Foreign Trade and Exchange RatesSlide 2Exports and imports within the circular flow of the economyThe Circular Flow-- in a closed economyThe Circular Flow-- in an open economyThe key drivers of exports and importsInterest rate parity and exchange ratesInterest rate parity and exchange rates: Complications in the simple storyMore Complications in the simple storyExchange Rate Drivers for Mature NationsHistorical View of the German Exchange RateReal and Nominal Exchange Rates: Much of the Historic DM Appreciation Has Been an Adjustment for Price LevelsA Comparison of Wholesale Price Inflation Rates Reveals a Strong Tendency for Lower German Inflation, Except in Periods of Exceptional Dollar StrengthBond Yields Are Another Substantial Driving ForceThe Real Exchange Rate (DM per $US) Rises / Falls with the Bond Yield Spread (US minus German)The Correspondence is Near-Perfect if Allowance is Also Made for Inflation DifferentialsBenefits of a strong currencyThe J-CurveAn Example of the J-CurveSlide 20Slide 21Slide 22BRINNER1902mit11.pptForeign Trade and Exchange RatesLecture 11BRINNER2902mit11.pptForeign Trade and Exchange RatesKey Concepts to Master–Exports and imports within the circular flow of the economy–The key drivers of exports and imports–Interest rate parity and exchange rates–The J-CurveBRINNER3902mit11.pptExports and imports within the circular flow of the economyGNP= C + I + G + X - MExports are an addition to the flow of spending created by domestic income–i.e. exports are purchases by foreign buyers of the same types of goods as C,I,G and add to US production (GDP)Imports are a subtraction, a leakage, from the circular flow–i.e.imports are all components of C, I, G, and even X and substitute for / subtract from US production (GDP)BRINNER4902mit11.pptThe Circular Flow--in a closed economySpending onPurchasesof GoodsProductionof GoodsExcise TaxesWages, Profits, RentsPayroll & Income TaxSavingBRINNER5902mit11.pptThe Circular Flow--in an open economySpending onPurchasesof GoodsProduction of Domestic GoodsExcise TaxesWages, Profits, RentsPayroll & Income TaxImported GoodsImported GoodsExport DemandsExport DemandsSavingSavingBRINNER6902mit11.pptThe key drivers of exports and importsImports are all components of C, I, G, and even X–This country’s income, production and policy choices drive our imports--all of the concepts discussed in the lectures and reading on these domestic sectorsExports are simply another country’s imports, thus part of its C, I, G, X–That country’s income and production and policy choices drive our exports The share of any country’s C,I,G,X grabbed by imports depends on relative prices, tastes, quotas, and other market restrictionsBRINNER7902mit11.pptInterest rate parity and exchange ratesA simple relationship should hold among exchange rates and interest rates in any pair of countries:–the percentage difference between the exchange rate today and the expected future exchange rate is the difference between today’s interest rates in the two countries for the same future time horizon–For example, the number of dollars the market will pay for 100 yen today equals the expected dollars a yen will cost next year minus the percentage difference between today’s one-year interest rates in Japan and the US. For example,»If 100 yen are expected to cost $1.05 next year, and the US 1-year rate is 6% while the Japanese is 1%, the market will only pay $1.00 today for 100 yen: thus relatively high interest rates produce a strong currency, other factors equal»$1 invested in the US today will be worth $1.06 or 101 (=$1.06 x 100 / $1.05) yen next year»100 Yen invested in Japan today will be worth 101 yen next yearBRINNER8902mit11.pptInterest rate parity and exchange rates: Complications in the simple storyBut what determines the expected value a year from now? Will purchasing power parity for a broad range of goods and assets prevail then? What is purchasing power parity?The expected future exchange rate depends on the expected future demand for each currency, hence a long list of drivers:–future monetary and fiscal policies affecting interest rates at that time –current goods and asset prices in both countries and expected inflation and appreciation rates–the relative stages of the business cycles hence levels of trade deficits and hence the immediate flow of a currency in or out of a country versus the existing stock–future trade policiesBRINNER9902mit11.pptMore Complications in the simple storyIn some very long run, perhaps ten to twenty years out, purchasing power parity might be expected to roughly prevail, out of ignorance of what other factors would be in force in either direction.Biases due to uncertainty or irrationality or lack of information also can break up the basic simple relationship.However, the fundamental premise is pretty strong: the higher a country pushes its interest rates today, the stronger will be that country’s exchange rate today.And, the stronger the exchange rate is, the weaker its export quantities and the stronger its import quantities, hence the weaker its real (inflation-adjusted) net exports .BRINNER10902mit11.ppt–Relative Inflation Rates / Price Levels Affect Long-Run Trends–Investment Opportunities Drive Short-Run Cycles»Bond-Yield Differentials Dominate»Business Cycle Impacts on Equity Returns are also ImportantExchange Rate Drivers for Mature NationsBRINNER11902mit11.ppt1.31.82.32.83.33.8197019721974197619781980198219841986198819901992199419961998DM / $Historical View of the German Exchange RateBRINNER12902mit11.ppt1.31.82.32.83.33.8197019721974197619781980198219841986198819901992199419961998Real and Nominal Exchange Rates: Much of the Historic DM Appreciation Has Been an Adjustment for Price LevelsNominalRealDM / $BRINNER13902mit11.ppt-10-50510152025197019721974197619781980198219841986198819901992199419961998A Comparison of Wholesale Price Inflation Rates Reveals a Strong Tendency for Lower German Inflation, Except in Periods of Exceptional Dollar Strength Spread=Germany-USGermanyUnited StatesBRINNER14902mit11.ppt-10-505101520197019721974197619781980198219841986198819901992199419961998Bond Yields Are Another Substantial Driving ForceSpread=Germany-USGermanyUnited StatesBRINNER15902mit11.ppt11.21.41.61.822.22.42.62.833.23.41981 1983 1985 1987 1989 1991 1993 1995 1997-3-2-10123456789The Real Exchange Rate (DM per $US) Rises / Falls with
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