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FIN 30220: Macroeconomic Analysis

FIN 30220: Macroeconomic Analysis. Open Economy Macroeconomics. Open economy macroeconomics looks at the interactions between the US and the rest of the world. Exports. Imports. 2005 Exports = $1,740,894M Imports = $2,545,843M.

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FIN 30220: Macroeconomic Analysis

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  1. FIN 30220: Macroeconomic Analysis Open Economy Macroeconomics

  2. Open economy macroeconomics looks at the interactions between the US and the rest of the world Exports Imports 2005 Exports = $1,740,894M Imports = $2,545,843M The current account keeps track of the flow of goods and services in and out of the US Net Exports = - $804,949

  3. 2005 US Current Account (in Millions) • In 2005, the deficit in merchandise increased by 17% as imports grew faster than exports • The surplus in services increased by 21% in 2005 as receipts grew faster than payments • The surplus in income decreased by 94% as payments increased faster than receipts

  4. What’s the meaning of a trade deficit? To answer this, lets look back at the national accounting identities… Y = C + I + G + NX A trade deficit signifies that we as a country are spending beyond our current income Solving for Net Exports, we get NX = Y – (C + I + G) Aggregate Expenditures National Income Alternatively, National Savings S = I + (G-T) + CA CA = S – [I + (G-T)] A deficit signifies that we are borrowing more than we are saving Aggregate Borrowing

  5. A trade deficit implies that the US is borrowing from the rest of the world (currently, we are borrowing at the rate of $2B per day). A equivalent statement is that the rest of the world is acquiring US assets Suppose that, while on vacation in France, you buy a case of French wine for $1,000. You pay for the wine with cash The French wine maker uses the $1,000 to buy a computer from Dell – Net exports equals zero (no change in asset holdings). The French wine maker uses the $1,000 to buy a US Treasury – Net exports are negative (Increase in French holdings of US assets). The French wine maker uses the $1,000 to buy stock in a French company from an American– Net exports are negative (Decrease in US holdings of French assets). Changes in Assets are recorded in the Capital and Financial Account

  6. 2005 US Capital & Financial Account (in Millions)

  7. Current Account Capital & Financial Account Note that every credit (+) has to be matched with a debit (-). Remember this: any transaction that involves money flowing into the US is a (+)

  8. Current Account Capital & Financial Account - $20M Example #1 Suppose that Wall Mart buys $20M worth or goods from a Chinese supplier. The Chinese company uses the $20M to buy stock in IBM. $20M

  9. Current Account Capital & Financial Account $40B $30B - $80B Example #2 Suppose that the US spends $80B on a foreign aid package to Iraq. The Iraqi government uses $40B to buy computers from Dell, $30B goes to pay employees of Haliburton, and $10B is deposited in a US bank. $10B

  10. Current Account Capital & Financial Account $20B - $50B Example #3 Suppose that Nike spends $50M on a production facility in Korea - $20M is used to buy equipment from US suppliers, $30M is used elsewhere. $30B

  11. As the US trade (current account) deficit worsens, it is matched by an equally large capital account surplus – that is, capital is flowing into the US as foreigners acquire our assets. By definition, the Balance of Payments (KFA + CA) should equal zero.

  12. With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week. Eastern Time 11 PM 12 AM 3 AM 8 AM 12 PM 5 PM 9 PM Australia: 5PM - 2AM 8PM - 5AM Tokyo London: 3AM -11AM New York City: 8AM -5PM

  13. The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1.9T PER DAY!! • $600B in Spot market Transactions • $1.3T in Derivative Market Transactions • $200B in Forwards • $1T in Swaps • $100B in Options The ten most active traders account for 73% of the volume

  14. US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).

  15. An exchange rate is generally defined as the domestic currency price of a foreign currency, but be careful… Most currencies are quoted two ways: US Dollar Equivalent ($/-) Currency per US Dollar (-/$) The Euro is currently trading at .6246 The Euro is currently trading at 1.601 An increase in the US dollar equivalent rate signifies a depreciation of the dollar An increase in the currency per US dollar rate signifies an appreciation of the dollar

  16. The dollar has had quite a wild ride against the Euro since it began circulating in 1999. Recession Dollars per Euro

  17. Suppose that a dealer were offering Euro at $1.22 in New York City while a dealer in London was offering Euro at $1.24 Use the proceeds to buy Euro in New York 1 Sell Euro short in London 2 Use your newly acquired Euro to pay off your short position 3 Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)

