Foreign Trade and Exchange Rates

1. Foreign Trade and Exchange Rates Lecture 11

2. Foreign Trade and Exchange Rates • Key Concepts to Master • Exports and imports within the circular flow of the economy • The key drivers of exports and imports • Interest rate parity and exchange rates • The J-Curve

3. Exports and imports within the circular flow of the economy • GNP= C + I + G + X - M • Exports are an addition to the flow of spending created by domestic income • i.e. exports are purchases by foreign buyers of the same types of goods as C,I,G and add to US production (GDP) • Imports are a subtraction, a leakage, from the circular flow • i.e.imports are all components of C, I, G, and even X and substitute for / subtract from US production (GDP)

4. The Circular Flow--in a closed economy Excise Taxes Production of Goods Spending on Purchases of Goods Wages, Profits, Rents Saving Payroll & Income Tax

5. The Circular Flow--in an open economy Imported Goods Export Demands Excise Taxes Production of Domestic Goods Spending on Purchases of Goods Wages, Profits, Rents Saving Payroll & Income Tax

6. The key drivers of exports and imports • Imports are all components of C, I, G, and even X • This country’s income, production and policy choices drive our imports--all of the concepts discussed in the lectures and reading on these domestic sectors • Exports are simply another country’s imports, thus part of its C, I, G, X • That country’s income and production and policy choices drive our exports • The share of any country’s C,I,G,X grabbed by imports depends on relative prices, tastes, quotas, and other market restrictions

7. Interest rate parity and exchange rates • A simple relationship should hold among exchange rates and interest rates in any pair of countries: • the percentage difference between the exchange rate today and the expected future exchange rate is the difference between today’s interest rates in the two countries for the same future time horizon • For example, the number of dollars the market will pay for 100 yen today equals the expected dollars a yen will cost next year minus the percentage difference between today’s one-year interest rates in Japan and the US. For example, • If 100 yen are expected to cost $1.05 next year, and the US 1-year rate is 6% while the Japanese is 1%, the market will only pay $1.00 today for 100 yen: thus relatively high interest rates produce a strong currency, other factors equal • $1 invested in the US today will be worth $1.06 or 101 (=$1.06 x 100 / $1.05) yen next year • 100 Yen invested in Japan today will be worth 101 yen next year

8. Interest rate parity and exchange rates: Complications in the simple story • But what determines the expected value a year from now? Will purchasing power parity for a broad range of goods and assets prevail then? What is purchasing power parity? • The expected future exchange rate depends on the expected future demand for each currency, hence a long list of drivers: • future monetary and fiscal policies affecting interest rates at that time • current goods and asset prices in both countries and expected inflation and appreciation rates • the relative stages of the business cycles hence levels of trade deficits and hence the immediate flow of a currency in or out of a country versus the existing stock • future trade policies

9. More Complications in the simple story • In some very long run, perhaps ten to twenty years out, purchasing power parity might be expected to roughly prevail, out of ignorance of what other factors would be in force in either direction. • Biases due to uncertainty or irrationality or lack of information also can break up the basic simple relationship. • However, the fundamental premise is pretty strong: the higher a country pushes its interest rates today, the stronger will be that country’s exchange rate today. • And, the stronger the exchange rate is, the weaker its export quantities and the stronger its import quantities, hence the weaker its real (inflation-adjusted) net exports .

10. Exchange Rate Drivers for Mature Nations • Relative Inflation Rates / Price Levels Affect Long-Run Trends • Investment Opportunities Drive Short-Run Cycles • Bond-Yield Differentials Dominate • Business Cycle Impacts on Equity Returns are also Important

11. Historical View of the German Exchange Rate DM / $

12. Real and Nominal Exchange Rates: Much of the Historic DM Appreciation Has Been an Adjustment for Price Levels Nominal Real DM / $

13. A Comparison of Wholesale Price Inflation Rates Reveals a Strong Tendency for Lower German Inflation, Except in Periods of Exceptional Dollar Strength Spread=Germany-US Germany United States

14. Bond Yields Are Another Substantial Driving Force Spread=Germany-US Germany United States

15. The Real Exchange Rate (DM per $US) Rises / Falls with the Bond Yield Spread (US minus German) Real Exchange Rate 10-Year Bond Yield Spread

16. The Correspondence is Near-Perfect if Allowance is Also Made for Inflation Differentials Real Exchange Rate Interest Spread

17. Benefits of a strong currency • But a strong exchange rate does have some positive effects in the short- and the long-run. • It does mean a country can buy other countries goods, services, and assets more cheaply, raising its own relative and absolute standard of living. • It may also mean a temporarily higher nominal (non-inflation-adjusted) trade deficit.

18. The J-Curve • This name refers to the shape of a graph depicting changes through time in a country’s nominal net exports after a depreciation of that country’s currency Change in Nominal Net Exports Relative to a Baseline 0 0 Time Elapsed After Depreciation

19. An Example of the J-Curve Both price elasticities = -1

20. An Example of the J-Curve

21. An Example of the J-Curve Both price elasticities are small

22. An Example of the J-Curve