INTERNATIONAL FINANCE UNIBO BELLETTINI - part 1, Slide di Finanza

Scarica INTERNATIONAL FINANCE UNIBO BELLETTINI - part 1 e più Slide in PDF di Finanza solo su Docsity! INTERNATIONAL FINANCE * Introduction to the course —.———_—e Î An FLVIVAVAN Exchange rate between the euro and the dollar (since day 1). We can see a lot of fluctiations and volatility — implying a lot of instability in the economy. fe h 1° period — up to 2008 — we can see the euro getting stronger and p by stronger. Euro begins at 100, goes up to 140 — this is the appreciation of the euro. LL European exporters suffer from this. 2° period — after financial crisis — a drop ofthe euro k IVI Tia Dio piciu 27 Chavase eanminte etna 101725, Dona Exchange rate between the cinese currency and the dollar F A] Less instability. (Look till 2005) Why? Cinese central bank was very active in the market. This is a strong strategic move. Ifyou want to help your exporters you don't make the exchange rate too strong. After some discussions, they let it fluctuate a bit. But then we can see another period of Li stability, which is their response to the financial crisis. Once the financial crisis was over, we can see a further appreciation of the cinese renminbi. “|| «LL “L] i How effective and powerful central bank announcements can be Graph shows different currencies (of very different countries). Common trend: strong deprecciation in less then a month. Why? The announcement was that the crisis was basically over, so interest rates will increase. After years of int rates being basically 0. People immediately started to sell after this announcement, after years of investing. 2014 — the swiss franc for a lot oftime we can see stability betweeen swiss franc and the euro clearly someone is doing something to keep it this way. Swiss authority wanted to avoid swiss franc appreciation. It's the same as with cinese example. We can see that all currencies are currently getting stronger relative to the dollar Depreciation of the dollar : : : Transactions within a closed economy * Lecture 1— National and international accounts REGGINA scossi Piodace Acco Let's look at the flow of circular payments in a closed economy. We start at the gross national expenditure GNE = private consumption C + investment I + government exp enditure G Where will this expenditure go? On final goods and services, produced in the country. We move from expenditure to production + Gross domestic product GDP = sales of all final and intermediaries — intermediate goods and services purchased in the country. We take all final and intermediate goods sold in the country and we subtract those intermediate goods purchased by firms as inputs. Since we are in a closed economy the intermediates dissappear. For these, people receive income. Labor, income, land ecc Gross national income GNI = the sum of all payments received thanks to the sell of final goods and services In a closed economy, GNE = GDP = GNI Total national resources devoted to expenditure (C+1+6) Gross Natioral Exparditure GNE Foyments for final goods ana services Value aaded (sales minus intermediates) Gross Domestic Product. GDP Payments for factor services. Receints for factor services Gross Neticnal Income GNI Total national rasources avcilable for espendieure Giom income) In an open economy we have to take into account transactions with the rest ofthe world, that may increase or decrease our income. We start from gross national expenditure. Notice that if we want to move to GDP, Transoctions within the home county re we have to take into account that part of our expenditure that comes from abroad. e mas e We have to subtract it. (-IM imports). But on the other hand we have to add the spende (€ + 1 6) part that foreigners buy from us (+EX exports). After that we reach GDP. GDP = GNI — EX — IM = GNI + trade balance TB E ora O Vate ode Gross Done Product ‘60P Garni Acoun da Vote finports of IM oo cod serie: +EX Vale fort of Now we want to move to income Some of the factors of production may be foreign (could be labor, could be products). We take income for foreigners -IM fs (imports of factor services) Pnnt fr foca seni Mrs fto seices But we may have people working abroad. +EX fs (value of exports of factor ® TESS services) Roc fo foto seni iosa GNI = GDP + net factor income from abroad NFIA Gross Neon Income GN Now we have to take into account other stuff: for example international aids 3 (income for nothing in return) or we may be the one giving the aid. ae These are called NUT net unilateral transfers +UTy Vote fine rasi rtl Gross Nina Dispsable Income GNDI Which brings us to gross national disposable income S se TT a inni Account LIE E, magone | A Now we have to take into account importing or exporting financial assets. 