ECO215 INTERNATIONAL FINANCE

1. ECO215INTERNATIONAL FINANCE Numan ÜLKÜ, Ph.D. Associate Professor of Economics and Finance

2. Course Program Topic 1: Open Economy and Balance of Payments Topic 2: Foreign Exchange Markets Topic 3: Exchange Rate Determination

3. TOPIC 1:OPEN ECONOMY MACROECONOMICS • Closed Economy: Y = C + I + G Open Economy: Y = C + I + G + EX − IM • EX − IM = CA Y − (C + I + G) = CA • CA = ΔNFA

4. Unlike closed economy, in an open economy S and I need not be equal. EX > IM ≡ S > I ; EX < IM ≡ S < I • S = Y − (C + G) Hence, in a closed economy: S = I • In an open economy: S = I + CA Unlike a closed economy, an open economy with profitable investment opportunities does not have to increase its saving to exploit them.

5. Private and Government Saving: Sp = Y − (C+T) Sg = T − G S = Sp + Sg = Y − C − T + T − G = Y − C − G Sp = I + CA −Sg = I + CA + (G − T) » CA = Sp − I + T − G CA = Sp − I − (G − T) Current account and budget deficits are usually called “twin deficits”, and budget deficits are argued to lead to CA deficits. However, the above equations show that budget deficit’s effect on private savings may change this link.

6. TOPIC 2: BALANCE OF PAYMENTS Balance of Payments Accounting: any FX inflows are recorded as a (+), any FX outflows are recorded as a (–). old system: Balance of Payments = Current Account + Capital Account Trade Balance = Exports − Imports Current Account = Trade Account  Tourism  Worker’s Remittances  International Transportation  Interest Payments on Foreign Debt (and dividend receipts from foreign equity holdings)  International Insurance and banking fees + international aid + net errors and omissions Capital Account = Portfolio Flows + FDI + Bank borrowing

7. BALANCE OF PAYMENTS(new system) • Balance of Payments = Current Account + Financial Account + Capital Account Financial Account: Buying and selling foreign financial assets by domestic residents or domestic financial assets by foreign resident. - Direct Investment Flows - Portfolio flows - Bank lending and borrowing Capital Account: nonmarket capital transfers (moving cash, foreign aid). Net Errors and Omissions:

8. Return Return means percentage change in the value of an investment. One can calculate the return on an exchange rate in the same way. Real Return:

9. Return on Foreign Currency Denominated Assets R = (1+R*) ∙ (1+RFX) − 1 R is the return in home currency R* is the return of the foreign asset in foreign currency RFX is the return of the exchange rate (defined as the price of foreign currency in domestic currency) You can get the same result by calculating the value of the foreign asset in terms of domestic currency at the beginning and end of the period.

10. The concept of Expected Return: It means Required Return. As , the expected return E(R) is the distance of the expected future price E(PT) from the current price Pt. Assume that expected future price is given. Then: a decrease in the current price ≡ higher expected return an increase in the current price ≡ lower expected return.

11. TOPIC 3:EXCHANGE RATE DETERMINATION Equilibrium condition in the FX market: ii* + E(RFX) A rise in i* relative to i results in appreciation of foreign currency. A rise in expected future exchange rate causes a rise in the current exchange rate. In real life, E(RFX) is typically unobservable, so we can infer it from interest rate differentials: E(RFX) = i− i*E(RFX) = E(St+1) / St 1 Notice that the forward price formula comes from this.

12. Fisher Effect: Nominal interest rate is proportional to expected inflation.i = E(ΔP) + real If Fisher effect holds in both domestic and foreign country and if real interest rates are constant and equal across countries, then IRP and PPP are equivalent.E(ΔS) = i – i* = E(ΔP) + real − E(ΔP*) − real = E(ΔP) − E(ΔP*)

13. A Reminder of Monetary Theory Demand for Money: Md = P ∙ f (i-, y+) Real Money Demand: Md / P = f (i-, y+) Ms is assumed to be given. Equilibrium in the money market is established when Md/P = Ms/P (i.e., at the intersection of Md/P and Ms/P curves). The market always moves towards this equilibrium.

14. Money Supply and Exchange Rates Short-run[price level (P) and real output (y) fixed] Ms ↑ »i ↓ » currency depreciates (i.e. S ↑) Ms ↓ »i ↑ » currency appreciates (i.e. S ↓) Long-run: [after P and W adjust to the new Ms] P = Ms / Md (a once-for-all increase in Ms causes a proportionate increase in the price level, and has no effect on i and y, especiallyif the economy was initially at full employment –if not, y may change-). FX rate behaves just as any other price: Ms ↑ » S ↑

18. Gold (Jan.2008 – Mar.2012)

20. Dollar index

23. Price Levels and Exchange Rates THE LAW OF ONE PRICE: On the assumption that transportation costs and barriers to trade are zero, identical goods sold in different countries must have the same value. LOP Equation: Pi = S ∙ Pi*E.g.:PiBG = S ∙PiUS Prices and exchange rates should adjust to satisfy low of one price. (If PiBG < S * PiUS, merchants would arbitrage until the mispricing is eliminated. If Bulgaria can produce infinite amounts of this good at a lower price, then S will adjust) Hence: Absolute PPP Equation PPP Equation is the general price level version of LOP equation.

