Trade & International Finance Lecture Notes PDF

Password for all slides: tradespl2 FINANCE Financial globalization and capital flows Financial globalization - Financial globalization ≠ Trade globalization - Measures of trade openness / trade globalization: ○ What are the restrictions (tar...

Password for all slides: tradespl2 FINANCE Financial globalization and capital flows Financial globalization - Financial globalization ≠ Trade globalization - Measures of trade openness / trade globalization: ○ What are the restrictions (tariffs and regulations) to free trade? ○ (Exports + Imports)/GDP - Measure of financial globalization: extent of the openness in cross-border financial transactions - De Jure and de Facto financial openness measures ○ De Jure: What are the restrictions to international capital movements? Based on the information from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) ○ De Facto: how much international trade in financial assets? Which assets? Characteristics of financial assets = mean to transfer purchasing power across periods - Portfolio investment: equity or debt - Foreign direct investment (> 10% ownership) - Other investments: bank loans, trade credit - Derivatives (futures, options...) - Reserves (Central Banks) Flows and stocks If the flow of capital is negative, people are selling more financial assets than buying. Password for all slides: tradespl2 The First Financial Globalization - World capital markets were very integrated at the end of the 19 th century. Share of British wealth invested overseas: 17 % in 1870 and 33 % in 1913 (larger than most countries today). Similar in France, Germany. - Capital outflows from UK (purchase of foreign assets): mostly to the « New World » with natural resources: Canada + Australia (28 %), US (15%), Latin America (24%) - What form? Portfolio investment (equity and bonds to invest in railroads, harbors...) - Causes of first financial globalization: ○ transportation and communication (telegraph) ○ global UK banks - Basic theory: Solow growth model - Capital scarce countries should have high returns to capital ○ end of 19th century = first globalization - Capital flows from capital abundant countries to capital scarce ones - European capital chased European labor (vice versa): both migrated to new world where returns are high Production function The marginal productivity of capital (MPK) Capital falls whenever K increases. The marginal productivity of capital (MPK) refers to the additional output produced by adding one more unit of capital, holding other factors of production (like labor) constant. It measures the contribution of capital to the production process and typically diminishes as more capital is added, a concept known as diminishing marginal returns. In simpler terms, MPK shows how much extra value is created from each additional investment in capital. Password for all slides: tradespl2 Return on capital (diminishing marginal product of capital) Marginal productivity in the US decreases slowly; the moment a country starts to open it goes to the situation of the country that is already financially open… This graph highlights why economies or firms with low levels of capital benefit significantly from investing in additional capital, while economies or firms with abundant capital see limited returns from further capital accumulation. It is a foundational concept in growth theory and production analysis. This graph illustrates the effects of capital mobility between countries when barriers to capital flow (such as in autarky) are removed. When capital flows are allowed, capital moves from the capital-abundant country (UK) to the capital-scarce country (US) to equalize returns. Capital leaves the UK, lowering its capital stock but increasing its MPK. Capital enters the US, increasing its capital stock but lowering its MPK. Capital flows continue until both countries reach the same MPK, which corresponds to the world interest rate. The case for financial globalization - Washington Consensus: collection of loosely articulated ideas in the beginning of the 1990s aimed at modernizing, reforming, deregulating and opening economies. - Consequence: many emerging markets opened up their capital markets in the early 1990s (while most developed markets were already opened since the 1980s). Password for all slides: tradespl2 - Important to note that restrictions on capital mobility are still more stringent for developing countries. Expected gains from financial integration Intertemporal trade gains - Capital should flow from capital rich (low return due to decreasing returns) country to capital poor country (high return) - Allows increased investment in capital poor country - Positive effect on growth = faster transition to steady state 𝑠𝑡𝑒𝑎𝑑𝑦 𝑠𝑡𝑎𝑡𝑒 - The steady-state capital stock in the graph (𝑘 ) represents the long-term, stable level of capital (𝑘) a country converges to in the presence of open capital markets and global capital mobility Intertemporal trade gains occur when countries optimize their consumption and investment over time by borrowing or lending in international markets. Capital-scarce countries borrow to invest in growth, while capital-abundant countries lend to earn returns. This allows both to achieve higher overall welfare through better resource allocation and consumption smoothing. Small gains from financial integration - Event studies on sample of emerging markets - Pick up financial integration dates. compare outcomes before and after financial integration - Find at most a 1% increase in real GDP growth after financial integration. mostly through capital accumulation and falling cost of capital (small effects on TFP growth) - Limits: ○ temporary effect. no evidence that financial globalization has long term impact on growth ○ Is the date random? Is it financial integration or just financial development? upper bound to the effect? Financial integration across countries allows for 1. Efficient Capital Allocation: Capital flows to where it’s most productive, boosting global investment and growth. 2. Consumption Smoothing: Countries can borrow during downturns and save during booms, stabilizing consumption. 3. Risk Sharing: Diversifies risks by enabling access to international financial markets. Password for all slides: tradespl2 4. Faster Growth: Capital-poor countries grow faster with access to foreign investment. These gains lead to improved global welfare and economic stability. The Lucas puzzle - despite low capital/labor ratios, capital flows to developing countries are small and often in the wrong direction - many emerging markets lending to rich countries - main explanations ○ differences in TFP ○ institutional quality ○ capital market imperfections (sovereign risk, asymmetric information) Uphill capital flows after financial integration Capital poor country → instead of going to capital rich it will just become capital poorer and worsen the situation. Expected gains from financial integration - International risk sharing (=risk diversification) ○ If investors are risk averse, diversification of country-specific risk through a diversified portfolio. Incentives to diversify abroad. ○ From portfolio theory, better diversification opportunities allow investors to reduce the risk of