10 er AIl of these will increse our available resources for expenditure. rs rc Now look at the green side: all transactions with the rest of the world we can find in the current account. Then we have two more accounts: financial and capital. * Three Approaches to Measuring Economic Activity — The expenditure approach - looks at the demand for goods: it examines how much is spent on demand for final goods and services. The key measure is GNE. — The product approach - looks at the supply of goods: it measures the value of all goods and services produced as output minus the value of goods used as inputs in production. The key measure is GDP. — The income approach - focuses on payments to owners of factors: it tracks the amount of income they receive. The key measures are gross national income (GNI) and gross national disposable income (GNDI) (which includes net transfers). * Personal consumption expenditures (usually called “consumption’) equal total spending by private households on final goods and services, including nondurable goods such as food, durable goods, and services. * Gross private domestic investment (usually called “investment”) equals total spending by firms or households on final goods and services to make additions to the stock of capital. Investment includes construction of a new house or a new factory, the purchase of new equipment, ‘and net increases in inventories of goods held by firms (i.e., unsold output). * Government consumption expenditures and gross investment (often called “govemment consumption”) equal spending by the public sector on final goods and services, including spending on public works, national defense, the police, and the civil service. It does not include any transfer payments or income redistributions, such as Social Security or unemployment insurance payments—these are not purchases of goods or services, just rearrangements of private spending power. amen \ GP = CH4G + a Sii This formula says gross domestic product is equal to gross national expenditure (GNE) plus the trade balance (TB). The trade balance (TB), also referred to as net exports, may be positive or negative. *If TB >0, exports are greater than imports and we say a country has a trade surplus. *If TB<0, imports are greater than exports and we say a country has a trade deficit. GNI= C+1+G +(EX -IM)+ (EX IM) ST, TT Og NI er, Give naioraleapeitne Vesta GRE To i GE Wi ddr Gross national income equals gross domestic product (GDP) plus net factor income from abroad (NFIA). How important is NFIA? Exchange rates the world over are set in the foreign exchange market (or forex or FX market). The forex market is not an organized exchange: trade is conducted “over the counter” In April 2019, the global forex market traded $6.5 trillion per day in currency! The three major foreign exchange centers are located in the United Kingdom, the United States, and Japan. Other important centers for forex trade include Hong Kong, Paris, Singapore, Sydney, and Zurich. The simplest forex transaction is a contract for the immediate exchange of one currency for another between two parties. This is known as a spot contract. The exchange rate for this transaction is often called the spot exchange rate. The use of the term “exchange rate” always refers to the spot rate for our purposes. The spot contract is the most common type of trade and appears in almost 90% of all forex transactions. In addition to the spot contracts other forex contracts include forwards, swaps, futures, and options. Collectively, all Si these related forex contracts are termed derivatives. The spot and forward rates closely track each other. Di ® Forwards—A forward contract differs from a spot contract in that the two parties make the contract today, but the settlement date for the delivery of the currencies is in the future, or forward. The time to delivery, or maturity, varies. However, because the price is fixed as of today, the contract carries no risk. Swaps — A swap contract combines a spot sale of foreign currency with a forward repurchase of the same currency. This is a common contract for counterparties dealing in the same currency pair over and over again. Combining two transactions reduces transactions costs. Futures — A futures contract is a promise that the two parties holding the contract will deliver currencies to each other at some future date at a prespecified exchange rate, just like a forward contract. Unlike the forward contract, futures contracts are standardized, mature at certain regular dates, and can be traded on an organized futures exchange. Ù Options — An option provides one party, the buyer, with the right to buy (call) or sell (put) a currency in exchange for another at a prespecified exchange rate at a future date. The buyer is under no obligation to trade and will not exercise the option if the spot price on the expiration date tums out to be more favorable. Derivatives allow investors to engage in hedging (risk avoidance) and speculation (risk taking). Example 1: Hedging. As chief financial officer of a U.S. firm, you expect to receive payment of €1 million in 90 days for exports to France. The current spot rate is $1.20 per euro. Your firm will incur losses on the deal if the dollar weakens to less than $1.10 per euro. You advise that the firm buy €1 million in call options on dollars at a rate of $1.15 per euro, ensuring that the firm’s euro receipts will sell for at least