immediate delivery. Settlement usually occurs two days after the trade date. Participants in this market want to convert to the other currency relatively quickly. Transactions in the spot market are often used for investments, or to settle commercial purchases of goods. 

2. The Forward Currency Exchange Market – This market involves contracts for currency exchange in which settlement will take place more than two days after the trade date. While settlement dates are negotiable, standard foreign currency forward contracts usually settle 30, 90 or 180 days after the trade date. If a dealer quotes the 90-day ¥ / $ exchange rate at 109.80-109.83, that means the dealer is willing to commit today to buying dollars for 109.80 yen in 90 days, or to selling dollars at 109.83 yen per dollar 90 days from today.

5.12 - Forward Market CalculationsSpreads on Forward Currency QuotationsThe spread on a forward currency quotation is calculated in the same manner as the spread for a spot currency quotation.

The reasons that spreads vary with forward foreign currency quotations are similar to the reasons for the variability of spreads with spot foreign currency quotations. The unique factor associated with spreads for forward foreign currency quotations is that spreads will widen as the length of time until settlement increases. Currency exchange rates would be expected to have a higher range of fluctuations over longer periods of time, which increases dealer risk. Also, as time increases, fewer dealers are willing to provide quotes, which will also tend to increase the spread.

Calculating a Forward Discount or Premium, Expressed as an Annualized Rate.Forward currency exchange rates often differ from the spot exchange rate. If the forward exchange rate for a currency is higher than the spot rate, there is a premium on that currency. A discount exists when the forward exchange rate is lower than the spot rate. A negative premium is equivalent to a discount.

Example: Forward Discount PremiumIf the ninety day ¥ / $ forward exchange rate is 109.50 and the spot rate is ¥ / $ = 109.38, then the dollar is considered to be "strong" relative to the yen, as the dollar's forward value exceeds the spot value. The dollar has a premium of 0.12 yen per dollar. The yen would trade at a discount because its forward value in terms of dollars is less than its spot rate.

The annualized rate can be calculated by using the following formula: Formula 5.3

Annualized    =         Forward Price – Spot Price   x             12                 x 100%Forward Premium                Spot Price                   # of months                                                                                  forward

Answer:

So in the case listed above, the premium would be calculated as:

Annualized forward premium=

((109.50 – 109.38 ÷ 109.38) × (12 ÷ 3) × 100% = 0.44%

Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward and spot rates for the Japanese yen in terms of dollars per yen. Those numbers would be (1/109.50 = 0.0091324) and (1/109.38 = 0.0091424), respectively.

So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be: ((0.0091324 – 0.0091424) ÷ 0.0091424) × (12 ÷ 3) × 100% = -0.44%

5.13 - Interest ApplicationsInterest Rate ParityInterest rate parity enforces an essential link between spot exchange currency rates, forward currency exchange rates and short-term interest. It specifies a relationship that must exist between the spot interest rates of two different currencies if no arbitrage opportunities are to exist. The relationship depends on the spot and forward exchange rates between the two currencies.

The following example illustrates what interest rate parity is and why it must exist.

Example:Assume the following data for the euro (¬) and the U.S. dollar ($):

One-year forward exchange rate              ¬/$     = 0.909

Spot exchange rate                                  ¬/$     = 0.901

One-year interest rate, euro                                   7%

One-year interest rate, dollar                                 5%

A speculator could borrow dollars at 5%, convert them into euros and invest    the euros at 7%. The speculator would be making a profit of 2%.

However, at the end of the time period, euros will need to be converted to dollars so that the initial borrowing can be repaid. The speculator runs the risk that dollars may have depreciated relative to the euro during that time period.

The speculator's position can potentially be made into a risk-free one by purchasing a forward exchange contract so that the exchange rate used to convert euros back to dollars is a known one.

Over one year, the speculator would experience the following exchange rate loss:(0.901 – 0.909) ÷ 0.901 = -0.9%

Because of the 2% interest rate differential, the speculator makes a net profit of 1.1% for each dollar borrowed. This is a certain gain, as all exchange and interest rates were fixed and known at the beginning of the trade, and no capital had to be invested in the position either!

If such rates existed in the real world, enormous swaps of capital would be made to take advantage of such a risk-free arbitrage. To prevent this from occurring, the forward discount rate would have to equal the difference in interest rates. Note that if the discount forward rate is greater than the interest rate differential, the arbitrage will be made in the other direction.

