1 Topic 3: Exchange rate theory, capital flows and International Institutions

2 Overview Topic 3: Exchange rate theory, capital flows and International Institutions a.Real and nominal exchange rates and capital flows b.International Monetary Fund

3 Real and Nominal Exchange Rates, Capital Flows Source: Mankiw (2002), Macroeconomics, 5 th Edition, Worth Publishers, Chapter 5. The textbook is in library on desk reserve. Exchange rates and capital flows: –What are they? –Nominal exchange rate –The Real Exchange Rate –Fixed and floating exchange rates

4 Real and Nominal Exchange Rates, Capital Flows What is an exchange rate: –The exchange rate between two countries is the price at which residents of those countries trade with each other Two exchange rates: –Nominal and real exchange rates

5 Nominal Exchange Rate The Nominal Exchange Rate: the relative price of the currency of two countries It is the exchange rate normally quoted Example: Euro/USD exchange rate –1euro = 1.20 USD –You can exchange 1 euro for 1.20 USD Tells you how much of the foreign currency you can buy with one euro

6 Nominal Exchange Rate The euro is quoted first, therefore the euro is the base currency Depreciation of a currency: –A fall in the value of the currency –E.g. a change in the exchange rate from 1euro = 1.20USD to 1euro = 1.10USD –Makes a country’s goods cheaper for foreigners –Increases the price of imports from abroad (price of imports rise) –Decreases the price of exports for foreigners (price of exports fall)

7 Nominal Exchange Rate Appreciation of a currency: –A rise in the value of a currency –E.g. a change in the exchange rate from 1euro = 1.20USD to 1euro = 1.50USD –Makes a country’s goods more expensive for foreigners –Decreases the price of imports from abroad (price of imports falls) –Increases the price of exports for foreigners (price of exports rise)

8 Nominal Exchange Rate Demand curve: –Downward sloping –Increase in nominal exchange rate, e,(Euro/USD) leads to a decrease in demand for European exports - it makes Europe’s goods more expensive for US citizens (price of exports rise) –Decrease in demand for euros –Negative relationship

9 Nominal Exchange Rate Supply curve: – Upward sloping –Positive relationship –Increase in the nominal exchange rate, e, (Euro/USD) leads to an increase in the demand for European imports –Increase in supply of euros (to buy foreign currency to buy imports)

10 Nominal Exchange Rate Trade Balance: is defined as net exports i.e. the difference between exports and imports Trade deficit –Exports < Imports –Deuros < Seuros –Downward pressure on exchange rate –Trade deficit tends to cause currency to depreciate Trade surplus –Exports > imports –tends to cause currency to appreciate

11 Nominal Exchange Rate Shifts in the demand and supply curves will alter the nominal exchange rate Determinants of nominal exchange rate: –Inflation –Interest rate differentials –Speculation Inflation: –Increase in inflation in euro area, exchange rate depreciates

12 Nominal Exchange Rates Increase in inflation in euro area Decrease in D exports and Increase in D imports Decrease in D euros and Increase in S euros D1 shifts left to D2 and S1 shifts right to S2 Exchange rate depreciates from e1 to e2 e1 D1 D2 S1 S2 e2 Euro/usd Euros

13 Nominal Exchange Rate Interest rate differentials: –Real interest rate: real return –Higher domestic real interest rate may raise the exchange rate as a higher real interest rate makes acquiring financial assets in that currency more attractive wealth holders acquire the currency in order to be able to acquire the financial assets –Lower real interest rates lead to capital outflows which lead to a currency depreciating

14 Nominal Exchange Rate Use Fisher equation to find out real interest rate Nominal interest rate = real interest rate + inflation i = r+ inflation The real interest rate is the nominal interest rate adjusted for inflation and reflects the real return r d > r*capital inflowappreciation r d < r*capital outflowdepreciation where: r d is the domestic real interest rate r* is the foreign real interest rate r euro > r us capital inflow to euro area euro/usd

15 Nominal Exchange Rate European Central Bank increases euro area interest rates, ceteris paribus Increase D euros. D1 shifts right to D2. Increase in e r euro > r us capital I/F to euro area euro/usd Seuros D1 D2 e1 e2 Euros Euro/USD

16 Nominal Exchange Rate Speculation: –Speculative flows: supply & demand of currencies that arise from individuals and institutions trying to make money by dealing in currencies –If speculators expect a currency to depreciate, they will sell the currency (sell high). If they are proved right and currency depreciates, they can buy back the currency (buy low) and make a capital gain

