Lecture Principles of economics (Asia Global Edition) - Chapter 26

Chapter 26 - Exchange rates, international trade, and capital flows. When you finish this chapter, you should be able to: Define the nominal exchange rate and use supply and demand to analyze how the nominal exchange rate is determined in the short run, distinguish between fixed and flexible exchange rates and discuss the advantages and disadvantages of each system, define the real exchange rate and show how it is related to the prices of goods across pairs of countries,…

Exchange Rates, International Trade, and Capital Flows Chapter 26 McGraw­Hill/Irwin Copyright © 2015 by McGraw­Hill Education (Asia). All rights reserved.26­1 Learning Objectives Define the nominal exchange rate and discuss the advantages and disadvantages of flexible versus fixed exchange rates Use supply and demand to analyze how the nominal exchange rate is determined in the short run Define the real exchange rate, summarize the law of one price, and understand how purchasing power parity determines the long-run real exchange rate Use the relationship between domestic saving and the trade balance to understand how domestic saving, the trade balance, and net capital inflows are related Analyze the factors that determine international capital flows and how these flows affect domestic saving and the domestic interest rate 26­2 The International Economy • • • • Every day, news draws our attention to the global economy – The U.S sub-prime mortgage crisis of 2007 – 2008 quickly became a worldwide event because of the trade in mortgage securities Since the mid 1980s, international trade has grown twice as fast as world GDP Changing trade patterns have reduced the sensitivity of foreign economies to events in the U.S Innovations in transportation and communication can make events abroad an immediate issue worldwide 26­3 Importance of Exchange Rates • Domestic purchases are made with local currency – Purchasing goods abroad requires converting your local currency to their local currency • • The exchange rate measures the rate of conversion Exchange rates are set in the foreign exchange market, with a small number of exceptions – – Rates are determined by supply and demand Affect the value of imported goods and the value of financial investments made across borders • Changes in exchange rates can have a significant effect on most economies 26­4 Nominal Exchange Rates • The nominal exchange rate is the rate at which two currencies can be traded for each other Rates for July 5, 2013 China (yuan, ¥) Hong Kong (HK$) Japan (¥) Singapore (S$) Thailand (baht, ฿) Foreign Currency / Dollar 6.132 7.755 100.940 1.281 31.240 Dollar / Foreign Currency 0.163 0.129 0.010 0.781 0.032 26­5 Nominal Exchange Rates • Consider currencies: US$, Singapore dollars (S$), and Chinese yuan (¥) – – One dollar buys ¥ 6.132 or S$ 1.281 The exchange rate between Chinese yuan and Singaporean dollars can be calculated from this information ¥ 6.132 = S$ 1.281 ¥ = S$ 1.281 / 6.132 ¥ = S$ 0.209 OR S$ = ¥ 6.132 / 1.281 S$ = ¥ 4.787 26­6 1065 39865 38665 374 65 36265 35065 33865 100 32665 314 65 30265 29065 27865 26665 Exchange rat e index, 1973=100 U.S Nominal Exchange Rate, 1973 - 2012 160 14 120 U.S Nominal exchange rate 80 60 40 20 Year 26­7 Changes in Exchange Rates • Appreciation is an increase in the value of a currency relative to other currencies – Example: U.S dollar appreciates when it goes from $1 = £ 0.5 to $1 = £ 0.6 • • A dollar buys more of the foreign currency Depreciation is a decrease in the value of a currency relative to other currencies – Example: the Canadian dollar depreciates when it goes from C$ = ¥ 96 to C$ = Ơ 95 A Canadian dollar buys fewer yen 26­8 Exchange Rates • Definition – e = the number of units of foreign currency that each unit of domestic currency will buy • • • • Example, e is the number of Japanese yen you can buy with $1 e is the nominal exchange rate Domestic currency appreciates if e increases Domestic currency depreciates if e decreases 26­9 Exchange Rate Strategies – • • – – The foreign exchange market is the market on which currencies of various nations are traded A flexible exchange rate is an exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market A fixed exchange rate is an exchange rate set by official government policy Can be set independently or by agreement with a number of other governments Fixed rates can be set relative to the dollar, the euro, or even gold 26­10 International Trade • Trade is important even to a large economy such as the U.S – – • Exports 13% of GDP in 2008 Imports 17% of GDP in 2008 Trade and capital flows are easily politicized – – Free trade can be seen to cost U.S jobs Foreign control of "essential" assets such as ports or telecommunications infrastructure 26­38 Trade Balance • Trade balance is another name for net exports (NX) – • A trade surplus is a positive trade balance – • Value of a country's exports minus the value of its imports Exports > imports A trade deficit is a negative trade balance – Imports > exports 26­39 2012 2008 2004 2000 1996 1992 1988 1984 1980 1976 1972 1968 1964 1960 Percent age of