this rate. This locks in a minimal profit even if the spot rate falls below $1.15. This is hedging. Example 2: Speculation. The market currently prices one-year euro futures at $1.30, but you think the dollar will weaken to $1.43 in the next 12 months. If you wish to make a bet, you would buy these futures, and if you are proved right, you will realize a 10% profit. Any level above $1.30 will generate a profit. If the dollar is at or below $1.30 a year from now, however, your investment in futures will be a total loss. This is speculation. The market for foreign exchange — private actors — Most forex traders work for commercial banks. About 3/4th of all forex transactions globally are handled by just 10 banks. The exchange rates for these trades underlie quoted market exchange rates. Some corporations may trade in the market if they are engaged in extensive transactions in foreign markets. — government actions — Some governments engage in policies that restrict trading, movement of forex, or restrict cross-border financial transactions are called a form of capital control. In lieu of capital controls, the central bank must stand ready to buy or sell its own currency to maintain a fixed exchange rate. — Arbitrage is if you buy the pound in new york because it is 4 0 EN È n cheaper and then sell it where it's higher in price 1 della i ER = E 15" po ; ri . sui in ew York ET oi — inequilibrium there shouldn't be any arbitrage opportunities in Noi York — The pound that you receive in new york vs the one you receive in london cannot be different nds to London Arbitrage with 3 currencies E 3 — In general, three outcomes are again possible. nrdoliar E ted pound 1. The direct trade from dollars to pounds has a better rate: in Lordon Sell dallar for pounds in London Es> Ege Ees in London Ees means how many euros do you get when you sell your dollar Arbitrage and Spot Rates Arbitrage ensures that the trade ofccurrencies in New York 2. The indirect trade has a better rate: Exis < Eze Ees along the path AB occurs at the same exchange rate as via London along path ACDH. 3. The two trades have the same rate and yield the same result: At B the pounds received must be the same, Regardless of the route taken to get to B. _ ° EST = "London Es = Ewe Ees. es Pes Only in the last case are there no profit opportunities. This no- arbitrage condition: The right-hand expression, a ratio of two exchange rates, is called a cross rate. 7 = E — Pere Eos = EgweEes = Di Esse rec exchange ate RR È xEx i 1 dollar = Feys= Eesdfens The majority of the world's currencies trade directly with Sell dollar for p Pounds only one or two of the major currencies, such as the dollar, euro, yen, or pound. xEn Many countries do a lot of business in major currencies such Sell'euros for pounds as the U.S. dollar, so individuals always have the option to c engage in a triangular trade at the cross rate. Lens euros: When a third currency, such as the U.S. dollar, is used in these transactions, it is called a vehicle currency because it is Arbitrage and Cross Rates Triangular arbitrage ensures that the direct trade of currencies not the home currency of either of the parties involved in the along the path AR occurs at the same exchange rate as via a third eurreney along path. trade and is just used for intermediation. ACB. The pounds received at B must be the same on both paths, and Exis Sell dollar for euros Es reEe;s An important question for investors is in which currency they should hold their liquid cash balances. Would selling euro deposits and buying dollar deposits make a profit for a banker? These decisions drive demand for dollars versus euros and the exchange rate between the two currencies. The Problem of Risk A trader in New York cares about retums in U.S. dollars. A dollar deposit pays a known return, in dollars. But a euro deposit pays a retum in euros, and one year from now we cannot know for sure what the dollar-euro exchange rate will be. Riskless arbitrage and risky arbitrage lead to two important implications, called parity conditions. Riskless Arbitrage: Covered Interest Parity Contracts to exchange euros for dollars in one year's time carry an exchange rate of F sie dollars per euro. This is known as the forward exchange rate. If you invest in a dollar deposit, your $1 placed in a U.S. bank account will be worth (1 + is) dollars in one years time. The dollar value of principal and interest for the U.S. dollar bank deposit is called the dollar retum. If you invest in a euro deposit, you first need to convert the dollar to euros. Using the spot exchange rate, $1 buys 1/E se euros today. These 1/Es/e euros would be placed in a euro account eaming ie, so in a year’s time they would be worth (1 + i @/Esie euros. R To avoid that risk, you engage in a forward contract today to make the future transaction at a forward rate Fs;e. The (1 + ie)/Es/e euros you will have in one year’s time can then be exchanged for (1 + i €) Fs/Esie dollars, or the dollar retum on the euro bank deposit. : sE (l+i,) = (i Dollar rotum ov dollar denosite DI alta rim GA e depunit This is