The actual mathematical relationship is slightly more complicated than what was specified above because a perfect arbitrage would require that the forward contract cover both the initial principal borrowed plus the accrued interest. For the rates discussed above, the speculator would actually need to hedge, for every dollar borrowed, 0.901 (1.07) = 0.964.

The interest rate parity relationship between two currencies can be expressed (using indirect quotes) as: Formula 5.4(Forward rate – Spot rate) ÷ Spot rate = (rfc – rdc) ÷ (1 + rdc),or (F – S) ÷ S= (rfc – rdc) ÷ (1 + rdc)

Where rdc is the risk-free interest rate of the domestic currency, rfc is the risk-free interest rate of the foreign currency and the exchange rates quoted are indirect quotes expressed as the number of units of the foreign currency used to obtain one unit of the domestic currency.

The interest rate parity relationship can also be expressed as: F × (1+ rdc) = S × (1 + rfc)

Look Out!

Note that currencies trading at a premium are associated with lower interest rates. Weak currencies must have high risk-free interest rates to compensate for expected depreciation.

5.14 - Foreign Exchange Parity Relations

How Exchange Rates are DeterminedWith a flexible or floating exchange rate system, the value of a currency, as related to other currencies, is determined by the market forces of supply and demand. Suppose that the current exchange rate between the U.S. dollar and British pound is $1.50 = 1 British pound and that Americans then increase their purchases of British goods, while the purchase of U.S. goods by the British stays the same.

We would then expect that at that exchange rate, more U.S. dollars are available than are demanded. The exchange rate of the U.S. dollar would be expected to go down until a new equilibrium is achieved. Shifts in supply and demand for a nation's currency will cause the nation's currency to appreciate or depreciate.

One advantage of a floating exchange rate system is that it reflects existing economic fundamentals. Another advantage is that governments are not forced to defend some particular exchange rate (or range of rates), and are free to adopt fiscal or monetary policies that are independent of the exchange rate.

If you are baffled by exchange rates, or if you are just curious about why some currencies fluctuate while others don't, the following article has the answers:

The following page will prime you for the topics discussed in this chapter:Floating and Fixed Exchange Rates

The Balance of PaymentsThe balance of payments measures all financial flows that cross a country's border during a given period of time, typically a quarter or a year. It renders an account of all payments and liabilities to foreigners, and all payments and obligations received from foreigners. For example, when a U.S. company sells a product overseas, that export creates a financial inflow to the U.S., while an American citizen purchasing an imported item creates a negative financial inflow (an outflow).   By definition, the sum of all the components of the balance of payments must be equal to zero.

With regard to balance-of-payments accounts, there are three major types of accounts:

1.The Current Account – This type of account records transactions with foreign countries for all current transactions that take place as part of normal business. The current account is specifically made up of:

·Imports and exports, which is also called the trade balance or balance of merchandise trade·Services, such as accounting and insurance·Factor payments, such as interest and dividends paid·Current transfers such as gifts, which do not have an associated exchange factor

2.The Financial Account – Also known as a balance-on-capital account, this account covers changes in ownership of financial and real investments. Parts of this account include:

·Net foreign purchases of long-term domestic assets, such as bonds, stock, real estate and other business assets, netted against similar purchases of foreign assets made by the country's citizens·Private transfers of financial assets such as cash and other forms of payments made by domestic entities

to foreigners in order to settle balances owed to the foreigners, netted with similar transfers of financial assets from foreigner to domestic entities.

3.The Official Reserve Account – This account keeps track of all transactions made by monetary authorities. The sum of the current and financial accounts, which is called the overall balance, should be equal to zero. The central bank can use some of its reserves when the overall balance is negative. If the overall balance is positive, the central bank can choose to add to its reserves.

Look Out!

Know these components well – they are critical to understanding later sections.

The following page will prime you for the topics discussed in this section:What is the Balance of Payments?

5.15 - Currency Appreciation and Depreciation

Current and Financial Account Surpluses and DeficitsCurrent account deficits (or surpluses) and financial deficits (or surpluses) do not directly affect an economy. In fact, these deficits (surpluses) are actually the result of what is occurring in an economy, instead of being the cause. Trade deficits often occur when a nation's economy is growing faster than the economies of its trading partners. Rapid domestic growth increases the demand for imports, while slow or no growth with foreign economies can cause a decline in demand for the country's exports.