their portfolio (for the same expected returns) Are global financial markets integrated? - international asset holdings are large and have grown substantially - but portfolio home bias remains large and puzzling. portfolios not very diversified internationally. - looking at the internationally diversified part of their portfolio, investors tend to hold a larger share of assets geographically close to their own market. effect of distance on Password for all slides: tradespl2 asset trade comparable to its effect on real trade → reasons are; home bias, familiarity, lower transaction costs, information asymmetry, currency risks. Lecture 8 National accounting and the balance of payments National accounting GDP and GNI - GDP (Gross Domestic Product): value of all final goods and services produced within national borders - GNI (Gross National Income): value of all final goods and services produced by national factors of production - GNI = GDP + net receipts of factor income from the ROW (income domestic residents earn on wealth held in ROW – payments domestic residents make to foreigners who own wealth located in domestic economy) - Net receipts of factor income from the ROW = NFI - Usually small difference (except few well identified countries like Ireland) The fundamental current account identity → If current account is positive, export is larger than import → selling more than the rest of the world; it means you are able to loan money to the rest of the world meaning that export is so large that you earn a lot and this money is “loaned” from the rest of the world which can be used to investing again and export more. → S is positive: meaning you are saving more than investing, which means your overall savings is larger than your investment meaning you can invest more abroad. → This works vice versa meaning that if you are in a deficit, negative, you are importing more than exporting, meaning you are the one loaning money from the rest of the world… → Twin deficit: If a country has a fiscal deficit it is more likely to have a current account deficit; meaning the overall economy has a deficit and will be borrowing money from the rest of the world Password for all slides: tradespl2 US saving and investment → When looking at the current account, you get an idea of who is lending money to who. → China is the biggest creditor of the US → China’s current account is positive → China’s export is larger than import and therefore has a lending capacity to the rest of the world. The balance of payments - Registers all transactions with foreign economic agents 3 main sorts of transactions: - exports and imports of goods and services = current account (CA) - sale and purchase of financial assets = financial account (FA) - certain transfers of wealth (small) = capital account (KA) What does the balance of payments have to balance? - Essentially an accounting trick - every credit needs to be matched by a debit Password for all slides: tradespl2 - The current account shows overall situation in transactions of goods and services. The capital and financial account shows how this is financed. - Consider the case of the U.K running a current account deficit, in other words the U.K cannot pay its import bill from exports alone. - One solution is for the U.K to sell any overseas assets and use the money to pay the import bill. Another option would be to sell some U.K assets (say Canary Wharf). This would create a financial account surplus equal to the current account deficit. The current account - Trade balance = exports of goods and services - imports of goods and services ○ Trade balance = (EX - IM) - Current account = balance on goods and services + net investment income + net foreign workers remittances ○ CA = (EX - IM - NFI) The financial & capital accounts - Financial Account(FA): records flow of financial assets. These are Foreign Direct Investment, Net Portfolio Flows and Net Other (mainly bank loans and trade credits) ○ FA = inflows – outflows of financial assets - Capital Account (KA): records flow of non-financial assets between countries – debt forgiveness, purchase of royalty rights - However because of measurement error also category called “errors and omissions” Understanding current accounts - Consumption smoothing = intertemporal approach ○ Countries borrow and lend to smooth income shocks.Higher income tomorrow (e.g. faster growth) should lead to a current account deficit. I > S. Fast growth implies high returns to capital, high I. Borrow against future consumption (low S). - Demographics ○ Aging countries should be saving more (rising life expectancy). Low expected growth in the future if low fertility and rising old dependency ratios. S>I. Aging countries should run current account surpluses. To the opposite, countries expected to stay young should import capital. - No obvious normative judgment on sign (or size) of current accounts. - Often capital flows do not reflect an efficient allocation of capital. - Domestic Distortions ○ Too high private savings: lack of social insurance, lack of financial development, financial repression, … ○ Too low private saving: asset bubbles (real estate), excessive leverage, … ○ “Excessive” public borrowing - Systemic Distortions Password for all slides: tradespl2 ○ After the Asian Crisis (1997-98), emerging markets ran large current account surpluses and accumulated large foreign exchange reserves. ○ Partly Insurance (precautionary saving) against speculative attacks. Individually rational but globally may lead to excessive imbalances. The Chinese Saving Puzzle - China ○ Fast growing country. Very high productivity growth. ○ As expected, large investment rates. ○ But savings are growing at an even faster pace and China runs current account surpluses. - Why? ○ Domestic financial distortions: financial markets not very developed (borrowing constraints). ○ Precautionary motive (lack of social insurance,...) ○ Demographics («one child» policy)Still difficult to explain such a high saving rate Current accounts and net foreign assets Valuation effects on external positions - CA deficits are only one factor of the evolution of the NFA position. - 𝑁𝐹𝐴𝑡 − 𝑁𝐹𝐴𝑡−1 = 𝐶𝐴𝑡 + Capital gains (or losses) on external assets and liabilities. - Changes in exchange rate and/or market value of stocks/bonds affect the value of both foreign assets held by domestic agents (assets) and domestic assets held by foreign agents (liabilities). - Valuation effects have become large due to financial globalization and the increase in gross positions (assets and liabilities). Capital gains on NFA are extremely volatile. Understanding valuation effects - Application: US current account imbalances in the early 2000s - Growing divergence between accumulation of CA deficits and NFA position in the US. Password for all slides: tradespl2 - Period 2002-2006: despite large CA deficits (about 5% of GDP), the USNFA position (measures the difference between the value of foreign assets held by US agents and US assets held by foreigners) barely changed. - Cumulative of CA deficits around $3.4 trillions should have raised US net external liabilities about $5.5 trillions (40%ofGDP). The NFA deterioration was only $400 billion. As a ratio of GDP it actually improved. - Where did those other $3 