called covered interest parity (CIP) because all exchange rate risk on the euro side has been “covered” by use of the forward contract. Evidence on Covered Interests Parity AREA) prtt impied da one i deriaion codino (5 per ana) Arbitrage and Covered Interest Parity Under CIP, retums to holding dollar deposits ETRE TREIA ERE CRE REI EEA ing interest going along the path AB must cqual the retums from investing in curos Fi E I CES a e oi Interest Parity Arno mo no cn going along the path ACDB with risk removed by use of a forward contract. Henec, at B, | 5 de and German mark using forward cover rem 1990 t0 1995, In the 1705, the differen the riskless payoff must be the same on both paths, and: Foe ERIN ESATA E INVENTORE To Leni 9 (AR fp ce (+3)= 2%) vas positive and often large: (raders would have profited (rom urbitrage by moving money from pound deposits to mark deposits, but capital controls prevented them from freely doing so. s/e FIGURE 2-9 (2 0f2) Profit implied 15% by deviation from CIP (% por annum) Riskless Arbitrage: Uncovered Interest Parity tetra on Ut. deposte in * In this case, traders face exchange rate risk and must make a forecast of the future spot rate. We refer to the forecast as Eîe, which we call the expected exchange rate. 2978: 01. cita contri av! Based on the forecast, you expect that the (1-;,)/E,, euros you will have in one year's time will be worth (11i:)/Et /Ese when converted into dollars; this is the expected dollar return on euro deposits. 9615 Grma copli ano bolshes The expression for uncovered interest parity (UIP) is: (+i) = (+) Los ia Ratei e REmo asta iste 916 ato ti6o iste isos 1960 nose 130 inn sm Financial Liberalization and Covered Interest Parity: Arbitrage Between the United Kingdom and Germany (continued) After financial liberalization, these profits essentially vanished, and no arbitrage opportunities remained. The CI condition held, aside from small deviations resulting from transactions costs and measurement errors. E, Psve Lixpected dollar retum (01 euro deposils FIGURE 210 _ I dotto Arbitrage and Uncovered Interest Parity Under CIP, returns to holding dollar deposits aceruing interest going along the path AB must cqual retums from investing in curos going along the risky puth ACDR. Hence, at h, the expected payoff must be the same on both path, and (1+;,)= Di (146) sE n ‘What Determines the Spot Rate? Uncovered interest parity is a no-arbitrage condition that describes an equilibrium in which investors are indifferent between the returns on unhedged interest-bearing bank deposits in two currencies. _ We can rearrange the terms in the uncovered interest parity expression to solve for the spot rate: Birg Ela l+i 1l+ * Dividing the UIP by the CIP, wc obtain 1= £$,/ Fi, or Esse = Faje Although the expecred future spot rate and the forward rate are used in two different forms of arbitrago—risky and riskless, in equilibrium they should be exactly the same! * Ifboth covered interest parity and uncovered interest parity hold, the forward must equal the expected future spot rate. + Investors have no reason to prefer to avoid risk by using the forward rate, or to embrace risk by awaiting the future spot rate. If the forward rate equals the expected spot rate, the expected rate of depreciation equals the forward premium (the proportional difference between the forward and spot rates): Fiie_1 _ Ese Esse ue Forward premium —Expected rate of depreciation While the left-hand side is easily observed, the expectations on the right-hand side are typically unobserved. Evidence for PPP in the Long Run and Short Run Evidence for PPP in the Long Run and Short Run FIGURE 3-2 FIGURE 3-3 Rate of inner UiS. dollars 52.75 depreciation sprecati per pound | tetaie price nre sterlina eso levi Rota I (8/8) des Facherge tate. En 5 1980 1985 1999 1995 2000 2005 2010 Exchange Rates and Relative Price Levels Data forthe U.S. and the UK for 1975 to 2010 show that the exchange rate and relative price levels do not always move together în the short run Relative price levels tend to change slowly and have a small range of movement; exchange rates move quickly and experience large flucmations. Therefore, relative PPP does not hold in the short run. Itis a better guido to the long run, and we can sce that the two scrics do tend to driît together over the decades. Infatton differential 1975-2003 (% per yeer versus 1.5.) nflation Differcatials and ihe Exchange Rate, 1975-2005 This scallerplot shows the relationship berween the rate ofexchange rate depreciation against the 1/.S. dollar and the inflation -d States over the long run, for a sample of 82 countries. The correlation between the two variables is strong and bears a close resemblance to fhe prediction of PPP that all data points would appear on the 45-degree line. How slow is convergence to PPP? Research shows that price differences—the deviations from PPP—can be quite persistent. Estimates suggest that these deviations may die out at a rate of about 15% per year. This kind of measure is often called a speed of convergence. Approximately half of any PPP deviation