Trade balances are also affected by capital flows. If a nation's economy offers investment opportunities that are relatively better than other nations, then capital will flow into the country. With flexible exchange rates, this capital inflow will tend to increase the value of the nation's currency.

Economic statistics support the hypothesis that trade deficits are associated with investment opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant economic growth for the U.S., trade deficits and net foreign investment were fairly small. As the U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly increased. During the recession of the early 1990s, capital inflow greatly decreased and the current account was actually slightly positive during one of those years. The time between 1993 and 2000 was one of substantial economic growth; net capital inflows greatly increased, which caused the U.S. dollar to appreciate and the current account ran large deficits.

Budget deficits and trade deficits tend to be linkedAn increase in the U.S. government budget deficit will cause an increase in the real interest rate, which causes additional foreign capital to flow into the country. The inflow of foreign currencies will cause the value of the U.S. dollar to increase in relation to other currencies. The increase in value of the U.S. dollar will make U.S. exports relatively less attractive to foreigners and imports into the U.S. will be relatively less expensive; therefore, net exports will go down. The increase in the budget deficit leads to an increase in the trade deficit.

Causes of a Nation's Currency Appreciation or DepreciationFactors that can cause a nation's currency to appreciate or depreciate include:

·Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy those goods. In order to buy those goods, they will need to buy the nation's currency. Countries with the lowest price levels will tend to have the strongest currencies (those currencies will be appreciating).

·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a nation's central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.

·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of its trading partners remain relatively stable. U.S. goods will seem very expensive to foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods. The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate adjustments permit nations with relatively high inflation rates to maintain trade relations with countries that have low inflation rates.

·Income Changes - Suppose that the income of a major trading partner with the U.S., such as Great Britain, greatly increases. Greater domestic income is associated with an increased consumption of imported goods. As British consumers purchase more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will appreciate. 

5.16 - Effect of Monetary PolicyUnanticipated changes in monetary policy will produce both price (substitution) and income effects. For example, suppose monetary authorities begin a program of expansionary (easy) monetary policy.

We would then expect the following sequence of events to occur with regard to the price effect:

·Real interest rates will be reduced.·As real interest rates are reduced, domestic financial and capital assets become less attractive as a result of their lower real rates of return. Foreigners will reduce their positions in domestic bonds, real estate, stocks and other assets. The financial account (or balance on capital account) will deteriorate as a result of foreigners holding fewer domestic assets. Domestic investors will be more likely to invest overseas in the pursuit of higher rates of return.·The reduction in domestic investment by foreigners and the country's citizens will decrease the demand for the nation's currency and increase the demand for the currency of foreign countries. The exchange rate of the nation's currency will tend to decline.·With no government intervention, the financial account and the current account must sum to zero. As the financial account declines, the current account will be expected to improve by an equal amount. In other words,

the balance of trade should improve. The country's export will have become relatively cheaper and imports will be relatively more expensive.

The effect of an expansionary monetary policy is to lower the exchange rate, weaken the financial account and strengthen the current account. A restrictive monetary policy would be expected to result in the opposite: a higher exchange rate, a stronger financial account and a weaker current account (a more negative, or a less positive balance of trade).

With a program of expansionary (easy) monetary policy, the following sequence of events would be expected to occur with regard to the income effect:

·The domestic GDP will rise.·The rise in domestic GDP will tend to increase the demand for imports. The increase in imports will cause the current account to deteriorate.·The increase in imports purchased will increase the need to convert domestic to foreign currency. As a result, the exchange rate of the domestic currency will decrease.·With no government intervention, the financial account must now move toward a surplus as the financial and current account must sum to zero. Due to the increase in imports, foreigners will now have a surplus of the nation's currency. If foreigners do not use that currency to purchase the country's exports (which would improve the current account balance), they will ultimately need to invest that currency in the assets of the domestic country. This explains why countries such as China and Japan invest large sums in assets such as U.S. Treasuries. The holders of the U.S. currency must put it to work somewhere! Note that foreign investors are often getting better rates of return than what might be readily apparent because the value of the domestic currency is falling relative to their own currency.