trillions of US net borrowing go? How can that be? - Americans usually buy bonds that are not in the US currency, e.g. bonds in U.K. However, its liability is mostly labeled in US dollars; it is mostly affecting its assets side and not so much the liability side. - Capital gains on NFA. Foreign assets held by Americans (mostly denominated in foreign currency) increased in value much more than foreign-held assets in the US (mostly denominated in $) - $ depreciation over 2002-2007. - Foreign stocks did better than US stocks. - If repeated: can suggest that due to dollar role (US debt in dollar) foreigners get a weak return on American assets = exorbitant privilege. Exorbitant privilege - Gourinchas and Rey (2005): From world banker to world venture capitalist: US external adjustment and the ‘exorbitant privilege’ - Total return on US assets held by foreigners (US debt) < Return on foreign assets held abroad by US investors ○ US borrow at 3.6% and lend or invest at 5.7% ○ 2.1%! = (large) exorbitant privilege ○ Both a composition effect (assets are riskier and less liquid than liabilities) and a return effect (excess return within class of assets). ○ Even larger privilege (3.5%) post Bretton-Woods (post 1973). Return effect: returns are not equalized even within classes - could be that assets and liabilities of US of different maturities - role of dollar as reserve currency + liquidity of US financial markets: foreigners are willing to hold underperforming US assets because more liquid (exorbitant privilege of $) Composition effect: assets are in risky/high return (equity/FDI), liabilities are in low returns bonds: plays a less important role (but more important through time) Exorbitant privilege and exorbitant duty - Consequence of exorbitant privilege: US external constraint relaxed. - → CA deficits without worsening of external position Password for all slides: tradespl2 - Gourinchas, Reyand Govillot (2017) Find large exorbitant privilege in normal times. Financial crisis → dramatic worsening of USNFA (19% of GDP): dramatic valuation adjustment (price of US holdings abroad contracted more than foreign holdings US): exorbitant duty during disasters (insurance) External Adjustment - What happens when a country runs a current account deficit for years (e.g. the US, Southern Europe)? - Should the country adjust and reduce its deficit?How Does It Happen? - Consequences For Exchange Rates? - Should we worry about the persistent current account deficit of some countries? - Adjustment Mechanisms To Close A Current Account Deficit. - Countries Need To Pay Back Their Net External Debt. Two Channels Of External Adjustment - Trade Channel ○ Consume Less Than What Is Produced. ○ Run Trade Surpluses. - Financial Channel (valuation effects) ○ Capital Gains On Net External Positions. ○ Higher Returns On Foreign Assets Than Liabilities. ○ Default External adjustment of exchange rates Exchange Rates Changes Essential For External Adjustment. - Trade Channel ○ Depreciation Helps Exports And Decreases Imports. - Financial Channel (valuation effects) ○ A depreciation facilitates the adjustment if debts are in local currency and assets are in foreign currency (e.g. the US) ○ In Emerging markets, a currency depreciation (against the $) makes the adjustment more difficult because external debts are in $ (‘original sin’) External adjustment and the eurozone crisis - Pre-2008 financial crisis, current account imbalances within the Eurozone. Deficits in South European surplus in the North.Post 2008,external adjustment to close imbalances. - Postcrisis,Southerncountriesneedtoreducespendingandruntradesurpluses.Costlyinperiodofrece ssion. - Nominalexchangeratecannotdepreciate(common currency).Valuation Effects Limited.Competitiveness Restored Through Very Low Inflation (deflation). Password for all slides: tradespl2 Summary - Financial globalization has been increasing significantly over the last decades, even though the recent crises have led to a drop in international capital flows. - Financial globalization should provide small intertemporal gains by fostering the transition to steady-state of capital scarce countries and risk-sharing gains. - Countries whose investment exceeds savings run current account deficits and import capital. The balance of payments record these transactions with the rest of the world. It is balanced since current account deficits must be financed by capital inflows. - Global imbalances have emerged, with the US running persistent current account deficits financed by borrowing to some industrialized countries (e.g. Japan and Germany), oil producers but more surprisingly some fast growing emerging markets (China). Current account deficits accumulate into negative net foreign asset positions. - Adjustment of current account imbalances requires trade surplus or capital gains on net foreign assets. The US earns higher returns on their external assets than what they pay on their liabilities (exorbitant privilege). This relaxes their external constraint. Lecture 9 The foreign exchange market The nominal exchange rate - Two types of quotation - E is the exchange rate of the euro/dollar: price of the foreign currency (dollar) in units of the domestic currency (euro) 1 $ = E euros - E increases mean euro depreciates (takes more euros to buy one dollar) - You see how much Euros you will need to get one Dollar. - E is the price of the domestic currency (euro) in units of the foreign currency (dollar) 1€=E$ - In the following, we use the first (more standard, although not most intuitive) convention. - Here we look at the exchange rate the other away around. The only thing changes is which valuta we are looking at, it will be the same conclusions. The Foreign Exchange Market - Decentralized. Over the counter between participants. Password for all slides: tradespl2 - Interbank transactions (or involving other financial institutions) are largely dominant. - Permanent. Concentrated ○ Few markets concentrate most of the trading (London, NY, …) - Very small transaction costs - High liquidity and volumes ○ About 6000 billion $ / day - Key role of the dollar - High volatility of the nominal exchange rate Spot and forward exchange rate - Spot rate: Price agreed today for a contract to buy and sell FOREX immediately (immediate trade). - Forward Rate: Price agreed today for a (forward) contract to buy and sell FOREX in the future (7, 14-day, 1, 3, 6, 12-month). No money changes hands now. Trades on futures markets. ○ Example: On January 10, 2017, two banks agree to trade on June 10, 2017, 1M € at the rate of € 0.9 per $. - Other derivatives also traded (swaps, options,…). Not covered in the course. The US Dollar at the center of the market in percentages You can see that 27 % of the transaction is between dollars and Euros, and the 87 % of the transaction on the international market is between dollars and some other valuta. Autres (means other currencies) The dollar as a vehicle currency - Dollar main vehicle currency for forex transactions. (because the dollar is the mean currency) - To exchange Australian dollars into Mexican peso, less expensive to transact through US $. ○ Most times, the exchange rate is cheaper from dollar to another currency. Password for all slides: tradespl2 ○ The difference