11International Economics & Foreign Exchange RatesAgenda• Open Economy Macroeconomics ¾ International Trade without Exchange Rates¾ Foreign Exchange Rates2International Trade• International Trade is an important component of economic activity.¾ Net exports are part of GDP.Y = C + I + G + ( X – M )3International Trade Balance• Net Export Arithmetic¾ X = X0 + xYf¾ M = M0 + mY¾ X – M = X – M0 – mY, where • X0 are exogenous exports,• Yf is foreign income (and x is a parameter),• M0 are exogenous imports.¾ TB = X – M = X0 + xYf – M0 – mY¾ TB + X – M = Xo – Mo + xYf - mY4Net Export LineYX - MSurplus (+)Deficit (-)TB0X – M05International Trade Balance• Ye is determined in the IS – LM model¾ Which is influenced by X, M0 and m• X – M is determined by the TB line6Increase X or Decrease M0YX - MSurplus (+)X – M0Deficit (-)TB0X – M0TB127Increase mYX - MSurplus (+)X – M0Deficit (-)TB1TB08International Trade Linkages• Net Export Assumptions¾ Exports are exogenous• X = X0 + xYf¾ Imports are endogenous• M = M0 + mY• However, one country’s exports are another country’s imports¾ Exports are exogenous with respect to your own country’s Y but not with respect to the world’s Y• X = X0 + xYf9International Trade Linkages• Suppose there are 2 countries: the US and Japan¾ Japan exports a lot to the US but¾ the US does not export a lot to Japan• What happens if the US experiences an investment boom?10International Trade Linkages, 1Y0 Y Y0 Y1 YRR1R0IS0RR0LM0Japan United StatesIS1LM0IS011International Trade Linkages, 2Y0 Y1 YY0 Y1 YRR1R0IS0RR1R0LM0Japan United StatesIS1LM0IS0IS112International Trade Linkages, 3Y0 Y1 YY0 Y1Y2 YRR2R1R0IS0RR1R0LM0Japan United StatesIS1LM0IS0IS1IS2313International Economics• Conclusions¾ The larger the international trade flows, the stronger the economic inter-relationship between countries.• Exports affect domestic economic activity.– Which is influenced by foreign economic activity.• Imports allow economic activity to be exported.– More imports generates higher foreign economic activity and foreign employment.¾ Globalization makes business cycles more synchronous.14International Economics• Other Considerations¾ These effects can be OFFSET by domestic monetary and fiscal policy actions.¾These effects do NOT consider exchange rate effects or financial flows. 15International Economics• There are other channels by which international trade affects economic activity¾ Foreign exchange rates¾ International capital flow16Foreign Exchange Rates• Introduction¾ International transactions require the exchange of one country’s currency for another.• To buy or sell goods and services and/or• To acquire or dispose of assets (both financial and nonfinancial)17Foreign Exchange Rates• How Exchange Rates are Quoted¾ The Dollar as the fixed currency¾ The Dollar as the variable currency• The Sterling bloc•The Euro18Foreign Exchange Rates• Determinants of Exchange Rates: Supply and Demand¾ Assume there are only 2 countries:• United States•Mexico419Foreign Exchange RatesQD$S$Pesos per $P:$20Foreign Exchange Rates• Determinants of Exchange Rates: Supply and Demand¾ The Mexican demand for Dollars is equivalent to the Mexican supply of Pesos and¾ The U.S. supply of Dollars is equivalent to the U.S demand for Pesos21Foreign Exchange Rates• Sources of Supply and Demand¾ International trade in goods and services¾ Foreign direct investment¾ Long-term investment portfolio flows¾ Short-term investment/speculative or hot money flows• Mutual funds• Hedge funds¾ Safe haven status (of a reserve currency)22Foreign Exchange Rates• Sources of Supply and Demand¾ Alternatively, can think of the money flows in and out of a country, i.e., the credits and debits23Foreign Exchange Rates• Credits (or money in) or the demand for the domestic currency:• Exports of goods and services• Investment income on foreign assets owned by domestic residents• Transfers to domestic residents• Net purchases of domestic assets by foreign residents 24Foreign Exchange Rates• Debits (or money out) or the supply of the domestic currency:• Imports of goods and services• Investment payments on domestic assets owned by foreign residents• Transfers to foreign residents• Net purchases of foreign assets by domestic residents525Foreign Exchange Rates• Determinants of Exchange Rates: Supply and Demand¾ Suppose there is increased Mexican demand for U.S. products or assets• The demand for dollars increases causing the peso price for dollars to increase as well.26Foreign Exchange RatesQD$S$Pesos per $P:$D$P:$27Foreign Exchange Rate Systems• Flexible Exchange Rates• Exchange rate is free to fluctuate daily.¾ Clean float¾ Dirty or managed float• Exchange rates adjust to any imbalances in the supply and demand for a currency¾ Appreciate if there is a excess demand.¾ Depreciate if there is a excess supply.28Foreign Exchange Rate Systems• Why will an appreciating Dollar reduce the demand for Pesos and increase the supply of Dollars?¾ Exports: X = X0 + x*Yf – φ*er• Exports now have an inverse relationship with the exchange rate.¾ Imports: M = M0 + m*Y + ψ*er• Imports now have a positive relationship with the exchange rate.29Foreign Exchange Rate Systems• Changes in Flexible Exchange Rates¾ Appreciation: an increase in the foreign exchange value of the currency.¾ Depreciation: a decrease in the foreign exchange value of the currency.30Foreign Exchange Rate Systems• Fixed Exchange Rates¾ Exchange rate is fixed for long periods of time.¾ Central banks must finance or absorb any imbalances in supply and demand of a currency through changes in foreign exchange reserves.• Buy excess foreign currency when there is excess demand for the domestic currency.• Sell foreign currency when there is excess supply of the domestic currency.631Foreign Exchange RatesQD$S$Pesos per $P:$D$Excess D$32Foreign Exchange Rate Systems• Foreign Exchange Intervention¾ Mexican central bank MUST sell Dollars from their foreign exchange reserves to buy Pesos.• What is the effect on the Mexican money supply?¾ Mexican money supply will contract.¾ This is like an international open market operation.¾ This is “non-sterilized” foreign exchange intervention.• Can the Mexican central bank neutralize this affect?¾ Domestic open market purchase of government