In summary, the income effect of expansionary monetary policy tends to lower the domestic currency exchange rate, weaken the current account and work to improve the financial account. A restrictive monetary policy tends to cause the opposite due to the income effect. The domestic currency exchange rate increases, the current account improves and the financial account weakens.

As both price and the income effects of monetary policy move in the same direction regarding their impact on the exchange rate, it is clear that expansionary (restrictive) monetary policy will lower (raise) the country's exchange rate. The effect of monetary policy on the current and financial accounts is not so clear because the price and income effects move in opposite directions. For example, the price effect of easy money on the current account tends to strengthen it, while the income effect tends to weaken the current account. Since the effects move in opposite directions, it is not immediately clear what the ultimate impact will be.

We should note that investors can buy and sell financial assets such as stocks and bonds more quickly than producers and consumers can sell and buy physical goods. So initially, interest rate (substitution) effects would be expected to dominate. An unanticipated increase in the money supply will cause the exchange rate to go down, the financial account to weaken and current account to gain strength. Over time, the income effect will come into play. A rising GDP will cause both the trade balance and financial account to weaken.

Some argue that for an economy with a foreign sector, monetary policy can create cyclical movements that tend to destabilize an economy. Unanticipated expansionary monetary policy initially causes the trade balance to improve, but as time progresses, it causes the trade balance to become more negative. It initially causes the capital account to weaken due to lower interest rates, but then later tends to improve it. In the long run, the main effect of the expansionary monetary policy is a lowering of the nation's currency exchange rate, which is the international equivalent to the long-run effect of expansionary monetary policy, inflation. Empirical evidence indicates that countries with high rates of monetary supply growth experience both inflation and declining currency exchange rates. An important point to consider is the exchange rates of two countries - their relative rates of money supply growth will help determine how the exchange rate changes.

Fiscal policy changes will produce both price (substitution) and income effects for exchange rates and balance of payments. Suppose government policymakers enact a program of unanticipated fiscal stimulus. This would be expected to cause the following sequence of events to occur with regard to the price effect:

·Greater government budget deficits caused by tax cuts and/or increased spending will increase the demand for investable funds, which will cause interest rates to rise.·The increase in interest rates will cause capital inflows (foreigners will purchase more domestic financial assets). As a result, the capital account will strengthen (become more positive or less negative).·Foreign investors will need to exchange their currency for the domestic currency. The increased demand for the domestic currency will cause its exchange rate to increase.·If there is no government intervention with the balance-of-payments, the current account will need to become more negative (or less positive). The trade balance will weaken as imports increase and/or exports decrease. This makes sense because the strengthening of the nation's currency will make its exports relatively less attractive to foreigners and imports will be less expensive relative to the country's consumers and domestic businesses.

To summarize, the price effect of a stimulative fiscal policy is to raise the value of the domestic currency, strengthen the capital account and weaken the current account. A restrictive fiscal policy would have the opposite effects: a weaker domestic currency, a weaker capital account (there would be net capital outflows) and a stronger current account.

With a program of fiscal stimulus, the following sequence of events would be expected to occur with regard to the income effect:

·The tax cuts and/or increase in government spending associated with the fiscal policy, and the associated multiplier effect, will increase GDP.·The rise in GDP will cause the demand for imports to increase and the current account will be weakened (become more negative or less positive).·More domestic currency will need to be converted into foreign currencies to purchase the increased quantity of imports. The increased supply of domestic currency on the international markets will cause the exchange rate to decline.·With no government intervention, the financial account will need to become more positive (or less negative) in order to compensate for the weakening of the current account. Foreigners will be holding more of the domestic currency and are therefore in a position to purchase more of the nation's financial assets. Also, as the domestic economy is improving, they may find it more attractive as a place to invest.

To summarize, the income effect associated with fiscal stimulus will tend to lower the exchange rate of the country's currency, weaken the current account (trade balance) and strengthen the financial account.

Fiscal policy price and income effects move in the same direction with regard to their impact on the financial and current accounts. Stimulating fiscal policy will clearly weaken the current account (balance of trade) and strengthen the capital account. Restrictive fiscal policy will strengthen the current account (balance of trade) and weaken the capital account.

The impact of fiscal policy on exchange rates is not so clear because the price and income effects work in opposite directions. The income effect tends to weaken the currency exchange rate, while the price effect will tend to strengthen the currency exchange rate. Because foreign investors can trade financial assets (such as stocks and bonds) more quickly and easily than consumers and producers can alter the purchase and sale of physical assets, the price effect would be expected to have the larger initial effect. Over time, the income effect will increasingly come into play.