is the cost of the exchange. Most times is also cheaper to go through the US Dollar, bc its cheaper to go through a known and use currency as the dollar, than going from one small currency to another. Like the krone to EGP Punds. There the $ plays a large role on the international market. - High liquidity so low transaction costs (1 to 2 basis points 0.02%) for $10 millions on €/$) - Network effects. Economics of currency use like economics of language. Coordination of forex participants on the dollar. International interest parity conditions Exchange rates and the return on assets The relationship between exchange rate and interest rate over time - Uncovered interest parity condition (UIP) - The link between the exchange rate E euro/dollar today, the expected exchange rate 𝑒 𝐸 (one year) and the interest rate differential. - An investor has the choice between: ○ Invest one euro in (riskless) bond (treasury bond) or euro interbank interest rate : 1 + 𝑟$ ○ Buy dollars with this euro at rate E, invest it in US Treasury bonds or dollar interbank markets at rate 1 + 𝑟$ 𝑒 ○ In one year, at what rate, can she sell her dollars? 𝐸 Two possible investment strategies 1 1 𝑒𝑢𝑟𝑜 - 𝐸 is the amount of 𝑡ℎ𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑑𝑜𝑙𝑙𝑎𝑟 𝑤𝑖𝑡ℎ 1 𝑒𝑢𝑟𝑜 - Now you have the amount of euros in dollars 1 + 𝑟$ after a year 𝐸 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 , therefore we need to change it into euros again. 𝑒 - E is the exchange rate, and 𝐸 is the expected euro/dollar exchange rate. Password for all slides: tradespl2 - Therefore, the expected return is depending on how you this the value of one valuta is changing overtime. - We assume everyone is expected the same growth of the currency; therefore everyone invests in the same currency. If this happens, the one valuta, that has an expected growth rate, will grow. And therefore will have a higher growth rate, due to the fact everyone is demanding that currency. Uncovered interest parity condition (UIP) - A risk neutral investor should be indifferent between the two. Condition for equilibrium on the FOREX market (no transaction costs) 𝑒 1+𝑟𝑠 1+𝑟€ 𝑒 𝐸 - (1 + 𝑟€) = 𝐸 𝐸 and 𝐸 = 1+𝑟$ 𝑒 𝐸 −𝐸 1+𝑟€−1−𝑟$ - 𝐸 = 1+𝑟$ = 𝑟€ − 𝑟$ 𝑒 - If 𝐸 > E, an investor in euro must be compensated by a higher interest rate in euro than in dollar - Note: Another way to take an approximation of the UIP is to take logs: ( ) = 𝑙𝑛( ); 𝑐𝑎𝑙𝑙 𝑒 𝑒 1+𝑟€ 𝑒 𝑒 𝐸 ○ 𝑙𝑛 𝐸 1+𝑟$ = 𝑙𝑛𝐸 𝑒 ○ 𝑒 − 𝑒 = 𝑙𝑛(1 + 𝑟€) − 𝑙𝑛(1 + 𝑟$) = 𝑟€ − 𝑟$ - With approximation, equilibrium on FOREX market if 𝑒 𝐸 −𝐸 ○ Return on € asset: 𝑟€ − 𝑟$ + 𝐸 - Expected return on $ asset in euros ○ Otherwise: expected returns on € assets and $ assets ≠ Profit maximizer investors would buy the asset with higher expected return (abstracting from transaction costs) 𝑒 𝐸 (1+𝑟$) 𝑒 𝐸 −𝐸 - If E ↑ (€ depreciates today) : return on $ assets 𝐸 ↓ or 𝑟$ + 𝐸 ↓ : relatively € asset return ↑ - Why? If € depreciates (cheaper), $ appreciates (for given interest rates and Ee given): more expensive to buy and invest in $ assets today and return in $ falls Password for all slides: tradespl2 This graph represents the relationship between exchange rates (€/$) and the expected returns on assets denominated in euros (€) and dollars ($), expressed in euro terms. Here's a short explanation: - Vertical axis (Exchange rate E): Shows the euro price of the dollar (€/$). Movements represent changes in the exchange rate. - Horizontal axis (Return in units of €): Represents the return on assets in euro terms. - Downward-sloping curve: Represents the expected return on dollar-denominated assets converted into euro terms. The return depends on the interest rate on dollar assets (𝑟$ ) and the expected change in the exchange rate (𝐸𝑒−𝐸)/𝐸 - Vertical line: Represents the fixed return on euro-denominated assets (𝑟\€). Key Points: - Point 1 (𝐸′): The expected return on € assets is greater than $ assets, leading investors to prefer € assets. - Point 2 (𝐸: Equilibrium where the expected return on € assets equals that on $ assets. This indicates no incentive to switch between € and $ assets. - Point 3 (𝐸′′ ): The expected return on $ assets is greater than € assets, causing a shift toward $ assets. This graph illustrates the concept of interest rate parity, where investors make decisions based on relative returns adjusted for exchange rate expectations. At equilibrium the rate is the same on both foreign and home market. - At point 1, the euro is depreciating - that means it is better to invest in the Euro asset. E increased. When everyone then invests in Euro the euro will appreciate, and we will end back at equilibrium. Password for all slides: tradespl2 - At point 2, the euro appreciates and the dollar depreciate, which makes people invest in the dollar and with time the dollar appreciates, and go back to equilibrium. - Here we see the € asset depreciate, the € will appreciate. - Now the $ is appreciates, due to a rise in the $ - asset. - We can see that the dollar goes from the worth of 1 € to the worth of 2 €, and therefore will be the best investment. This is due to the expected exchange rate. - The expected exchange rate is going to react to the news. But everyone thinks the same, so if we think the worth of the dollar will grow, then it will probably happen. Exchange rate volatility - Today’s exchange rate depends on expected exchange rates which itself depends on all information that can influence future exchange rates. Password for all slides: tradespl2 - For instance, future changes in interest rates (which themselves depend on future monetary policies, which depend on production, inflation…) - Exchange rates are forward looking, like any asset price. Empirical validity of uncovered interest parity condition: 𝑒 𝐸 −𝐸 𝑟€ = 𝑟 + 𝐸 $ Strong assumptions - Perfect mobility of capital (zero transaction costs). - Rational expectations: agents do not make systematic errors in forecasting and use all information. - No speculative bubble. - No risk aversion: only expected returns matter for the choice of investors. Assets are perfectly substitutable (US Treasury bond and German bond). Risk premium and UIP - If agents are risk averse, they want to diversify assets and do not want to hold too many assets in one currency (for example in €): if share of € assets increases in portfolio then must be compensated by a “risk premium” on holding € assets 𝑒 𝐸 −𝐸 𝑟€ = 𝑟 + 𝐸 + 𝑝 $ - This risk premium depends on the portfolio structure and can vary with time. Empirical validity of uncovered interest parity condition - Unexpected increase of differential of interest rate (r€ - r$ ) implies a € appreciation today. Password for all slides: tradespl2 - For given expectations on Ee, implies an expected depreciation (or less of expected appreciation) - If rational expectations, Eeis on average = future realized exchange rate 𝐸𝑡+1 with 𝐸𝑡+1−𝐸𝑡 𝐸 = 0, 𝐸𝑡 = 𝑟𝑡€ − 𝑟𝑡$ + 𝑒𝑟𝑟𝑜𝑟𝑡 - A random walk does better than UIP. Best predictor of future exchange rate is today’s exchange rate: E (Et+1) = Et. Better than UIP for horizons of 1 to 12 months (UIP does better in medium/long-run) - Risk premium non observable, varies with time. - Speculative behaviors and bubbles (e.g. carry trade speculation) - UIP still useful? Yes to understand the response of