  18. Suppose that a dealer in New York City was offering the following prices: Euro/USD = $1.25 USD/JPY = Y115 Euro/JPY = Y135 Use the dollars to buy Yen at Y115 2 Use the Yen to buy Euro at Y135 3 Sell Euro short at $1.25 1 Repay your short position The USD/JPY, and Euro/JPY rates imply a Euro/USD rate Y135 USD/JPY = Y115 Euro/JPY = Y135 Euro/USD = = $1.17 Y115

  19. Recall that in a closed economy, all borrowing had to be supplied by domestic savings – the domestic interest rate will insure that this happens. At the equilibrium interest rate

  20. In the global economy, interest rates are determined in an integrated global capital market. The world interest rate equates world saving with world borrowing. At the world equilibrium interest rate At the equilibrium world interest rate, the US is running a trade deficit

  21. The extent to which a country can effect global interest rates depends on size. The US controls 35% of the global economy. An increase in world investment demand has a negligible impact on world interest rates The increase in domestic investment demand increases the domestic trade deficit New Deficit

  22. One method for valuing exchange rates is known as Purchasing Power Parity. This simply states that the same good should cost the same everywhere when its price is expressed in the same currency. Suppose we have the following gold prices in the US and England. The current exchange rate is $1.15/L P = $500/oz P = L 400/oz Given these prices, you could make money by shorting gold in the US, converting your dollars to pounds, and then buying gold in England to cover your short position. $500 = $1.25/L The ‘PPP’ Exchange Rate should be L400

  23. The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England PPP Exchange Rate CPI (USA) e = USA CPI = 199.8 (March 2006) CPI (UK) England CPI = 195.0 (March 2006) 199.8 = = $1.025/L 195.0 Currently, the British Pound is trading at $1.786 $1.786 – $1.025 Is the British pound really overvalued by 74%? X 100 = 74% $1.205

  24. The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England PPP Exchange Rate CPI (USA) e = USA CPI = 199.8 (March 2006) CPI (UK) England CPI = 195.0 (March 2006) 199.8 = = $1.025/L 195.0 • Problems: • The CPI in the US and Britain are different bundles of goods • The CPI in the US and Britain are benchmarked by different base years A better method is to look at changes rather than levels

  25. The PPP method values exchange rates by looking at price indices across countries. For example, consider the US and England USA Inflation = 3.4% (12 months) England Inflation = 2.4% (12 months) The dollar should depreciate by 1% against the pound 12 months ago, the British pound was trading at $1.904 $1.904 ( 1.01) = $1.923 $1.786 – $1.923 Now, it looks like the British pound is undervalued X 100 = -7.1% $1.923

  26. The real exchange rate is the price level adjusted exchange rate. Its meant to capture the relative value of goods and services across countries Foreign CPI Nominal Exchange Rate Domestic CPI By definition, the PPP explanation of exchange rates assumes that the real exchange rate is constant (and equal to one)

  27. Empirically, real exchange rates are clearly not constant. In fact, the correlation between real and nominal exchange rates is nearly one. This casts some serious doubt on PPP.

  28. One difficulty with PPP is that it requires arbitrage of goods, which can be costly (shipping costs, tariffs, taxes, etc). Arbitrage with assets is relatively costless. Suppose we have the following interest rates in the US and England. The current exchange rate is $1.25/L and the brtish pound is expected to appreciate by 10% to $1.375/L over the next year. i = 6% i = 4% Buy Pounds at $1.25 (you will get L800) and buy British bonds Short $1,000 in T-Bills (You will owe $1,060 in one year) 1 2 Convert to dollars at $1.375 (You will have $1,144) and pay off loan On maturity, your British bonds pay L832 (4%) 4 3

  29. Interest Rate Parity is an arbitrage condition for assets. It states that assets with similar risk characteristics should produce the same common currency yield. Interest Parity i = 3.20% (March 2005) i = 4.59% (March 2005) The dollar should appreciate by 1.39% against the pound 12 months ago, the British pound was trading at $1.904 $1.904 ( .986) = $1.877 $1.786 – $1.877 X 100 = -4.8% $1.877

  30. Interest parity fails just as miserably as PPP does for predicting exchange rate movements…actually, if you look closely, they are actually the same condition. Interest Parity Condition The nominal interest rate equals the real interest rate plus inflation Integrated world capital markets insure that the real return is equalized across countries Purchasing Power Parity

  31. So, if both interest parity and purchasing power parity fail, then how are we supposed to predict movements in exchange rates? FIN 40500: International Finance Coming soon to a theatre near you!!

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