International Economics

Equilibrium in an open economy

Foreign Exchange Markets

May 10-17, 2005

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International macroeconomics• International microeconomics

– Individual production and consumption decisions produce patterns of trade

– Free trade encourages the efficient resource use, government intervention and amrket failures can cause waste

• International macroeconomics– Effective use of resources maximising long term economic

growth• Unemployment (labour use)• Savings (capital accumulation – a country can consume an amount

equal to its income a country’s saving and borrowing• Trade imbalance (EX=IM international saving and borrowing)

– Connected to the previous elements:• Money and the price level (barter theory)

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National income

• GNP: the value of all final goods and services produced by the country’s factors of production, and sold on the market in a given time period

• Calculating: measuring production, consumption, incomes– Adding up the market value of all expenditures on

final output (measuring consumption)– Y=C+I+G

– Domestic demand (YD) – full demand in a closed economy

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National income in an open economy

• Difficulties in an open economy:– Some of the goods purchased were not

produced using the country’s resources IM (-)

– Some of the goods produced with the country’s resources are purchased abroad EX (+)

Y=YD+EX-IM

CA (current account)

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Current account balance

• The current account usually is not balanced

CA<0 (surplus) CA>0 (deficit)

The country purchases more than it sells to foreignersThe deficit must be financedThe country borrows from foreigners: increase in net foreign debt, decrease in net foreign wealth

The country purchases less than it sells to foreignersThe surplus must be spentThe country lends to foreigners

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Saving and current accountClosed economy Open economy

- National saving (part of the income not consumed by the country):

S=Y-C-G- National income

Y=C+I+G I=Y-C-G- Equilibrium:

S=I

- National saving (part of the income not consumed by the country):

S=Y-C-G- National income

Y=C+I+G+CA I+CA=Y-C-G- Equilibrium:

S=I+CA- Sources of investment: I=S-CA

- National savings (S)

- CA deficit (borrowing

foreign savings)

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Exercises1. The following data are known: C=100+0,8Y; I=150; G=200; EX=400;

IM=50+0,2Y.a) Give the value of income when the market of goods is in equilibrium!b) What is the current account balance at that income?

2. The autonomous consumption is 50, the autonomous import is 20, the value of investments is 200, while it is also known that the country borrows a value 90 from foreigners at the equilibrium income which is equal to 800. It is also known that a 5% growth in the country’s GDP will increase the country’s imports by 3%, and a 360 unit increase in exports is needed in order to ensure a balanced current account.a) Give the value of consumption, imports and exports! What is the consumption and import function of the country? b) What is the value of the new equilibrium income?

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Exchange rate

• The price of one currency in term of another one• The relative price of a currency can be given in two

ways:– Direct (American) terms: the price of the foreign currency in

terms of the home currency (Ft/€)– Indirect (European) terms: the price of the home currency in

terms of the foreign currency (€/Ft)• Changes in the exchange rate:

– Depreciation of euro against the forint: a fall in forint price of the euro

– Appreciation of the euro against the forint: a rise in the euro price in terms of forints

• When a currency depreciates against the other, the second currency simultaneously appreciates against the first

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The effects of depreciation

• When a country’s currency depreciates, foreigners will find that its exports are cheaper, and domestic residents find that imports from abroad are more expensive

• Example– E1

FT/€=250; E2FT/€=400; PEX=1000 Ft; PIM=10€

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The effects of appreciation

• Appreciation has opposite effects: foreigners pay more for the country’s export products, and domestic consumers pay less for foreign products

• Example:– E1

FT/€=250; E2FT/€=200; PEX=1000 Ft; PIM=10€

• All else equal an appreciation of a country’s currency raises the relative price of its exports, and lowers the relative price of its imports

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Foreign Exchange Market

• On foreign exchange markets currencies are traded like any other asset

• Prices are determined by the interaction of buyers and sellers of different sellers

• Actors of the foreign exchange market– Commercial banks: the vast majority of foreign

exchange transactions involve the exchange of bank deposits denominated in different currencies – interbank trading

– Corporations and individuals– Central banks – intervening in foreign exchange

markets

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Theories of exchange rate determination

1. Interest rate, and exchange rates

2. Price levels, and exchange rates

3. Fixed exchange rate – market intervention

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1. Interest rate, and exchange rates – an asset approach

• The demand of major exchange market actors is determined by the asset return

• Example

– What is the annual rate of return of a MOL share bought at January 2004?