exchange rates to unexpected changes of fundamentals (interest rates, …) Exchange rates and the returns on assets - One possible riskless arbitrage - Covered interest parity condition - Link between E, the forward rate F (one year) and the interest rate differential - An investor has the choice between: ○ Invest one euro in a euro denominated bond : 1+r€ ○ Convert this euro in dollar at rate, invest this in $ denominated bond: 1+r$ ○ Will resell dollars at rate F contracted today (no risk) Empirical validity of the CIP - Free capital movements (arbitrage) - Agents are profit maximizers (do not give up a riskless opportunity of profit) - Covered interest parity condition perfectly satisfied except in exceptional circumstances (e.g. 2008 financial crisis) - Not true in the 1980s due to restrictions on capital movements. Password for all slides: tradespl2 Monetary models of exchange rates How does monetary policy affect exchange rates? - Integrating money supply, interest rate determination and exchange rate determination. - In the long-run, nominal exchange rates reflect differences in the supply of money. - The dynamics of exchange rate from the short to the long term = the overshooting result. - In the short term, exchange rate adjust but prices are rigid/sticky. The exchange rate adjusts instantaneously but goods prices are much more rigid - Changes in exchange rates and price level ratios-U.S./Japan (percent per month) The money demand - Three factors affect the demand for money/liquidity (by firms and households) 1. Interest rate (on a riskless asset such as Treasury Bond, TB), r€ 2. Price level, P€ 3. Transactions (GDP), Y€ - The interest rate is the opportunity cost of holding the most liquid asset, money : easily used to pay for goods and services (or to repay debt) but money does not pay interest rate (or lower than less liquid assets such as TBs). - ↑ of interest rate r€ → ↓ demand of money: firms and households buy assets less liquid (TBs, saving accounts,) that pay r€ - Demand for money increases with economic activity (think GDP). Demand for money increases with GDP (Y€) as firms and households transactions increase. Determinants of money demand 𝑑 𝑀€ = 𝑃€ * 𝐿(𝑟€ , 𝑌€) in real terms 𝑑 𝑀€ 𝑃€ = 𝐿(𝑟€ , 𝑌€) In short term, P is rigid (Keynesian assumption) Demand for money decreases with (r€ ) and increases with GDP (Y€) 𝑑𝐿 𝑑𝐿 𝑑𝑟€ < 0 and 𝑑𝑌€ > 0 Money market equilibrium such that: 𝑠 𝑑 𝑀€ = 𝑀€ = 𝑃€ * 𝐿(𝑟€ , 𝑌€) Password for all slides: tradespl2 𝑠 Money supply 𝑀€ determined by Central Bank An increase in the interest rate will make an increase in income, because? Password for all slides: tradespl2 Lecture 10 Monetary model of exchange rates Exchange rate results from both US and euro monetary policies - Interest rate intervals and exchange rate variations - Short term model, so prices are fixed (rigid) - Also a Keynesian model → short term models with rigid prices Exchange rates in monetary policies (graphs) Above graphs combined - Bottom equilibrium in the money market - Top is eq in asset market - We see the impact of the change in monetary policy; how market supply change exchange rate - Expansionary monetary policy money supply in eurozone increases shift in horizontal line (money supply). - Increasing money supply means increasing money demand Password for all slides: tradespl2 - Increase demand for money by decreasing interest rate (opportunity cost) - If interest rate of the eurozone decrease it becomes relatively less interesting to invest in euros and more interesting to invest in dollar assets → more dollars will be demanded Expansionary monetary policy in eurozone It increases the amount of money supply, so the central bank has to decrease the interest rate and the expected return to euro asset decreases compared to dollar assets and leads to a depreciation of the euro currency ( → depreciation of domestic currency) Key Outcomes - Interest Rate Effect: Expansionary monetary policy reduces Eurozone interest rates (𝑟€ → 𝑟'€). - Exchange Rate Effect: The euro depreciates relative to the dollar (𝐸 → 𝐸′). - Investment and Demand Effect: A lower interest rate in the Eurozone stimulates investment and consumption, which are the broader goals of the policy. Recession in eurozone - Less GDP decreases money demand - Recession does not affect money supply but money demand - Less demand for money → market equilibrium results in interest decreasing - Interest rate decreases to stimulate money demand (negatively linked to interest rate) - Depreciation of domestic currency because euros become less attractive Password for all slides: tradespl2 Key takeaways: - Recessionary Impact: Lower income dampens the demand for money and reduces interest rates, making euro-denominated investments less attractive. - Exchange Rate Mechanism: The euro's depreciation boosts Eurozone exports by making them cheaper abroad, which could partially counteract the effects of the recession. What about expectations on exchange rate Ee? - Up to now, a change in monetary policy has no impact on expected exchange rates Ee - But should have an impact on future exchange rates if prices are flexible in the long term. - A change in money supply only affects prices in the long run = monetary neutrality in the long run. - Nominal exchange rate should adjust accordingly. Monetary only affects prices and nominal exchange rates. - It can only lead to inflation as it cannot change the total amount of economic activity → does not change the quantity of the variable we are looking for Price and money in the long run Inflation and pieces move one for one in money growth in the long run. ONLY in the long run, monetary policy neutrality holds, also in real life. Password for all slides: tradespl2 Exchange rate, money and prices in the long run - Nominal exchange rate = price of foreign currency in units of the domestic currency. - In long term: - Depreciation of € with respect to $ in the long run. - Otherwise, some relative prices (European to US) would be affected with real effects ≠ Monetary neutrality - Remark. Purchasing Power Parity in the long run: Leads to depreciation, there are no other change: Monetary policy, exchange rates and overshooting 𝑆 - What is the effect of a permanent increase in money supply 𝑀 € on exchange rate dynamics? Password for all slides: tradespl2 - Main result: instantaneously, the € overshoots its long run value = it depreciates by more than in long run (= Dornbush’s overshooting result) - Result of slow adjustment of goods prices and immediate adjustment of the exchange rate. - High volatility of exchange rate in the short run even with forward looking rational agents. - Increase money supply - Long run: E↑ - Short run 1. rational agents know that in the future, E↑: change the expectations (Ee↑) and E ↑ immediately. 