International Trade and Finance

1. International Trade and Finance PPTs series 5 Econ 455

2. List of Contents • Part II Finance • The Balance of Payments • a) Concept and Structure of BoP • b) BoP and GDP • c) BoP goals • 2. Foreign exchange • a) Exchange rates and Markets • b) Exchange rate Mechanics • c) Exchange Rate Policies • 3: Exchange Regimes • a) Gold Standard • b) The Bretton Woods System • c) Extensions • d) Controversies • 4. Agents and their Activities • 5. Selected Exchange Rate Theories Introduction Part I Trade 1. Theories of Trade a) Motives for Trade b) Absolute Ádvantage c) Comparative Advantage d) Extensions 2. Barriers to Trade a) Non.tariffary Barriers b)Tariffs c) Quotas d) Subsidies Econ 455

3. Exchange Rates Econ 455

4. Exchange rates Exports Imports Financial Transactions Interest Rates Money Supply Employment Price Level Production and Income Econ 455

5. Definitions: The exchange rate is the price of one unit of a foreign currency, i.e. e = x€/1$ Which will be used in the lecture Or The quantity of foreign exchange equivalent to one unit of domestic currency. i.e. e‘= y$/1€ Econ 455

6. Example: e= 1,33421 €/$ e‘=0,74951 $/€ An increase in e (decrease in e‘) is called Devaluation (or depreciation) A decrease in e (increase in e‘) is called Revaluation (or appreciation) Econ 455

7. The Simple Mechanics of Exchange Rates - First Approach Exchange rates are prices Prices are determined on a market A market joins supply and demand Supply: Exports and Capital Imports Demand: Imports and Capital exports Econ 455

8. Foreign Exchange Market S e D $ Econ 455

9. Supply of foreign exchange from exports • Rises with a rising exchange rate e, • Rises with rising foreign national income Y‘ • Rises with inflation abroad above inflation at home P‘- P >0 or X = f(e,Y‘,P‘, P) with dX/de>0; dX/dY‘ >0, dX/d P‘>0, dX/d P<0, Econ 455

10. Demand for foreign exchange for Imports • drops with a rising exchange rate e, • drops with rising national income Y • drops with inflation abroad above inflation at home P‘- P >0 or M = f(e,Y,P‘, P) with dM/de<0; dM/dY >0, dM/d P‘<0, dM/d P>0, Econ 455

11. A Small Simplification: Capital export rises with rising difference betweeen foreign and national interest rates Capital import rises with falling difference between foreign and national interest rates CX =f(i‘-i) Econ 455

12. Revaluations and Devaluations (Examples) S (i‘↑, i↓) S e S (Y‘↑) D (i‘↑, i↓) D $ Econ 455

13. Politics: • Should exchange be free or restricted? • How will the exchange rate be determined? Econ 455

14. Degree of Freedom of exchange: All government regulations concerning the acquisition, possession and utilization of foreign exchange by residents and the acquisition, possession, and utilization of national currency by foreigners Econ 455

15. Exchange Rate Systems: All government regulations concerning the formation of the exchange rate under the assumption of free exchange Econ 455

16. Systems with fixed exchange rates System of flexible exchange rates Mixed systems Econ 455

17. Gold Parities 1M = 0,2 grams of gold 1$ = 0,8 grams of gold 1Lb = 4 grams of gold  Bilateral Parities 1M = 0,25 $ 1M = 0,05 Lb 1Lb = 20 M 1 Lb = 5 $ etc Rules: Money supply consists of gold and banknotes backed by gold and checkable deposits with the banking system Banknotes my freely be exchanged into gold by every holder regardless of identity There is no restriction against the export or import of gold Fixed Exchange Rates: The classical Gold Standard Econ 455

18. Mechanics: foreign exchange under the Gold Standard e S GOLD EXPORT Gold Transport cost D $ Econ 455

19. Mechanics: foreign exchange under the Gold Standard e S GOLD IMPORT Gold Transport cost D $ Econ 455

20. IMF-Members define a Gold or $-par value, i.e.1$ = 4,00 The exchange rate may not rise above or fall below a limit of ±1% of the $-par value Central banks are obliged to maintain the exchange rate within the so defined band Par values may be changed in the event of a fundamental desequilibrium Mixed System: Bretton Woods, NH 1944 Econ 455

21. Mechanics: foreign exchange under Bretton Woods System S e Upper Limit Par Value Lower Limit Band of permitted fluctuation D Central Bank Purchases of $ $ Econ 455

22. Problems: Intervention at lower limit: Rise in international reserves raises money supply and may lead to inflation Intervention at upper limit: International reserves may be depleted Econ 455

23. Metamorphosis of the Bretton Woods System Dollar glut Abandoning of Dollar-gold par value in 1971 Floating rates – managed float Dollar replaced by currency baskets als anchor i.e. European Monetary system 1978 - 1999  Econ 455

24. European Monetary System 1978 - 1999 Postwar european unification process. Near-common currency by $ serving as anchor currency. Transition to floating rates, threat of European destabilization Founding of EMS in 1978. Elements: • Creation of the ECU as currency basket • Definition of ECU-Parities • Calculation of bilateral parities by „parity grid“ • Agreement to maintain a band of 2,25 % around bilateral parities by mutual interventiuons • Possibility of realignments 1992 Maastricht Treaty 1999 EMU and introduction of the Euro Econ 455

25. The controversy: Fixed (pegged) versus flexible exchange rates Econ 455

26. The controversy: Fixed (pegged) versus flexible exchange rates • The advice: • Flexible exchange rates to be recommended as the normal exchange rate system • Pegged exchange rates, when the previously flexible rate has shown stability • over a longer period, this being the case when countries show great similarity • In their economic performance: • Optimum currency area. • Similarities in • industrial structure, trade patterns, mobility, interest rates, rates of inflation • and unemployment, etc. Econ 455

27. An extension: Monetary Unions Durable and reliably fixed exchange rates in only feasible optimum currency areas. If member countries are suboptimal currency areas distortions present problems  EMU Econ 455