• Expected rate of return: The decision is based on expected rate – the percentage difference between the expected future value, and the price paid for the asset

Jan. 2004 Jan. 2005

Price of 1 share (MOL) (Ft) 11,000 15,000

Dividend payed (Ft/share) 150 200

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• Expected real rate of return: the expected rate of return divided with the rate of price change

• Calculating the rate of return of different currencies– How the money value of a deposit will change – interest rate: the

amount of currency an individual can earn by lending a unit of that currency for a year

• When someone deposits money in a given currency for a year, he acquires an asset denominated in that currency, and the rate of return of this asset is the interest rate

– How the forint value of an asset denominated in a foreign currency will change – changes in exchange rates

• Calculating the forint rate of a euro deposit: if 1 forint worth of euro is deposited, how many forints will the deposit yield in a year’s time?– What the interest rate of the euro deposit is?– What the exchange rate will be in 1 year’s time

• Exercise: The current exchange rate is 250Ft/€, and it is expected to rise to 300 for next year. The interest rate on forint deposits is 10%, on euro deposits 2%. Which of the two deposits offers the higher forint return?

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• 5-step solution– What is the forint price of a 1€ deposit?

– What is the future return of a 1 € deposit?

– What is the future forint value of a 1 € deposit?

– What is the expected forint rate of return of a 1 € deposit?

– Comparing the two rates of return• Generalising:

– R€ - today’s interest rate on a one-year € deposit– RFt - today’s interest rate on a one-year Ft deposit– EFt/€ - today’s direct exchange rate– Ee

Ft/€ - expected direct exchange rate in one year’s time– The expected rate of euro deposits measured in terms of forints:

R€+(EeFt/€-EFt/€)/EFt/€

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• Equilibrium in the foreign exchange market: when deposits of all currencies offer the same expected rate of return – interest parity condition

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Changes in exchange rates• All else stays unchanged

• Depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits (a fall in the direct forint exchange rate lowers the expected forint return on euro deposits)

• Appreciation of the forint raises the expected forint return of euro deposits

• Example: How will affect the decision on investment a fall in forint exchange rate to 270 Ft/€, or a rise to 200 Ft/€?

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Exchange rates always adjust to maintain interest parity

• E1Ft/€ - the strong

forints makes the euro deposits more valuable – demand for euro grows, the euro gets more expensive

• E2Ft/€ - the strong

euro makes the forint deposits more valuable – demand for forints grows, the forint gets more expensive

a

EFt/€

E2Ft/€

EFt/€

E1Ft/€

R2€ RFt R1

€ Rates of return in Ft term

Expected Ft return on € deposits

RFt=R€+(EeFt/€-EFt/€)/EFt/€

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Changes in interest rates

All else equal, an increase in the interest paid on deposits of a currency causes the currency to appreciate against foreign currencies

E

E1

E2

E

E2

E1

R1Ft R2

Ft

R (Ft)

R€(Ft)

RFt

R (Ft)

R1€(Ft)

R2€(Ft)

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2. Price level, and exchange rates

• Law of one price: in competitive markets identical goods sold in different countries must sell for the price when expressed in term of the same currency

• Example: EFt/€=250; PxHU=10000 Ft; PxEU=40€. What if the exchange rate drops to E=200?

