International Economics Notes PDF

The **cross exchange rate** is calculated by using a third, benchmark currency (usually the US dollar) to find the exchange rate between two currencies. When direct exchange rates between two currencies aren't available, the formula is: This principle helps calculate rates between currencies that d...

The **cross exchange rate** is calculated by using a third, benchmark currency (usually the US dollar) to find the exchange rate between two currencies. When direct exchange rates between two currencies aren't available, the formula is: This principle helps calculate rates between currencies that don't have direct exchange rate data, useful for traders, financial institutions, and businesses.  **Converting One Currency to Another:** - To convert currency, you multiply or divide by the exchange rate depending on the direction of conversion. **Factors Affecting Exchange Rates:** - **Inflation**: Countries with lower inflation rates will generally see their currency appreciate in value. - **Interest Rates**: Higher interest rates attract foreign capital, which can increase the demand for that country\'s currency. - **Economic Stability**: A country's political and economic stability can impact investor confidence and thus its currency value. - **Supply and Demand**: The value of a currency is also affected by the demand for it in international trade and finance. lekcija 1 ========= 1. **Trade theory is a barter theory** -- goods are exchanged directly for other goods on the basis of their relative prices. In practice, we use money (as a medium of exchange) to express prices. 2. Economists use two essential and related tools (accounting concepts) to describe a country's level of production and international transactions: **national income accounting, and** **balance of payments accounting.** 3. **National income accounting** records all the expenditures that contribute to a country's output and income. 4. **Balance of payments accounting** shows [changes] in a country's indebtedness and international competitiveness, connection between foreign transactions and national money supply, etc. 5. **[Gross national product (GNP)]** is the value of all final goods and services produced by a nation's factors of production (labour, capital and natural resources) in a given period of time.(In order to avoid double counting, only final goods and not intermediate goods are included in GNP, for example: the price of a book but not the price of ink used for printing the book.) GNP is a basic measure of output in macroeconomic analysis and it is often used as one of the measures of national income. NI = GNP -- depreciation of capital -- indirect business taxes 6. **[National income (NI)]** is the income earned by a nation's factors of production 7. **[Gross domestic product (GDP)]** measures the value of all final goods and services that are produced *within a country* (both by a nation's factors of production and foreign factors of production) in a given period of time. GDP = GNP -- factor payments from foreign countries + factor payments to foreign countries [A closed economy case:] National income is equal to value of production (expenditure of production). Y = C + I + G C -- private consumption; I -- private-sector/business investment; G -- government spending; [An open economy case:] National income is equal to value of production (expenditure of production). Y = C + I + G + (EX -- IM) Y = C + I + G + CA C -- private consumption; I -- private-sector/business investment; G -- government spending; CA -- current account balance or net export; EX -- export; IM -- import; 8. **Four types of expenditures:** **Consumption:** expenditures by residents (individuals); **Investment:** expenditures by firms on plants and equipment; **Government purchases:** expenditures by governments on goods and services (excluding transfers); **Current account balance:** net export i.e. net expenditures by foreigners on domestic goods and services; [Definition: ] 9. **Balance of payments** is a record of all economic transactions (regardless monetized or not) between the residents of one country and the rest of the world over the period of one calendar year or over shorter period. [Each transaction is either a debit or a credit transaction.] [Deficit or surplus occurs because one or more of subaccounts of balance of payments are not in equilibrium.] 10. **[Types of BoP Disequilibrium]:** **[temporary or short term] disequilibrium --** for example, the reason could be floods; **[cyclical] disequilibrium** -- the reason are cyclical fluctuations (cyclical changes in income, employment, output and price variables that are different in different countries); **[structural] disequlibrium -** is caused by structural changes occurring in some sectors of the economy at home or abroad; **the most** **problematic type is [fundamental]** **disequilibrium (**chronic and extremely large disequilibrium in balance of payments); **payments** is out of balance over a long period of time, leading to significant and ongoing problems. Fundamental disequilibrium could be caused by factors such as **chronic trade deficits**, **unsustainable national debt**, or **severe inflation**. current account + capital account + financial account = 0 LEKCIJA 2 ========= Foreign exchange rate is the price of a foreign currency in term of the domestic currency. Foreign exhange rate shows [how many units] of the domestic currency should be paid for an unit of a foreign currency: - if the foreign exchange rate [increases], we have to pay [more] units of the domestic currency for an unit of the given foreign currency (the domestic currency becomes weaker -- it depreciates); - if the foreign exchange rate [decreases], we have to pay [fewer] units of the domestic currency for an unit of the given foreign currency (the domestic currency becomes stronger -- it appreciates); The exchange rate in the foreign exchange market (FOREX) of a given country can be quoted in two ways: - [Direct] quotation - [Indirect] quotation - [Direct] quotation -- the price of a foreign currency in terms of the domestic currency: - 1 EUR ≈ 2 KM (1 EUR = 1.955830 BAM) - [Indirect] quotation -- the „price" of the domestic currency in terms of a foreign currency: 1 KM ≈ 0.50 EUR (1 BAM = 0.51129 EUR) In the domestic foreign exchange market: - [**a foreign currenc**y] is a traded good (although a specific one) and has its price -- the exchange rate; - **[the domestic currency]** is not a good than a measure of value and serves to express prices of other goods; - a currency that is being bought or sold is a [reference currency]; in direct quotation -- the second currency in a currency pair; - a currency in which transaction is denominated is [base or accounting currency]; the first currency quoted in a currency pair on FOREX; - Cross exchange rate between two currencies is calculated from their exchange rates with a third, benchmark currency. **Two component of determination of exchange rates:** - **[par value]** -- relation of the **domestic currency to some conventional common denominator (gold, dollar** or SDR); the external value of a currency; - **[purchasing power]** -- value of a **currency expressed in the quantity of goods that could be bought for an unit of the currency;** the internal value of a currency; - **[depreciation]** -- a real decrease in a currency value; decreasing of its internal value (purchasing power); - **[appreciation]** -- a real increase in a currency value; increasing of its internal value (purchasing power); - **[devaluation]** -- an official reduction of a currency value (reduction of the external value -- par value) by a **formal act of monetary authorities**; - **[revaluation]** -- an official increasing of a currency value (increasing of the external value -- par value) by a **formal act of monetary authorities;** **Fixed Exchange Rate:** In the fixed exchange rate system, the value of one country's currency is expressed in the value of another country's currency in a fixed amount. The official exchange rate is defined by the government. The domestic currency is fixed to a specific convertible foreign currency or exchange rate anchor, allowing only minimal fluctuations. The fixed exchange rate is determined by supply and demand, which can be manipulated. Stabilization of the exchange rate means an impact on supply and demand at the forex market. Intervention would occur when the exchange rate approaches a level which is regarded as inappropriate by monetary authorities. There have been two different approaches to exchange rate stabilization: Passive -- gold standard -- currencies were converted into gold at a fixed rate. The interval of fluctuations was limited by gold points. Active -- Bretton-Woods system and modern monetary systems -- central bank sells currencies from its international reserves and fills the gap between supply and demand for foreign exchange. Today fixed exchange rates are usually applied in small and developing countries. Stabilization of exchange rate means an impact on supply and demand at FOREX market. [Advantages of fixed exchange rate:] - stability (reduced foreign exchange risk); - predictability; *[Dollarization/Euroization:]* - Full or official dollarization means elimination of a national currency and its complete replacement by the foreign currency. **Multiple exchange rates system:** A **multiple exchange rate system** means there are two different exchange rates for the same currency: 1. **Official rate** -- Set by the central bank. 2. **Parallel rate** -- Determined freely by market supply and demand. **How does it work?** - The central bank decides how much of imports or exports must be traded at the official rate. - The rest must be traded at the parallel market rate, which is usually less favorable. **Example:** - Official rate: 1 USD = 1.5 domestic currency. - Parallel rate: 1 USD = 2 domestic currency.