2. Interest rate fall 𝑟€ ↓ (prices are rigid) 𝑆 - Between ST and LT, prices adjust slowly: 𝑃€ ↑ ; 𝑀 € / 𝑃 ↓ ; 𝑟€ ↑ € Overshooting in the long run (graph) Expectations change: depreciation of domestic currency → increase in returns in foreign currency; meaning that for every dollar you invest, by anticipating an exchange rate depreciation, you expect that the dollar is going to give you more euros than before. It increases the expected return of the US dollar asset. If you have an increase in the money supply by 10%, prices will slowly increase to 10%, only in the long run. The exchange rate is going to increase by more than 10% at first (E1 → E2), then it decreases again (E3) and that change is equal to 10%. Overshooting is due to the expectations, we are at E1 and know we are going to end up at E3. Password for all slides: tradespl2 Adjustment from the short to the long run The difference between E2 and E3 (the overshooting result) is due to the change in expectations, which happens in the moment of the announcement of the monetary policy. As the prices slowly adjust to the monetary policy, the exchange rate slowly decreases to E3. Look at the example above with 10%... First it depreciates (short run) and after prices adjust, it creates an appreciation (long run) → overshooting. Password for all slides: tradespl2 Economic policies in open economies The real exchange rate and competitiveness The Law of One Price (LOP) - On competitive markets, in absence of transport costs and tariffs, two identical goods must be sold at the same price (expressed in the same currency). - Law of one Price = long term arbitrage mechanism - Consider a good indexed by i - If 𝑃𝑖€ > E. 𝑃𝑖$: buy the US produced good, sell it in Europe; increase demand in US, increase supply in Europe: price converge. Purchasing power parity (PPP) - P€ = E. P $ where P € and P $ price indices of US and euro zone - An increase in the general level of prices reduces purchasing power of domestic currency and leads to a depreciation. - Price levels of different countries are equalized when measured in the same currency: Empirical validity of PPP - LOP fails in the short run : not puzzling for non-traded goods (haircuts); but also fails for traded goods. - Transport costs, trade barriers (tariffs and regulations): make arbitrage more difficult Password for all slides: tradespl2 - Imperfect competition: firms segment markets (to have high prices where price elasticity of demand is low) : “pricing to market”. “Branding”. - Many goods considered to be highly traded contain nontraded components. Retail and wholesale costs (distribution costs) account for around 50% of final consumer price. - Studies overwhelmingly reject PPP as a short-run relationship. - The variance of floating nominal exchange rates is an order of magnitude greater than the variance of relative price indices. - Failure of short-run PPP partly attributed to the stickiness in nominal prices (short run). - Works much better in the long term. Real exchange rate Empirical test of PPP in the long-run Password for all slides: tradespl2 The Current Account and the Real Exchange Rate The currency account is going to vary with the real exchange rate. Here the foreign economy is the US. If you have increased demand from foreign economy it increases your export and current account as well. - If q ↑ → volume of imports↓, exports↑: substitution - But if slow response of volumes (empirically 6 months-1 year): value of imports↑ - 1) Volume versus Value effect. In short term, the value effect can dominate. - Net effect on the CA of q? - 2) J-curve: initially worsening of the trade balance before improvement after q ↑. - Improvement under the Marshall-Lerner condition stating a large enough response of volumes (the sum of import and export elasticities to exchange rate > 1) The J-curve First, the initial value of the current account is where we have the depreciation of the domestic currency. What happens first is a decreased current account. This leads to a lower current account. Password for all slides: tradespl2 Immediate Effect (Point 1 to Point 2): - When the currency depreciates, imports become more expensive in domestic currency terms, and exports earn less in foreign currency initially. - Value Effect: The immediate impact is a worsening of the current account balance as the cost of imports rises faster than export revenues can adjust. This is shown by the initial downward slope of the curve (from Point 1 to Point 2). Short-to-Medium Term (Point 2 to Point 3): - Over time, the volume effect begins to dominate: Exports become cheaper for foreign buyers, so their volume increases. Imports become more expensive, so their volume decreases. - As trade volumes adjust, the current account balance starts improving, reflected in the upward slope of the curve from Point 2 toward Point 3. Long-Run Effect (Beyond Point 3): - Once the adjustment is complete, the current account reaches a new equilibrium (Point 3), which is higher than the initial level (Point 1) due to the sustained improvement in trade volumes. Volume Effect vs. Value Effect: - Initially, the value effect dominates (current account worsens). - Over time, the volume effect dominates (current account improves), forming the characteristic "J" shape. We assume from now on: - € nominal or real depreciation (E ↑ or q ↑) generates an ↑ in demand via an ↑ in net exports - A depreciation of the real exchange rate improves competitiveness. Net exports increase. Exchange rate and output - In the long-run, think in terms of Purchasing Power Parity. Nominal exchange rate neutral - But PPP deviations are large at medium term horizon and reversion towards PPP takes years. Deviations from PPP linked to price rigidities. - Impact on output when prices are rigid? - Build a theory of exchange rate and output in short/medium term Password for all slides: tradespl2 Asset and Forex Market Equilibrium - Focus on flexible exchange rates - Need to build the combinations of exchange rate and output that are consistent with equilibrium in the domestic money market and the foreign exchange market (AA Schedule) - Use uncovered interest parity: The effect of GDP on exchange rate E If the interest rate increases, investors are going to invest in the domestic economy → appreciation of domestic currency. Negative relationship with GDP leading to appreciation in domestic economy; E is lower when Y increases. Increase in monetary policy → decreases interest rate → increases exchange rate. Key takeaways: - Higher GDP (𝑌€) increases real money demand, raising domestic interest rates (𝑟€). - Higher interest rates attract capital inflows, leading to an appreciation of the domestic currency (a lower 𝐸). - The shifts are shown as: - Real money demand curve shifts right (bottom graph). - Equilibrium moves to higher 𝑟€ and lower 𝐸 (top graph). - This dynamic highlights the interaction between monetary policy, GDP, and exchange rates in an open economy. Password for all slides: tradespl2 Building the AA curve: - Higher GDP raises money demand and appreciates the exchange rate - Y€ ↑ → L € ↑ → r € ↑ → E ↓(euro appreciation) - AA curve: negative relation between Y € and E - AA curve describes combinations between Y € and E such that asset markets are in equilibrium - investors are going to prefer to invest in foreign currency, so depreciation in domestic currency - → curve moves upwards when there is an expansionary monetary policy Good markets equilibrium - Aggregate Demand (AD) determines production and income levels when prices are rigid. - Keynesian assumption valid in short-term (one year) because adjustment takes place through quantities and not prices - Components of aggregate demand: Password for all slides: