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  1. 1. The Open Economy & Exchange rates
  2. 2. Pure theory of trade   1. Absolute advantage: A country is said to have an absolute advantage in the production of a good when it is more efficient in the production of that good Assume each country has equal amounts of resources and devotes half to X and half to Y x y Country A 20 100 Country B 10 150
  3. 3.   Country A has an absolute advantage in the production of X and country B in production of Y. 2. COMPARATIVE ADVANTAGE :Two countries can trade with each other if each specializes in the industry in which it has the lowest opportunity costs. x Country A Country B 20 10 y 200 150
  4. 4.   Country A has a comparative advantage in the production of X and B in the production of Y Specialization leads to increased total production A 30 100 B 0 300 Total 30 400 A 35 50 B 0 300 Total 35 350
  5. 5. Instruments of trade policy o o o o o Tariffs: specific tariffs are a fixed charge for each unit of good produced Ad valorem: are levied as a fraction of the value of the imported goods Quotas Export subsidies
  6. 6. Effects of alternative trade policies: tariffs Exp.sub quota VER Producer Rises s’ surplus Consume falls r surplus Rises Rises Rises Falls Falls Falls Govt rev Rises Falls Total welfare falls No change Falls No change No change Falls
  7. 7.     Adjustable peg- where exchange rates are fixed for a period of time but may change Devaluation: where the Govt re-pegs the exchange rate at a lower level. Revaluation – re-pegs at a higher level. Dirty floating- a system where govt intervenes to prevent excessive fluctuations or even to achieve an unofficial target rate
  8. 8. Exchange Rates   Defining Exchange Rate Measuring Exchange Rate Movements    Appreciation/Depreciation of a currency Exchange Rate Equilibrium Factors that influence Exchange Rate Movements
  9. 9. Meaning of Exchange Rate and Measuring Changes in Exchange Rates     Value of one currency in units of another currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated
  10. 10. Appreciation/Depreciation  Percentage change in value US $ New Value of Foreign Currency per unit of $ - Old value of foreign currency per $ -------------------------------------------------- X 100 Old value of Foreign Currency per $  Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency -------------------------------------------------Old value of $ per unit of Foreign Currency X 100
  11. 11. Exchange Rate Equilibrium     Forces of Demand and Supply Demand for foreign currency negatively related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate
  12. 12. Demand for Foreign Currency Price for Foreign Currency D $2.00 $1.50 D 50m 75 m Units of Foreign Currency (£)
  13. 13.  Demand for pounds: 1.The firms, households and govt who import UK goods 2. US citizens travelling to UK 3. Holders of $ who want to invest in UK stocks and shares 4. US companies wanting to invest in UK 5. Speculators anticipating a fall in dollar price
  14. 14. Supply of Foreign Currency price of foreign currency S $2.00 $1.50 S 50 m 75 m Units of Foreign Currency (£)
  15. 15.  Supply of pounds: 1. Importers of US goods into UK 2. UK citizens travelling to US. 3. Holders of pounds who want to buy financial instruments into US 4. UK companies wanting to invest in US 5. Speculators anticipating a rise in the value of dollars.
  16. 16. Equilibrium Exchange Rate Exchange Rate D S $1.6775 S D Units of Foreign Currency(£)
  17. 17. Factors that influence the Exchange Rate Relative Inflation Rates  Relative Interest Rates  Relative Income Levels  Expectations of the Market  Political Events Exchange rate is the results of an interaction of these factors 
  18. 18. Relative Inflation    High inflation relative to a foreign country, decline in value of currency Low inflation relative to a foreign country, increase in value of currency If inflation rates in one country are higher, there is an increased demand for imported goods and decrease in exports. This increases the demand for foreign currency and reduces demand for local currency – leading to depreciation
  19. 19. Relative Interest Rates    High interest rates in home country relative to a foreign country may cause domestic currency to appreciate If US Interest rates fall then outflow of dollars leading to increase in demand for pounds and British citizens will not invest in US leading to a fall in supply of pounds. This causes dollar to depreciate An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign
  20. 20. Relative Income Levels   Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why? Imports are a function of income . Hence increasing incomes lead to increase in imports and hence increase in demand for foreign currency. This causes domestic currency to depreciate
  21. 21. Market Expectations        Expectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 – 2001 Weak Dollar today 2005 onwards 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies
  22. 22. Political Events      Fall of Berlin Wall and unification of East and West Germany Rumors about resignation of Mikhail Gorbachov Tiananmen Square Persian Gulf War September 11, 2001
  23. 23. Fixed vs flexible exchange rates:  Advantages of flexible exchange rates:       Better adjustment mechanism Better confidence No need for central banks to hold money Gains from freer trade Increases independence of policy Disadvantages:    Uncertainty and diminished trade Instability speculation
  24. 24.  Fixed exchange rate is maintained by      Use of reserves Trade policies Exchange control Domestic macro-adjustments Raising interest rates
  25. 25.  Advantages of fixed exchange rates      Certainty No speculation Automatic correction of monetary errors Prevents irresponsible macro policies Disadvantages:  Makes monetary policy ineffective    Imbalance persists BOP deficit may hurt the economy Problems of international liquidity
  26. 26. Surplus or a Deficit in the BOP:     A deficit in the BOP can have 2 consequences: The country can borrow from abroad. It may sell its assets To rectify a deficit:    Devaluation/depreciation Import restrictions Domestic deflation to reduce aggregate demand
  27. 27. Impact of a Devaluation:  Increase in exports depends on    Price elasticity of demand for the exportables Price elasticity of supply in the domestic market Decrease in imports depend on   Price elasticity of demand for imports May result in cost push inflation and hence a rise in price if exports as well.
  28. 28. J curve:   A depreciation leads to at first a deterioration of the trade balance and then an improvement Marshall Lerner condition: The sum of proportional change in exports plus the proportional change in imports minus the percentage change in depreciation must be positive
  29. 29. Balance of Payments    A record of international transactions between residents of one country and the rest of the world International transactions include exchanges of goods, services or assets “Residents” means businesses, individuals and government agencies, including citizens temporarily living abroad but excluding local subsidiaries of foreign corporations
  30. 30. Double-entry Accounting in the BOP   All transactions are either debit or credit transactions Credit transactions result in receipt of payment from foreigners  Merchandise exports (valued f.o.b.)  Transportation and travel receipts  Income received from investments abroad  Gifts received from foreign residents  Aid received from foreign governments
  31. 31. Double-entry Accounting (Cont’d)  Debit transactions involve payments to foreigners       Merchandise imports Transportation and travel expenditures Income paid on investments of foreigners Gifts to foreign residents Aid given by home government Each credit transaction has a balancing debit transaction, and vice versa, so the overall balance of payments is always in balance.
  32. 32. Balance of payments:  A. Current Account:  Balance of Trade in goods  Balance of Trade in services- travel, insurance and transportation.  Balance of trade in goods and services  Other income flows    Investment income Transfers, balance( aid, remittances) GNIE
  33. 33.  B. Capital Account:        1.Foreign investment FDI and FII 2.Loans and commercial borrowings 3. Banking capital – assets, liabilities and non resident deposits. 4.Rupee debt service 5. others. Capital account = 1+2+3+4+5 C. Errors and omissions D. Overall balances E. Monetary movements- IMF / foreign exchange reserves balance in current account + balance in capital account + monetary movts =0
  34. 34. Real exchange rates:   Relative prices of two currencies after adjusting for changes in domestic prices RER of $ per pound: = ($/£)(PUK/PUS) If exchange rate = 3$ per £ RER = 1 if prices in UK and US are 30 and 90 respectively.