So initially, the fiscal stimulus should cause the domestic currency to appreciate. Over time, as the demand for imports is stimulated, the domestic currency will weaken. If the fiscal stimulus is associated with inflation, there will be a further weakening of the domestic currency. Note that the fiscal stimulus will also have the effect of worsening the balance of trade and increasing the financial account in both the short and long run.

A stimulative fiscal policy is good for the economy when it is operating below full employment levels. There are a couple of factors that will mitigate the positive effects. One factor is that government deficits will work to increase interest rates, which can crowd out private investment. Another factor is that after foreign capital comes in (due to higher interest rates), the domestic currency exchange rate rises. This leads to a rise in imports, which reduces GDP. These two factors lessen the positive effects of fiscal policy stimulus.

5.17 - Fixed vs. Pegged Exchange Rate SystemsA fixed exchange rate system maintains fixed exchange rates between currencies; those rates are referred to as official parity. A nation with fixed exchange rates must enforce those rates. An early form of fixed exchange rates was to specify the value of a nation's currency in terms of gold (the "gold standard").

The Gold StandardThe gold standard system worked reasonably well during the 1800s, but it was gradually disbanded during the twentieth century. In 1944, leading non-communist nations agreed on a fixed exchange rate system (the Bretton Woods System) whereby the value of the U.S. dollar was pegged at $35 per ounce and other nations then fixed the value of their currencies in relation to the U.S. dollar. Private individuals could not acquire gold at that price; only governments traded gold at that price. During the 1960s, the U.S. government pursued an expansionary monetary policy in an attempt to finance the Vietnam War and increase domestic entitlement programs ("guns and butter") without raising taxes. The inflationary monetary policy induced nations to begin a run on U.S. gold, and the U.S. was forced to stop redeeming dollars for gold and break the fixed exchange rate system that had been started in 1944.

Read more on the Gold Standard's rise and fall in the following article:The Gold Standard Revisited

A nation operating under a fixed exchange rate system (pegged to the dollar) that experiences a balance of payments deficit will be forced to finance the deficit out of its dollar reserves. As the number of dollars declines, the nation's money supply is reduced. This causes prices to drop and interest rates to increase. The price drops make the nation's goods more competitive internationally; the higher interest rates also cause more capital to flow into the country. These forces help the nation to achieve equilibrium with its balance of payments.

The advantages of fixed exchange rate systems include the elimination of exchange rate risk, at least in the short run. They also bring discipline to government monetary and fiscal policies. Disadvantages include lack of

monetary independence and increases in currency speculation regarding possible revaluations.

Pegged Exchange Rate SystemA pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to a basket of currencies. The choice of the currency (or basket of currencies) is affected by the currencies in which the country's external debt is denominated and the extent to which the country's trade is concentrated with particular trading partners. The case for pegging to a single currency is made stronger if the peg is to the currency of a principal trading partner. If much of the country's debt is denominated in other currencies, the choice of which currency to peg it to becomes more complicated.

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they may need to resort to central bank intervention, the imposition of tariffs or quotas, or the placement of restrictions on capital flow. If the pegged exchange rate is too far from the actual market rate, it will be costly to defend and it will probably not last. Currency speculators may benefit from such a situation.Advantages of pegged exchange rates include a reduction in the volatility of the exchange rate (at least in the short-run) and the imposition of some discipline on government policies. One disadvantage is that it can introduce currency speculation.

5.18 - Absolute and Relative Purchasing Power ParityPurchasing power parity is the notion that a bundle of goods in one country should cost the same in another after exchange rates are considered.

There are two ways to express this concept:

1. Absolute Purchasing Power ParityThis concept posits that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept is derived from a basic idea known as the law of one price, which states that the real price of a good must be the same across all countries. To illustrate why this makes sense, suppose that soybeans are currently priced at $5 a bushel in the U.S., that soybeans are priced at ¬5.50 per bushel in Europe, and that the exchange rate is 1.10 euros per dollar. Suppose that the price of soybeans goes up to ¬6.05 per bushel (a 10% increase) in Europe, while the price of soybeans in the U.S. only goes up on 5%, to $5.25 a bushel. If there is no depreciation in the euro to offset the 5% difference, then European soybeans will not be competitive on the international market and trade flowing from the U.S. to Europe will greatly increase.

