BRINNER2902mit11.pptForeign Trade andExchange RatesLecture 11BRINNER3902mit11.pptForeign Trade andExchange Rates◆ Key Concepts to Master– Exports and imports within thecircular flow of the economy– The key drivers of exports and imports– Interest rate parity and exchange rates– The J-CurveBRINNER4902mit11.pptExports and imports within thecircular flow of the economy◆ GNP=C+I+G+X-M◆ Exports are an addition to the flow of spendingcreated by domestic income– i.e. exports are purchases by foreign buyersof the same types of goods as C,I,G and addto US production (GDP)◆ Imports are a subtraction, a leakage, from thecircular flow– i.e.imports are all components of C, I, G,and even X and substitute for / subtractfrom US production (GDP)BRINNER5902mit11.pptThe Circular Flow--in an open economySpending onPurchasesof GoodsProduction ofDomestic GoodsExcise TaxesWages, Profits, RentsPayroll & Income TaxImported GoodsExport DemandsSavingBRINNER6902mit11.pptThe key drivers ofexports and imports◆ Imports are all components of C, I, G, and even X– This country’s income, production and policychoices drive our imports--all of the conceptsdiscussed in the lectures and reading on thesedomestic sectors◆ Exports are simply another country’s imports, thuspartofits C,I,G,X– That country’s income and production and policychoices drive our exports◆ The share of any country’s C,I,G,X grabbed byimports depends on relative prices, tastes, quotas, andother market restrictionsBRINNER7902mit11.pptInterest rate parityand exchange rates◆ A simple relationship should hold among exchange rates and interestrates in any pair of countries:– the percentage difference between the exchange rate today and theexpected future exchange rate is the difference between today’sinterest rates in the two countries for the same future time horizon– For example, the number of dollars the market will pay for 100 yentoday equals the expected dollars a yen will cost next year minus thepercentage difference between today’s one-year interest rates inJapan and the US. For example,» If 100 yen are expected to cost $1.05 next year, and the US 1-yearrate is 6% while the Japanese is 1%, the market will only pay$1.00 today for 100 yen: thus relatively high interest ratesproduce a strong currency, other factors equal» $1 invested in the US today will be worth $1.06 or 101 (=$1.06 x100 / $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 story◆ But what determines the expected value a year from now?Will purchasing power parity for a broad range of goods andassets prevail then? What is purchasing power parity?◆ The expected future exchange rate depends on the expectedfuture demand for each currency, hence a long list of drivers:– future monetary and fiscal policies affecting interest ratesat that time– current goods andasset prices in both countries andexpected inflation and appreciation rates– the relative stages of the business cycles hence levels oftrade deficits and hence the immediate flowof a currencyin or out of a country versus the existing stock– future trade policiesBRINNER9902mit11.pptMore Complications in the simple story◆ In some very long run, perhaps ten to twenty years out,purchasing power parity might be expected to roughlyprevail, out of ignorance of what other factors would be inforce in either direction.◆ Biases due to uncertainty or irrationality or lack ofinformation also can break up the basic simple relationship.◆ However, the fundamental premise is pretty strong: thehigher a country pushes its interest rates today, the strongerwill be that country’s exchange rate today.◆ And, the stronger the exchange rate is, the weaker its exportquantities and the stronger its import quantities, hence theweaker its real (inflation-adjusted) net exports .BRINNER10902mit11.ppt– Relative Inflation Rates / Price LevelsAffect Long-Run Trends– Investment Opportunities Drive Short-Run Cycles» Bond-Yield Differentials Dominate» Business Cycle Impacts on EquityReturns 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 HasBeen an Adjustment for Price LevelsNominalRealDM / $BRINNER13902mit11.ppt-10-50510152025197019721974197619781980198219841986198819901992199419961998A Comparison of Wholesale Price Inflation RatesReveals a Strong Tendency for Lower German Inflation,Except in Periods of Exceptional Dollar StrengthSpread=Germany-USGermanyUnited StatesBRINNER14902mit11.ppt-10-505101520197019721974197619781980198219841986198819901992199419961998Bond Yields Are Another Substantial Driving ForceSpread=Germany-USGermanyUnited StatesBRINNER15902mit11.ppt11.21.41.61.822.22.42.62.833.23.41981 1983 1985 1987 1989 1991 1993 1995 1997-3-2-10123456789TheRealExchangeRate(DMper$US)Rises / Falls with the Bond Yield Spread (US minus German)Real Exchange Rate10-Year BondYield SpreadBRINNER16902mit11.ppt1.01.21.41.61.82.02.22.42.62.83.03.23.41981 1983 1985 1987 1989 1991 1993 1995 1997-3-2-10123456789InterestSpreadRealExchangeRateThe Correspondence is Near-Perfectif Allowance is Also Made for Inflation DifferentialsBRINNER17902mit11.pptBenefits of a strong currency◆ But a strong exchange rate does havesome positive effects in the short- and thelong-run.◆ It does mean a country can buy othercountries goods, services, and assetsmore cheaply, raising its own relativeand absolute standard of living.BRINNER18902mit11.pptThe J-Curve◆ This name refers to the shape of a graph depictingchanges through time in a country’s nominal netexports after a depreciation of that country’s currencyChange inNominalNet ExportsRelative toa BaselineTime Elapsed After Depreciation00BRINNER19902mit11.pptAn Example of the J-CurveAssume a 10% Devaluation of the dollarAssume the export and import demand equations reflects lagged response to relative prices as follows:log (Q) = constant+ sum ( b(j)*log(foreign price in period j/US price in period -j))b(lag j)=incremental elasticity of demand with a lag of "j" periodsb(j) follows a smooth, 2nd order polynomial: b(j)=a0 x
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