17 Real Exchange Rate The real exchange rate –Is the relative price of the goods of two countries –The rate at which we can trade the goods of one country for the goods of another –Often called the terms of trade Real exchange rate (for a single good)= Nominal exchange rate x Price of Domestic Good Price of foreign Good

18 Real Exchange Rate Real exchange rate (for a broad basket of goods) Є = e x (P/P*) where: Є = real exchange rate e = nominal exchange rate P = price level in domestic country P* = price level in foreign country

19 Real Exchange Rate If real exchange is high: –Foreign goods relatively cheap –Domestic goods relatively expensive If real exchange is low: –Foreign goods are relatively expensive –Domestic goods are relatively cheap

20 Real Exchange Rate The real exchange rate and the trade balance –Trade balance is the difference between exports and imports: Net exports –The real exchange is a relative price –The relative price of domestic and foreign goods affects the demand for these goods –If real exchange rate is low domestic residents will want to purchase few imported goods and foreigners will want to buy many of the domestic goods The quantity of net exports (exports minus imports) in the domestic country will be high

21 Real Exchange Rate –If the real exchange rate is high, domestic residents will want to purchase many imported goods and foreigners will want to buy few domestic goods Foreign goods are relatively cheap Domestic goods are relatively expensive The quantity of net exports in the domestic country will be low

22 Fixed and Floating Exchange Rates Floating exchange rate regime -Floating exchange regimes operate on the basis of market forces whereby the exchange rate between two currencies is determined by demand and supply -The central bank allows the exchange rate to adjust to changing economic conditions Fixed exchange rate regime Currencies that belong to a fixed exchange rate are pegged to each other at rates which are agreed by their respective central banks

23 International Monetary Fund Source: “International Economics: A European Focus”, Barbara Ingham (2004), Chapter 14, p Available in the library The IMF (International Monetary Fund) was set up in 1944, with 44 member countries It currently comprises of 184 member countries The IMF was established to promote international monetary co-operation, exchange stability, and orderly exchange arrangements, to foster economic growth and high levels of employment and to provide temporary assistance to countries Main purposes: surveillance, financial assistance and technical assistance

24 International Monetary Fund Surveillance: process of monitoring and consultation –Where the economic and financial policies of one country may affect many other countries –E.G. Exchange rate policies, monetary and fiscal policies –The IMF ensures that individual countries or groups of countries do not engage in destabilising speculation over exchange rates. –The IMF ensures that individual countries or groups of countries do not attempt to influence artificially the value of exchange rates in order to gain trading advantage

25 International Monetary Fund Financial Assistance: –A core responsibility of the IMF is to provide loans to countries experiencing balance-of-payments problems. –This financial assistance enables countries to stabilise their currencies and restore conditions for strong economic growth Technical Assistance: –The IMF provides technical assistance in its areas of expertise, namely: macroeconomic policy, tax policy and revenue administration, expenditure management, monetary policy, the exchange rate system, financial sector sustainability and macroeconomic and financial statistics

26 International Monetary Fund Technical Assistance (cont’d): –Approx. three-quarters of IMF technical assistance goes to low and lower-middle income countries, particularly in sub-Saharan Africa and Asia –Post-conflict countries are also major beneficiaries –The IMF helps individual countries reduce weaknesses and vulnerabilities, which thus contributes to a more robust and stable global economy

27 World Bank The World Bank was established in 1944 It currently has 184 member countries The IMF’s functions complement the World Bank’s but they are totally separate organisations: –The World Bank provides support to developing countries –The IMF aims to stabilise monetary systems and monitors the world’s currencies

28 World Bank The World Bank Group is made up of five organisations: –The International Bank for Reconstruction and Development –The International Development Association –The International Finance Cooperation –The Multilateral Investment Guarantee Agency –The International Centre for the Settlement of Investment Disputes The World Bank is headquartered in Washington DC

29 World Bank Each organisation within the World Bank Group plays its part in reducing global poverty and improving living standards It provides low-interest loads, interest-free credit and grants to developing countries for education, health, infrastructure, communications and many other purposes The objectives of the World Bank have change substantially since its founding The US proposed the formation of an international bank in 1943 to finance post-war reconstruction in continental Europe The World Bank turned (slowly at first) into an organisation that grants loans to developing countries

30 World Bank The World Bank borrows on the world markets and lends to needy countries for development purposes Because the World Bank is heavily creditworthy, it can borrow at relatively low rates of interest. Very poor countries can then borrow from it at concessionary rates. The less poor pay a rate of interest which is marginally above the rate at which the World Bank can borrow The World Bank is an institution which provides long- term development finance for developing and transition economies at relatively low rates of interest The IMF is an institution which provides developing countries and transition countries with short-term finance to tide over balance of payments problems