24. PPP Theory: (Even when LOP does not hold) Relative Version of PPP Equation (defined over a given time interval) Absolute version of PPP is difficult to measure in real life. As long as composition of goods remain the same, relative PPP is reliable.

25. Monetary ApproachIt is a long-run model, because it is based on P adjustment.Implications of the Monetary Approach:Ms↑ »P ↑ » S ↑y ↑ »P ↓ » S ↓i ↑ ≡ P ↑ » S ↑ (this seemingly tricky prediction stems from the assumption that i is caused by inflation expectations). Fisher Effect: i i* = E(P)  E(P*)

26. Ongoing Inflation and Exchange Rates • Interest rates immediately adjust to expected inflation. • In real life, once-for-all increases in Ms are unlikely; usually we see a constant growth rate (P) of Ms. • When the growth rate of Ms is public information, it becomes expected rate of inflation: E(P) • Thus, E(S) = E(P) E(P)* Now, analyze the effect of an increase in Ms growth rate: E(P) will adjust immediately, and due to Fisher effect i will rise. According to Monetary Model with flexible prices (long-run), Md will fall resulting in a jump in P. S will also jump as implied by PPP (i.e., following the jump in P).

28. Monetary approach contrasts to the “sticky prices” assumption. Under sticky prices, a fall in Ms, rather than an increase in Ms growth rate, results in a higher i. This higher i, however, is associated with S ↓ • PPP, IRPT and Monetary approach do poorly in empirical tests. • Monetary approach does well when there is high inflation driven by exogenous Ms increase.

33. Empirical Evidence on PPP: • Absolute version of PPP does not hold. This is understandably due to: 1) Transportation costs, 2) Trade Barriers, 3) Nontradables (housing, labor-intensive services, etc.), 4) Imperfectly-competitive market structures, 5) Differences in consumption basket. • Relative version of PPP does poorly in empirical tests, especially under floating exchange rates and in the short run. This can be attributed to changes in market structures and consumption basket composition, changes in relative prices of nontradables. Due to price stickiness and excessive volatility of exchange rates, there are more deviations in the short run than in the long run, and more under floating regime than under fixed regime.

34. Real Exchange Rates PPP implies that SR does not change. (Absolute PPP says SR=1; Relative PPP says changes in relative price levels will be offset by changes in S.) PPP is a basic building stone of exchange rate determination, however it cannot explain all exchange rate movements. Then, the task of a complete exchange rate determination theory can be defined as “explaining deviations from PPP” which amounts to “characterizing real exchange rates”.

35. The Relationship between Income Level and Real Exchange Rates The real value of the currency is positively related to per capita income of the country. This relationship is mainly driven by the relative prices of nontradables. Two theories to explain this relationship: • Balassa-Samuelson effect: In poor countries, labor is less productive in the tradables sector, while productivity differences in nontradables are trivial. As the prices of tradables are equal across the world, the workers in tradables sectors in poor countries must be paid less. As wages will be equalized across sectors, the wages in nontradables sector will also be less, leading to a lower price of nontradables. • Bhagwati-Kravis-Lipsey theory: is based on the capital and labor endowment. Rich (poor) countries have higher (lower) capital/labor ratio. Therefore, labor productivity, hence wages are higher in rich countries. Because nontradables are typically labor-intensive sectors, they are more expensive in capital-intensive countries.

36. A More General Model of Exchange Rate Determination This model allows for real exchange rate changes as well as national price level changes (i.e. nominal exchange rate changes), hence it is a generalization of the monetary approach (i.e. it combines monetary shocks with real shocks). 1) Ms ↑ » S ↑ (SR unaffected) 2)  Ms ↑ » S ↑ (SR unaffected) 3) Relative demand for domestic goods ↑» SR ↓ (P unaffected) S↓ 4) Relative supply of domestic goods ↑ » SR ↑ and P ↓ Net effect on S ambiguous When shocks are monetary, PPP holds; when they involve output markets, PPP may not hold.

37. Interest Rate Differentials and Real Exchange Rates i  i* = E(S) by IRPT i – E(P) – [ i* E(P*)] = i  i*  [E(P) – E(P*)] (real interest rate differential) = E(S)  [E(P) – E(P*)] E(S)  [E(P) – E(P*)] is E(SR) Expected real exchange rate change equals expected nominal exchange rate change  expected inflation difference. When relative PPP holds, E(SR) = 0. Expected Real Interest Rate = E(iR) = i – E(P) E(iR)  E(iR)* = i  E(P)  [i*  E(P*)] E(iR)  E(iR)* = E(SR) If relative PPP holds, then E(iR) = E(iR)*

38. Output and Exchange Rate (Short-Run) Up until now, we have been assuming that output shocks are exogenous, and we have ignored the impact of other variables on output. Now, we will analyze a more general model that also includes the response of output. Naturally, this is a short-run model (sticky prices). –in the long run, the economy is at full-employment and y=f(K,L). Aggregate Demand (AD): A main determinant of Output in the short run is AD. AD = C + I + G + CA • C = f (Y – T) Y-T is the disposable income. C / (Y-T) > 0 2C / 2(Y-T) < 0. (a more realistic model also includes wealth and i)