GDP US Trade Balance, 1960 - 2012 12 10 Imports/GDP Exports/GDP Year 26­40 Capital Flows • • International capital flows are purchases or sales of real and financial assets across international borders – Capital inflows are purchases of domestic assets by foreign households and firms – Capital outflows are purchases of foreign assets by domestic households and firms – Net capital inflows (KI) are capital inflows minus capital outflows Capital flows are not counted as imports or exports since they refer to the purchase of existing assets rather than currently produced goods and services 26­41 Trade Balance (NX) and Net Capital Inflows (KI) NX + KI = • • U.S resident purchases Japanese car for US$20,000 – Imports = US$20,000 Manufacturer holds US$20,000 in a U.S bank account – Option 1: purchase US$20,000 of U.S goods and services so exports = US$20,000 – Option 2: purchase U.S bonds or U.S real estate • NX = – US$20,000, KI = US$20,000 – Option 3: sell US dollars for yen • Follow the US dollars and see what the purchaser does with them to determine NX and KI 26­42 International Capital Flows • • • • Highly developed financial markets allow borrowing and lending across borders Transactions are subject to laws in the originating country and the target country – Size of international flows for a country depend on its regulations and laws – Also depend on economic integration and political stability Lending is acquiring a real or financial asset – Buying a share of stock or a government bond or a parcel of land Borrowing is selling a real or financial asset 26­43 Two Roles of International Capital Flows 26­44 International Capital Flows • Capital inflows to the U.S include foreign purchases of – Stocks and bonds of U.S companies – U.S government bonds – Real assets such as land and buildings owned by US residents KI KI < Capital flows respond to real Net capital interest rates outflows – Higher domestic interest KI > rates mean greater capital Net capital inflows inflows Domestic Real Interest Rate (r) • Net Capital Inflows (KI) 26­45 Risk and Capital Inflows For a given real interest rate, increase in riskiness of domestic assets decreases capital inflows – – – Shifts the capital inflow curve to the left Foreigners are less willing to buy domestic assets Domestic savers are more KI' KI willing to buy foreign assets Domestic Real Interest Rate (r) • Net Capital Inflows (KI) 26­46 Savings, Investment, Capital Inflows Definition of output Y = C + I + G + NX • • • • • Solve for I Y – C – G – NX = I National savings, S, is (Y – C – G) S – NX = I Also NX + KI = OR KI = – NX So S + KI = I 26­47 S + KI = I • • Savings plus net capital inflows equals investment in new capital goods – Foreign savings can supplement domestic savings to create capital goods to support economic growth S + KI In a closed economy, S=I – In an open economy, r S + KI = I * I Capital inflows mean more investment and lower S, interest rates Real interest rate (%) • SavingI and investment 26­48 The Saving Rate and the Trade Deficit • What causes trade deficits? – – – • Not the production of inferior goods Not the result of unfair trade restrictions A low rate of national saving is the primary cause Recall S – I = NX – – – Hold I fixed High level of S implies a high level of NX Low level of S implies a low level of NX 26­49 The Saving Rate and the Trade Deficit • Why is a low rate of national saving associated with a trade deficit? – – – – • Low savings implies high spending High spending includes more spent on imports High domestic spending leaves less available for export High imports and low exports Trade deficit country receives capital inflows – – Lack sufficient saving to finance domestic investment Interest rate will rise and attract capital inflows 26­50 The U.S Trade Deficit • • • • • • • U.S trade balanced until the mid 1970’s Large deficits since the mid 1970’s National saving has been less than investment since the mid 1970’s Large government budget deficits, especially in the 1908’s Decline in private saving in the 1990’s as consumption spending surged – More spending on imports Large government budget deficits in the 2000’s Trade deficits are not a problem as long as the economy continues to grow 26­51 Exchange Rates, International Trade, and Capital Flows • Exchange rates – – – Nominal and real Fixed and flexible Short run and long run • • • • • Purchasing power parity Monetary policy and the exchange rate Trade balance and net capital inflows International capital flows The saving rate and the trade deficit 26­52 ... / 1.281 S$ = ¥ 4.787 26 6 1065 39865 38665 374 65 3 6265 35065 33865 100 3266 5 314 65 3 0265 29065 27865 266 65 Exchange rat e index, 1973=100 U.S Nominal Exchange Rate, 1973 - 2012 160 14 120 U.S... rate 26 2 The International Economy • • • • Every day, news draws our attention to the global economy – The U.S sub-prime mortgage crisis of 2007 – 2008 quickly became a worldwide event because of. .. dollar buys fewer yen 26 8 Exchange Rates • Definition – e = the number of units of foreign currency that each unit of domestic currency will buy • • • • Example, e is the number of Japanese yen you