tradespl2 Lecture 11 Exchange rate and output Good market equilibrium (keynesian consumption function) If you have a depreciation of domestic currency, it's going to affect the current account and increase it → it affects the output → increases aggregate demand and consumption. Positive relationship between exchange rate and output if you only look at the good market equilibrium. All combinations between E and Y which are compatible in the good market equilibrium. If E increases you have an increase in Y by more than 1. This gives us a new graph. Password for all slides: tradespl2 The slope of the curve depends on if it is a closed or open economy. If the economy is really open (share of net exports represented in total GDP), then only a BIG depreciation is going to have a big impact on the GDP. The slope is going to change on the graph. If the economy is relatively closed, it's going to have a small impact on the exports and GDP; the more closed economy there is only going to be a small change in the GDP. Open economies suffer a bigger impact on their GDP → the steeper curve is for closed economies. The effect of monetary and fiscal policies Monetary and fiscal policies in an open economy - An important distinction: Temporary and permanent: if permanent, changes expectations on the exchange rate Ee ○ Monetary policy shock : increase in money supply ○ Fiscal policy shock: increase in G Focus on temporary shocks for simplicity. - Both have been used heavily to stabilize the economy (e.g during the 2008 financial crisis, during the Covid pandemic) Password for all slides: tradespl2 Temporary monetary policy shock (graph) - Decrease in interest rate to boost demand → depreciation of domestic currency because it is relatively less attractive to invest in it (the AA curve moves upward → E increases). - The good market → this is going to increase total GDP. The equilibrium points are where the two lines are crossing. - Monetary policy: very efficient (in stimulating demand) in an open economy - In addition to effect on I and C, ↓ in interest rate → E ↑ (depreciation) → ↑ in net exports EX € - IM € → Y € ↑ - Monetary policy is even more efficient in more open (smaller) economies to stabilize the economy (stimulating demand after a demand slump). - Exchange rate channel of monetary policy Temporary expansionary fiscal policy (graph) - You have an increase in GDP due to increase in government spending → GDP curve moves. If you have an increase in G the DD curve moves → higher GDP (Y). - Appreciated domestic currency → stimulates more demand due to government spending increasing. - If GDP increases (direct result of fiscal policy) → increase in demand for money. Money supply did not change (because it is a fiscal policy) → an increase in demand for money you need an increase in interest rate to slow down the demand for money as you are not producing more money → it is going to make investments in domestic currency more attractive → appreciation in domestic currency (Y2). - Appreciation in domestic currency decreases the current account → exports decreases, increase in import and decrease in total output. Password for all slides: tradespl2 - Conclusion: Higher GDP and appreciated currency. - Fiscal policy: less efficient (in stimulating demand) in an open economy. - Appreciation of the currency and deterioration of CA (the more so DD is flatter, more open economy) - Hence crowding out of net exports (on top of crowding out on investment). - Fiscal policy even more inefficient in more open (smaller) economies to stabilize economy. - Fiscal policies give bigger crowding out of exports in bigger economies → increase in public spending increases aggregate demand (output) → increase in interest rate → appreciation in domestic currency → dampen competitiveness → decrease exports and increase imports → decrease in current account → negative effect on output (decreasing). - In bigger economies monetary policies are boosting the economy (increasing the output again and doubling the effect), however the fiscal policies are not → fiscal policies are less efficient in stimulating demand in a very open economy. How has globalization changed macro-policy? - Trade openness makes domestic fiscal policy less efficient ○ Demand generated by fiscal expansion leaks more (increase in imports): shift in DD is smaller ○ Exchange rate appreciation affects negatively net exports: crowding out effect stronger the more open the economy. - Financial openness makes domestic fiscal policy less efficient Password for all slides: tradespl2 ○ Go to the extreme: Financial autarky means the interest parity condition does not hold and E is not affected by interest rate differential. Limited appreciation and limited fall in net exports. - Trade openness makes monetary policy more efficient ○ Fall in interest rate generates depreciation and increase in net exports ; if more open economy (DD flatter), larger effect on output - Financial openness makes monetary policy more efficient ○ Go to the extreme: financial autarky means the interest parity condition does not hold and E is not affected by interest rate differential. No depreciation and no increase in net exports. - In the past forty years, monetary policy has become the prime policy instrument. Fiscal policy is less used (issues of delay) unless desperate times. - Globalization means domestic fiscal expansion not very expansionary for the domestic economy BUT very expansionary for foreign economy. - Globalization means domestic monetary expansion very effective at Home but potentially at the expense of foreign economy: appreciation and fall in net exports. - Globalization increases international spillovers of domestic policies (externalities) - Requires international coordination Policies in times of crisis If Y and total demand decreases, the DD curve moves to the left → less aggregate demand. Depreciated currency → you end up and E2 and Y2. Increase money supply (lower interest rate). The interest rate decreases (expansionary monetary policy). Depreciation of domestic currency (exchange rate is increased). This Password for all slides: tradespl2 boosts aggregate demand as it increases net export → even more so if the economy is open. E3 and Y3 are both higher than before the crisis shock. Policies in crisis times - Conventional monetary policy has been used heavily: interest rates brought to zero globally, in US and euro zone during the 2008 crisis and during the Covid-19 pandemic. - But recession may have required even more monetary policy easing. Not possible to have negative nominal interest rates (= zero lower bound). ○ Global recession limits the exchange rate channel. ○ Standard monetary policy has reached its limits. ○ Large fiscal expansion globally, both in EU and US. - In a crisis, firms and households have difficulty to borrow/save for precautionary reasons: consumption and investment falls heavily. Important to replace falling private demand by public demand. International coordination of policies? - Unconventional Monetary Policy Spillover effects of fiscal policies (example) Password for all slides: tradespl2 Fiscal policy coordination - share the gains from the fiscal expansion (optimal equilibrium in table above) - both economies trying to boost