39. CA = EX(SR) – IM(SR,Y)CA / SR > 0CA / (Y-T) < 0 (a more realistic model also includes foreign income level, these complications are addressed in a richer model in Ch. 19). EX / SR > 0IM / SR~ ambiguous (as price effect may offset quantity effect) • G and I : for now, we assume them as given (exogenous). Hence, AD = f (SR, Y-T, G, I) * A real depreciation of the home currency increases the AD for domestic output. * An increase in real income increases AD. (because the increase in C is bigger than the decrease in CA). However, the increase in AD is much less than the increase in Y, as a portion of increased Y goes to S, and some portion goes to IM. A key assumption: the proportion of domestic output in domestic C is bigger than that of foreign output).

40. Empirical Evidence from Hungary: What happens to CA following an increase in S

41. Equilibrium condition in the output market: AD = AS Y = AS = AD(SR, Y–T, G, I) How Y and SR are simultaneously determined ?

42. Short-run Full Equilibrium in the Economy as a whole is achieved at the intersection of the DD and AA curves (i.e. when both output and the asset markets are in equilibrium.

43. DD curve gives possible pairs of S and Y at which the output market is in equilibrium (P and P* fixed). Y = f(S) On the S / Y diagram, it is upward-sloping, convex; implying that Y will increase, at a decreasing rate, as S increases. G ↑ , T ↓ , I ↑ , P ↓ , P* ↑ , propensity to consume ↑ , and a demand shifttowards domestic goods(i.e., anything that increases AD) result in a rightward shift of the DD curve, which means a higher Y for a given S. AA curve gives possible pairs of S and Y at which the asset (money and FX) markets are in equilibrium. S = f(Y) On the S / Y diagram, it is downward-sloping, convex; implying that S will decrease, at a decreasing rate, as Y increases. Ms↑ , Md ↓ , P ↓ , E(S) ↑ and i* ↑ (i.e., anything that makes home currency less attractive) result in an outward shift of the AA curve, which means a higher exchange rate (lower domestic currency value) for a given Y.

44. Analyzing the effects of macroeconomic policy tools: A temporary increase in G shifts the DD curve to the right. A (once-for-all) temporary increase in Ms shifts the AA curve shifts to the right. When the policy change is permanent, we have to consider the impact of long-run expectations on short-run equilibrium. Assuming the economy was initially at full-employment (Yf): A (once-for-all) permanent increase in Ms shifts the AA curve shifts to the right by more than an equivalent temporary increase would. This is because of its effect on long-run expected S. At this point, the economy is above Yf. In time, however, P will rise, DD curve will shift to the left; and AA will also shift to the left, until AA and DD curves intersect at Yf. (As long as Y > Yf, P ↑, and AA-DD curves will shift). A permanent increase in G will, in addition, raise expected currency value, i.e., lower E(S), –simply because it is permanent-, hence shift the AA curve to the left.

45. The effects of a permanent increase in Ms and G

46. Macroeconomic Policy and the Current Account XX curve plots the combinations of S and Y at which CA is maintained at a “desirable” level (say X). It slopes upwards, because a higher Y would cause a worsening in CA unless accompanied by an increase in S. The slope of the XX is less than the slope of the DD curve, because on DD curve CA remains constant (when Y grows, the economy can survive with a worse CA). Above this curve, CA > X; below this curve CA < X. The effect of the macroeconomic policy is found by intersection of DD and AA curves, and the position of the new equilibrium relative to XX curve will tell us the effect of the policy on the CA.

47. Ms ↑  CA ↑ G ↑  CA ↓ A permanent increase in G worsens the CA more, as it will also shift the AA curve to the left. This will eventually lead to a depreciation of the home currency.

48. J-Curve In reality, the CA may display a slow, rather than immediate, improvement in response to an increase in S, typically following an initial temporary worsening. This is called the J-Curve. The previous analysis needs to be modified accordingly: Ms ↑ may initially depress Y, further decreasing i and overshooting the exchange rate. • Exchange rate pass-through: (SP*) / S Our assumption that P* is unaffected by S (i.e. (SP*) / S = 1) may not be realistic, in reality (SP*) / S < 1 . This results in a dampening of the J-curve (i.e., slow adjustment of foreign trade to exchange rate). In high-inflation economies, it is very difficult to alter SR by changing S (exchange rate pass-through is close to 1). • Marshall-Lerner condition: Holding Y constant, CA / SR depends on the elasticities of export and import w.r.t. SR. CA / SR > 0 when eEX + (S2/S1)eIM > 1 (eIM is multiplied by -1).

50. Central Bank Intervention and Money Supply • Changes in CB’s assets automatically cause changes in Ms. • In the same manner, FX interventions cause changes in both foreign assets in CB balance sheet and thus domestic Ms. • Sterilized Intervention: Equal amounts of foreign and domestic asset transactions in opposite direction in order to nullify the impact of FX intervention on Ms. Thus, total value of CB assets are left unchanged.