If we take weighted averages of prices for all goods within an economy, absolute purchase power parity maintains that the currency exchange rate between two countries should be identical to the ratio of the two countries' price levels.

This relationship can be expressed as:

Formula 5.5

S=   P ÷ P*

Where Sis the spot exchange rate between two countries (the rate of the amount of foreign currency needed to trade for the domestic currency), P is the price index for a domestic country and P* is the price index for a foreign country. Note that the exchange rate used here is an indirect quote.

The following conditions must be met for this relationship to be true:  1.The goods of each country must be freely tradable on the international market.

2.The price index for each of the two countries must be comprised of the same basket of goods.

3.All of the prices need to be indexed to the same year.

Even if the law of one price holds for each individual good across countries, differences in weighting will cause absolute purchasing power parity. Determining comparable average national price levels is actually quite difficult and is rarely attempted. Analysts usually examine changes in price levels (indexes), which are easier to calculate; this gets around some of the problems of comparability.

5.19 - Relative Purchasing Power ParityRelative purchasing power parity relates the change in two countries' expected inflation rates to the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency. If a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year. Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.

The relationship can be expressed as follows, using indirect quotes:

Formula 5.6S1 / S0  = (1 + Iy) ÷ (1 + Ix)

Where,S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of currency x)S1 is the spot exchange rate at the end of the time period.Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.

Look Out!

Note that the spot exchange rate used must be the quantity of currency y (the foreign currency) needed to purchase one unit of currency x (the domestic currency). If we want the spot value of the U.S. dollar in British pounds, the quote must be 0.6667 British pounds per dollar, not $1.50 per British pound.

Example 1:Suppose that Mexico's expected annual rate of inflation is equal to 6% per year, while the expected annual inflation rate for the U.S. is 3%. As an approximation, we would expect that the Mexican peso would depreciate at the rate of 3% per year (or we could say that the U.S. dollar should appreciate at the rate of 3% per year.

Example 2:Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the U.S. The current exchange rate is $1.20 per euro (¬1.00 = $1.20). What would the expected spot exchange rate be in six months for the euro?

Answer:So the relevant equation is:

S0.5 ÷ S0       = (( 1 + Ius) ÷ (1 + Ieurozone))0.5

= S0.5 ÷ $1.20 per euro = (1.02  ÷ 1.08)0.5

Which implies   S0.5 = (1.20) × 0.978125 = 1.1662

So the expected spot exchange rate at the end of six months would be $1.1662 per euro.

Example 3:Assume that the U.S. is the foreign country and that Japan is the domestic country. The current spot exchange rate is S0 = 115 yen per dollar ($1 per ¥115.00).  The expected annual inflation rate for the U.S. is 4.89%, and the annual expected Japanese inflation rate is 6.23%. Compute the approximate expected spot rate and the expected spot rate one year from now.

Answer:Because Japan is the domestic country we have:

S0 = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.

The approximation method would indicate that the yen should decline against the dollar by:        (Iy – Ix) =(1.0489 – 1.0623) =  -0.0134   = -1.34%

So the value of the yen relative to the dollar would be expected to decline to

(1 – 0.0134)    ×    115           =    ¥113.46 per $

We can calculate the rate more exactly as:

S1 = (1.0489) / (1.0623) × 115   =   ¥113.55 per $

Purchasing Power Parity and Real Return on AssetsThe purchasing power parity principle also applies to the real returns on assets earned by various investors across the world. It holds that the real rate of return on assets should be the same for investors from any nation.

Suppose that a financial asset from Mexico has an annual rate of return of 10% in Mexican pesos. Assume that Mexico has an annual inflation rate of 4%, the U.S. has an annual inflation rate of 2% and that the U.S. dollar is appreciating by 2% a year, as predicted by purchasing power parity.

By the approximation method, U.S. investors would be earning about 8% per year in terms of Mexican pesos.

Their real rate of return would be approximately 6% per year after U.S. inflation is taken into account. This is equal to what Mexican investors are earning, which is about 6% (10% nominal rate of return - 4% inflation). All investors are getting the same real rate of return on specific assets.

Note that purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.  

Exam Tip!

Past exams have included questions that require purchasing power parity calculations, so it is a good idea to practice solving questions such as the examples given above.