aggregate demand (win-win situation) - free riding when only one is moving, because they are expecting someone else does it - Nash-equilibrium is the equilibrium of no fiscal expansion - Social planner is best in international coordination, for both countries (gains shared) - There is a cost of coordination Fiscal response to Covid-19 crisis - Very large in magnitude. ○ Larger than fiscal response to the 2008 crisis. ○ 2.5 trillions USD in the US in 2020. More than twice the 2009 Obama stimulus plan. 1.9 trillions for Biden early 2021. - Combination of various policies. Both demand and supply side policies. ○ Gov’t spending: health spending, spending for a ‘Green Recovery’, for digitalization of the economy. ○ Support for people (partial unemployment, cash transfers, tax breaks,... ) ○ Support for businesses (tax breaks, subsidized loans/credit and financial help,....). Additional supply side policies (lower production taxes in France) Fiscal response Does fiscal stabilization work? - Yes, fiscal multipliers are positive (but quite uncertain). - Why might fiscal policy be inefficient? ○ Lags involved ○ Ricardian equivalence. Crowding out of private consumption. ○ Crowding out of investment ○ Crowding out of net exports ○ Debt sustainability and sovereign ri ○ Low multipliers for highly indebted economies Fiscal austerity - After large fiscal stimulus, fiscal adjustment might be necessary in many countries. - Is the adjustment recessionary? Likely vary across countries, as adjustments tend to be more painful in large, closed economies (and countries with fixed exchange rates). Also more painful in highly indebted economies. - More painful if worldwide. - More painful if combined with more restrictive monetary policy Unconventional monetary policy Central Banks response to the crisis - Conventional response: Cut “policy” interest rates substantially Password for all slides: tradespl2 Non conventional responses: ‘Quantitative and Credit Easing’ - Act to prevent a complete collapse of the financial system. - Through central bank intermediation, maintain inter-bank transactions and liquidity provision to banks/firms. - Reduce borrowing costs and stimulate credit in the economy when interest rates are at zero. Typically through asset purchases and direct lending to firms/banks. Unconventional monetary policy and inflation - Is unconventional monetary expansion inflationary? - No, as long as credit does not find its way in the economy and the economy is very weak. Banks/Companies are hoarding cash. - Large increase in liquidity (“base money”) has initially not led to a corresponding increase in credit. - However, can affect future inflation and inflation expectations. Along the recovery, credit increases = inflationary pressures due to the large amount of liquidity in circulation Unconventional monetary policy and exchange rates Unwinding quantitative easing - Central Banks do not want to unwind too fast (Fed tightened too early in the Great Depression). - But rising inflation risk (lot of liquidity may find its way in the economy). - Strong recovery post-Covid and rising energy prices. - Need to raise interest rate to stabilize inflation. - Delicate balance to achieve: speed up of recovery (and later on stability of this recovery) versus price stability. - More recessionary if global monetary tightening. - Exchange rate effect depends on the magnitude and speed of monetary tightening relative to other countries Password for all slides: tradespl2 Unconventional monetary policy Unconventional monetary policy is used when traditional tools, like lowering interest rates, are insufficient—typically when interest rates are already near zero or negative. Here are two main types of unconventional monetary policy: Two ways to use unconventional monetary policy - Quantitative Easing (QE): ○ What It Is: Central banks purchase long-term government bonds or other financial assets to inject liquidity into the economy (increasing money supply). ○ Impact: Increases money supply. Lowers long-term interest rates. Encourages lending and investment. ○ Example: The Federal Reserve's large-scale asset purchases during the 2008 financial crisis and the COVID-19 pandemic. - Forward Guidance: ○ What It Is: Central banks commit to keeping interest rates low for an extended period to influence expectations. ○ Impact: Provides certainty to markets and consumers. Encourages spending and investment today based on future rate assurances. Summary - In the long-term, purchasing power parity equalizes prices across borders. Nominal exchange rate changes reflect inflation differentials across countries. It does not hold in the short-run leading to real exchange rate fluctuations. - A depreciation of the real exchange rate improves competitiveness, net exports and thus aggregate demand, at least in the medium-run (J-curve). - Globalization reduces the effectiveness of fiscal policy as a stabilization tool but increases the effectiveness of monetary policy through the exchange rate channel. - Globalization increases the international spillovers of policies and the need for international policy coordination. Password for all slides: tradespl2 - In exceptional times, when interest rate is at zero or near zero, monetary policy uses other tools such as liquidity provision. The international aspects of such policies depend on exchange rate expectations. Difference between conventional and unconventional monetary policy 1. Conventional Monetary Policy - Definition: The standard approach used by central banks to manage economic activity, primarily by influencing short-term interest rates and money supply. - Tools: ○ Open Market Operations (OMO): Buying or selling government bonds to influence the money supply ○ Policy Interest Rates: Adjusting the short-term interest rates like the Federal Funds Rate (in the U.S.) or Repo Rate (in India). ○ Lowering rates: Stimulates borrowing and investment. ○ Raising rates: Controls inflation and overheating economies. ○ Reserve Requirements: Changing the percentage of reserves banks must hold to influence lending capacity. - Objective: ○ Manage inflation. ○ Stabilize the economy. ○ Achieve full employment. - Typical Use: In normal economic conditions when interest rates are above zero. 2. Unconventional Monetary Policy - Definition: Non-standard measures employed by central banks when conventional tools become ineffective, typically during severe economic crises. - Tools: - Quantitative Easing (QE): Purchasing long-term securities (e.g., government bonds, mortgage-backed securities) to inject liquidity into the economy. - Forward Guidance: Providing explicit communication about future policy intentions to influence market expectations. Password for all slides: tradespl2 - Negative Interest Rates: Charging banks for holding excess reserves to encourage lending. - Credit Easing: Targeted asset purchases to improve specific credit markets. - Yield Curve Control: Targeting specific yields on longer-term bonds rather than just short-term rates. - Objective: - Combat deflation or severe recessions. - Stimulate economic activity when interest rates are near or at zero (Zero Lower Bound). - Typical Use: During economic crises, such as the 2008 Global Financial Crisis or the COVID-19 pandemic.