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Eco 344

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Eco 344

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  1. Eco 344 International Economic Relations

  2. Instructor •

  3. Office

  4. Textbook • Robert C. FeenstraUniversity of California, Davis • Alan M. TaylorUniversity of California, Davis

  5. Quiz (no grade)First Name_____, Last Name_______, Major_____ • Q1: What would happen to the oil price if the civil war in Libya ends now? Please use the demand-and-supply diagram. • Q2: People say that we need to bring jobs back to US from overseas. But how? Give one or two suggestions.

  6. World Economy in 2010 Do you want to buy house soon? Do you want to complain about no salary raise? What happens to unemployment rate in US? Why are the young people in Egypt so unhappy? What’s wrong with Ireland and Greece?

  7. Suggestions to bring jobs back • Tax • Tariff • Minimum Wages • Education, Infrastructure • New Jobs

  8. My Comments • Most oversea jobs are labor-intensive. USA does not have (comparative) advantage producing labor-intensive goods. • Companies make decisions. A workable solution should agree with companies’ interests. • Tariff may trigger trade war.

  9. External Debt • US is running (current account) deficit because expenditure exceeds income • The deficit is financed by borrowing from other countries (How about printing money?) • The absolute amount of US external debt is huge • Other countries have higher debt-income ratios than US •

  10. Default on US Debt? • Interest rate will go up • Investment will go down • Stock price will go down • Consumption will go down • Export will go down • Fiscal deficit will go up • Less confidence in US

  11. Credit Ratings of Sovereign Debts • Credit score for country • • BB+ or lower is junk bond • What’s wrong with Argentina?

  12. International Perspective • •

  13. (Bilateral) Exchange Rate • Exchange rate is price of currency • Two ways to quote exchange rate • One way is the reciprocal of the other: EA/B = 1/EB/A • Currency A appreciates if EB/A goes up • Currency A appreciates if EA/Bgoes down • To avoid confusion we use EA/Bfor currency A

  14. Multilateral (Effective) Exchange Rate • Available at • Trade-weighted average of bilateral exchange rate • Does currency A appreciate or depreciate against other currencies in general?

  15. US Effective Exchange Rate

  16. Discuss • What is the variable on vertical axis? • Why are there two lines? • Has dollar depreciated or appreciated in general? • Why is the red line steeper than the blue line?

  17. Using Exchange Rates to Compare Prices • PA is the currency-A price • PBis the currency-B price • Which price is cheaper? PA <> PBx EA/B PA<> PB/ EB/A

  18. Exchange Rates and Trade • What happens to country A’s export and import if currency A depreciates? • EA/B goes up • The price of imported goods PB x EA/B goes up, so import goes down • The price of exportedgoods PA / EA/B goes down, so export goes up • In short, depreciation helps export but hurts import

  19. Argentina’s Crisis Revisited • During the 2002 (Peso) crisis, Argentina’s currency depreciated against US dollar • Argentina’s export to US improved • But, the price of imported goods went up, so inflation was high

  20. Discuss: Chinese Yuan • Suppose Yuan appreciates against US dollar • What happens to US export to China? • What happens to US import from China?, and, from other countries like Vietnam? • What happens to US inflation rate?

  21. Review • Two ways to quote exchange rate (Corn Story) • If currency A depreciates against B, then B must appreciate against A • Depreciation increases export • Depreciation decreases import • Intuition is, if our currency becomes cheap (depreciate), our goods become cheap too. So more foreign people want to buy our goods and our export to foreign countries rises. • Appreciation has opposite effects

  22. Japanese Intervention • Yen’s appreciation hurts Japanese export • To stop the appreciation of Yen, supply curve for Yen should shift to right • Japanese central bank sells (supplies) Yen and buys (demands) dollars • Reality Check:

  23. Chinese Intervention • To keep Yuan from appreciating, Chinese central bank keeps selling Yuan and buying dollars • China’s dollar reserve accumulated, and money supply increased • Inflation rate in China went up • China is importing inflation (or expansionary monetary policy, QE) from US due to its fixed exchange rate • Letting Yuan appreciate helps mitigate inflation in China

  24. 1997 Asian Financial Crisis • Some Asian currencies were overvalued, and were expected to depreciate • To stop depreciation, their governments sold US dollar and bought domestic currencies • The crisis (the rapid depreciation) occurred when the government ran out of dollar reserve •

  25. Exchange Rates: Developed Countries

  26. Exchange Rates: Developing Countries

  27. Remarks • 1997 Asian Crisis • 2002 Argentina Crisis • Denmark uses fixed exchange rate against Euro • Ecuador dollarized in 2000, see • Euro was introduced in 1999, see

  28. Spectrum of Exchange Rate Regimes

  29. Foreign Exchange (FX) Market • Spot Contract; Spot Rate; Immediate Exchange of One Currency for Another • Derivatives (Forwards, Swaps, Futures, Options) • For forward contract, the delivery of currency is in the future • Forward rate tracks spot rate closely.