\ If the central bank allows 70% of imports at the official rate and 30% at the parallel rate, businesses will pay different amounts for the same USD depending on the proportion. **Floating exchange rate** Exchange rates are determinated in the foreign exchange market [by market forces] -- both supply and demand conditions. Supply is derived from credit transactions and demand is derived from debit transactions. The supply of foreign exchange refers to the amount of foreign exchange that will be offered to the market at various exchange rates, all other factors held constant. It results from credit transactions. Demand for foreign exchange is derived from debit transactions of the balance of payments An economy [adjusts by variation of exchange rate] maintaining stability of prices and income. Exhange rate is [always real], the domestic currency cannot be either overvaluated or undervaluated. *J-curve* - **[J-curve] indicates** changes in trade balance or in current account after currency devaluation/depreciation. - **"*Time lag*"** -- a relatively long period from the moment of a change in exchange rate until the moment of its effect on trade balance. Advantages for floating exchange rate: - more freedom in creating of monetary policy; - always balanced balance of payment; - always real exchange rate; - no need for large international reserves; **Combined exchange rate systems** **Combined Exchange Rate Systems:** There are many combined exchange rate systems: - **Crawling peg** -- small and frequent changes in the par value several times a year. - **Crawling band** -- central bank interventions prevent exchange rate from moving outside the allowed limits. There are changes in par value from time to time. - **Monitoring band** -- no central bank interventions, but there are changes in par value from time to time - **Managed flexible exchange rates --** exchange rate is stabilized by intervention of monetary authorities but it can vary inside a broader interval. A broader interval enables achieving the real exchange rate. - **Multiple exchange rates systems** -- officially set exchange rate and a second parallel rate that is freely determined by the market. The central bank determines the proportions of imports that can be purchased at the official rate, with the remainder being settled at the parallel rate. [Main criteria] for choosing an appropriate exchange rate system are country characteristics, as follows: - size and openness of the economy; - inflation rate; - degree of financial development (development of financial markets); - labor market flexibility The Theory of Purchasing Power Parity ===================================== **Theory of PPP (long run framework for determination of the exchange rate) was elaborated by Swedish economist Gustav Cassel.** **The key determinant of exchange rate is purchasing power parity i.e. ratio between purschasing powers of domestic and foreign currency.** **Purchasing power (PP) is the value of a currency expressed in quantity of goods that could be bought for the currency unit. It is real or internal value of the currency. Purchasing power depends on the prices: if prices increase, PP decreases, and vice versa.** **So, the key determinant of exchange rates are changes in price levels in given countries.** **Theory of PPP is based on [law of one price].** **commodity arbitrage law of one price (equalization of prices in different markets)** **Law of one price explains link between prices of goods and exchange rate.** **P~USA~ = P~UK~ (in US dollars) where P is price** **In the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country.** ***[Absolute version:]*** - **comparison of purchasing powers of foreign and domestic currencies;** **ER = PP^f^ / PP** **P↑ → PP↓ → ER↑** **P^f^ ↑ → PP^f^↓ → ER↓** - **comparison of relative prices of goods:** **ER = P / P^f^** **P↑ → ER↑** **P^f^↑ → ER↓** **P -- price level (market basket) in domestic country;** **P^f^ -- price level (market basket) in foreign country;** **ER -- exchange rate (direct quotation);** **The equilibrium exchange rate between two currencies is equal the ratio of the price levels in two countries (the ratio of domestic to foreign prices of a market basket of goods and services).** **In the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country. [Purchasing power parity exists if price levels in two countries are equal expressed in the same currencies.]** ***[Relative version:]*** **The change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same period i.e. to the difference between national inflation rates.** **Exchange rate will stay the same, if percentual changes of prices in both countries are the same.** **in developed form:** **(ER~t~ -- ER~t-1~)/ER~t-1~ = (P~t~ -- P~t-1~)/P~t-1~ - (P^f^~t~ -- P^f^~t-1~)/ P^f^~t-1~** - **comparison of price indices of two countries:** **ER~t~ = ER~0~(CPI/CPI^f^)** **ER~0~ -- exchange rate of the basic period;** **CPI -- consumer price index in domestic country;** **CPI^f^ -- consumer price index in foreign country;** **~CONEVRSION\ OF\ CUURENY~** INTO GOLD The **conversion of currencies into gold with a fixed rate** refers to the **gold standard**, where currencies were directly linked to a specific amount of gold. For example, 1 USD might equal a fixed amount of gold, like 1/35th of an ounce. This system ensured stability in exchange rates, but it ended in 1971 when countries, including the U.S., switched to fiat currencies, which aren\'t backed by physical commodities like gold.   - [overvalued currency:] official value (par value) \> purchasing power - makes import cheaper, stimulates import and consumption; works inflationary; - method of correction -- devaluation; - [undervalued currency]: official value (par value) \< purchasing power - makes domestic goods cheaper for foreigners thus stimulates export and allocation of resources towards export industries; method of correction -- revaluation