• PiFt – forint price of good i in Hungary

• Pi€ - euro cost of good i in the EU

• PiFt=Pi

€*EFt/€

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Purchasing Power Parity (PPP)• There are not one, but a lot of products – prices are shown by the

price level (price of a reference basket of goods and services)• Absolute PPP: exchange rates between two countries’ currencies

equal the ratio of the countries’ price levels – all countries’ price levels are equal if measured in terms of one currency– PFt – forint price of the reference basket in Hungary– P€ - euro price of the reference basket in the EU– EFt/€=PFt/P€

• The value of the reference basket in Hungary is 100,000 HUF, in the EU 1,000 €. What the exchange rate would be if calculated using the absolute PPP?

• Relative PPP: any change in the exchange rate is explained by the changes in price levels

• ΠFt- Π€=(E2-E1)/E1

• Example: The inflation was 10% in Hungary and 2 in the euro-zone? How will the E1

Ft/€=250 exchange rate change?

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Real exchange rate

• qFt/€=EFt/€*P€/PFt

• Example: the nominal exchange rate is 250, the value of the Hungarian reference basket is 25.000 Ft, the one of the European is 100 €.

• Real depreciation of the forint: a fall of forint’s purchasing power within the Euro-zone – the forint price of Euro-zone goods (P€*EFt/€) rises relative to that of the Hungarian goods (PFt) – qFt/€>1

• Real appreciation of the forint: a rise in forint’s purchasing power within the Euro-zone – the forint price of Euro-zone goods (P€*EFt/€) drops relative to that of the Hungarian goods (PFt) – qFt/€<1

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Fixed exchange rates

• Gold Standard

• Managed floating – ‘dirty floating’: central banks often intervene in currency markets to to influence the exchange rates

• Regional currency arrangements – exchange rate unions

• Many countries peg their currencies to a reference currency

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Gold standard• Each country fixes the price of its currency in terms of gold – gold

parity of currencies• Gold can be used to pay debts as well as notes

• Exercise

1. In the gold standard system 900 Fts are paid for 1 gram of gold in Hungary, and 20 DMs in Germany. Gold’s cost of transport between the two countries is 60 Fts. The following demand and supply curves characterise the Hungarian foreign exchange market: DDM=200-0,5e; SDM=28+e.

a) Calculate the exchange rate determined by the gold parity, and the value of the gold export, and gold import points.

b) How will the official reserves change in the two countries?

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Fixed exchange rate – anchored currencies

• Desired exchange rate – if market forces divert the exchange rate from the desired value, the central bank intervenes

• Central banks use their reserves to intervene

• When the central bank intervenes, both sides of the balance sheet change.• Purchase of assets automatically results in an increase in domestic money

supply, a sale a decline• Example: The central bank has 900 € in foreign assets, 1500€ in domestic

assets, the value of deposited money is 500€, and the currency in circulation is 1900€. What happens if the central bank sells 200€ worth of domestic bonds, or buys 100€ worth of foreign assets?

Balance sheet of the Central BankAssets Liabilities

Foreign assets (official international reserves; foreign currency bonds)

Domestic assets (domestic government bonds, loans to commercial banks)

Deposits held by private banks

Currency in circulation

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Market sterilisation

• Nullifying the impact of foreign exchange market operations

• Example: The central bank sells 100€ worth of foreign assets, and buys 100€ worth of domestic bonds.

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Exercises1. The equation of the currency supply curve in Hungary is S$=2e-

10, and the demand curve: D$=190-3e. The official exchange rate is fixed at 50Ft/$, the allowed range of exchange rate fluctuations is ±10%. What is the task of the Hungarian Central Bank in this situation.

2. The equation of currency supply and demand curves are S$=2e-10, and D$=180-3e respectively. How will affect the exchange rate if the central bank:

a) sells 10$ from its reserves;b) purchases 10$?

3. The current currency supply and demand curves are S$=470-5/3e, and D$=450-5/4e, the fixed exchange rate is e=60Ft/$.

a) What is the current account balance at the fixed exchange rate?

b) How can the current account be levelled (devaluation, appreciation, introducing a free floating policy)?