  30. Spot and Forward Rates

  31. Remarks about FX Market • The FX market is highly volatile (risky) • Government is an important player • Some currencies are not fully convertible due to reasons such as capital control • Transactions on FX market have different purposes: hedging, speculation, arbitrage, government intervention….

  32. Arbitrage • Arbitrage means buying low and selling high • Arbitrage push prices to converge • Everyone buys low, so the low price will go up • Everyone sell high, so the high price will go down • Prices become stable when prices become equalized (No Arbitrage Condition).

  33. Theory of Exchange Rates I: No-Arbitrage with Two Currencies • E1/2, Adenotes the exchange rate at location A • E1/2, Bdenotes the exchange rate at location B • No-arbitrage condition requires that E1/2, A= E1/2, B • In reality the two rates can differ due to factors such as transaction cost

  34. Two facts • Currency A appreciates (become more expensive) ↔ EA/B goes down • Currency A depreciates (become less expensive) ↔EA/Bgoes up • You can avoid many confusions if you keep these two facts in mind • When the corn price changes from Ecorn/$= 4 to Ecorn/$= 5 , the corn becomes cheaper

  35. Euro • Unit Europe monetarily: One central bank • Remove (part of) risk of foreign exchange • Make it easy to travel and do business within Eurozone • Next, one Treasury? • Challenge: heterogeneity in members

  36. Soros •

  37. Q 5 on Page 61 • Suppose quotes for the dollar-euro exchange rate E$/€are as follows: in New York $1.50 per euro, and in Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo.

  38. Answer • Euro is more expensive at Tokyo • Buy euro at New York and sell euro at Tokyo • The New York rate, 1.50 will go up • The Tokyo rate, 1.55 will go down • Trick for exams: arbitrage always pushes lower rate up and higher rate down (i.e., Two rates converge).

  39. Theory of Exchange Rates II: No-Arbitrage with Three Currencies • E1/3 is the direct rate • E1/2 E2/3 is the cross rate, and currency 2 is called vehicle currency • No triangular-arbitrage condition requires that E1/3 = E1/2x E2/3 or equivalently, E1/3 = E1/2/ E3/2 • In short, arbitrage pushes the direct rate and cross rate to be equal

  40. Covered Interest Parity (CIP)Theory for Forward Exchange Rate • F denotes the forward (exchange) rate • An investor can use dollar deposit • Alternatively an investor can convert dollar to euro using spot rate, use euro deposit and later convert euro back to dollar using forward rate • No arbitrage condition implies that

  41. Remarks about CIP • We can solve for forward rate if we know interest rates and spot rate • Forward rate and spot rate are positively correlated, explaining Figure 2-5 on page 40 • CIP implies that

  42. Evidence on CIP

  43. Uncovered Interest Parity (UIP)Theory for Spot Exchange Rate • No-Arbitrage also indicates UIP, which states that

  44. Implication of UIP • Everything else equal, a rise in American interest rate leads to a fall in current spot rate, i.e., instantaneousappreciation of dollar • Everything else equal, a rise in American interest rate leads to a rise in expected future spot rate, i.e., expected future depreciationof dollar

  45. Remarks about UIP • We can solve for current spot exchange rate if we know interest rates and expected future spot rate • The expected future spot rate is determined by the long-term PPP model discussed in the next chapter • Big Picture:

  46. Lesson for International Investment • When making decision regarding international investment, one needs to take both interest rate and exchange rate into account • If American interest rate is higher than euro interest rate, then according to UIP, dollar is expected to depreciate against euro

  47. Drawbacks of UIP and CIP • They are short-term models • They ignore the effect of trade on exchange rate • One cannot apply UIP or CIP for countries with capital control

  48. Q 6 on Page 61

  49. Bond Yields • • Bond price is negatively related to yield (interest rate) • The yield of Greek bond is highest, so the price of Greek bond is lowest. • US bond is still popular • Demand-and-supply diagram can be applied to the bond market

  50. Critical ThinkingFine-Tuning CIP and UIP • Read key points 12-15 on page 59 • We can improve a theory by relaxing its assumption • Assumptions for the basic form of CIP and UIP: • No capital control • No tax • No fee for currency transaction • No inflation…