still remains after four years: economists would refer to this as a four-year halflife. Such estimates provide a rule of thumb that is useful as a guide to forecasting real exchange rates. Forecasting When the Real Exchange Rate Is Undervalued or Overvalued When relative PPP holds, forecasting exchange rate changes is simple: just compute the inflation differential. But how do we forecast when PPP doesn't hold, as is often the case? Knowing the real exchange rate and the convergence speed may still allow us to construct a forecast of real and nominal exchange rates. The rate of change of the nominal exchange rate equals the rate of change of the real exchange rate plus home inflation minus foreign inflation: AEssea Aus evra E, SIe4 dusieuri — Tevri Tnfation cliferential —— —_— Rate of depreciation of the Rete of depreciation of the nominal exchange rate real exchange rate Economists have found a variety of reasons why PPP fails in the short run: * Transaction costs. Include costs of transportation, tariffs, duties, and other costs due to shipping and delays associated with developing distribution networks and satisfying legal and regulatory requirements in foreign markets. On average, they are more than 20% of the price of goods traded internationally. * Nontraded goods. Some goods are inherently nontradable; they have infinitely high transaction costs. Most goods and services fall somewhere between tradable and nontradable. * Imperfect competition and legal obstacles. Many goods are not simple undifferentiated commodities, as LOOP and PPP assume. Differentiated goods create conditions of imperfect competition because firms have some power to set the price of their good, allowing firms to charge different prices not just across brands but also across countries. * Price stickiness. Prices do not or cannot adjust quickly and flexibly to changes in market conditions. 2. Money, Prices, and Exchange Rates in the Long Run: Money Market Equilibrium in a Simple Model In the long run the exchange rate is determined by the ratio of the price levels in two countries. But this prompts a question: What determines those price levels? Monetary theory supplies an answer: in the long run, price levels are determined in each country by the relative demand and supply of money. This section recaps the essential elements of monetary theory and shows how they fit into our theory of exchange rates in the long run. We assume money demand is motivated by the need to conduct transactions in proportion to an individual’s income and we infer that the aggregate money demand will behave similarly (known as the quantity theory of money). d 7 7 M° = L x PY Ma, i EL Demand —Aconsiani Nominal for money (8) income ($) AII else equal, a rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. Dividing the previous equation by P, the price level, we can derive the demand for real money balances: \ M° = = Lx Y P, Accanto Redinone ni money Real money balances are simply a measure of the purchasing power of the stock of money in terms of goods and services. The demand for real money balances is strictly proportional to real income The condition for equilibrium in the money market is simple to state: the demand for money Md must equal the supply of money M, which we assume to be under the control of the central bank. Imposing this condition on the last two equations, we find that nominal money supply equals nominal money demand: M = L*P*Y and, equivalently, that real money supply equals real money demand: M/P=L*Y An expression for the price levels in the U.S. and Europe is: Mus Eli 3 vsttrs Leveteua These two equations are examples of the fimdamental equation of the monetary model of the price level. In the long run, we assume prices are flexible and will adjust to put the money market in equilibrium. FIGURE 3-5 Home Foreign topi Lt mete meg i Real income, | Money supol Real income, (exogenous voriabias) ton Ton fis Tue Price level, Price level, Ps Pan Building Block; The Monetary Theory of the Price Level According to the Long-Run Monetary Model Mm these models, he money supply and real income are treated as known exogenous variables (in the green boxes). The models use these variables to predici the unknown endogenous variables (in the red boxes), which are the pricc levels in cach country. ) (0 8° cadere) This is the fundamental equation of the monetary approach to exchange rates. P; ( M a rutocipaceless = |7Y \ ene eve Reliice nomina money supplics videc hg relazive real money demande The implications of the fundamental equation ofthe monetary approach to exchange rates are intuitive. Suppose the U.S. money supply increases, all else equal. The right-hand side increases (the U.S. nominal money supply increases relative to Europe), causing the exchange rate to increase (the U.S. dollar depreciates against the euro). Now suppose the U.S. real income level increases, all else equal. Then the right-hand side decreases (the U.S. real money demand increases relative to Europe), causing the exchange rate to decrease (the U.S. dollar appreciates against the euro). The U.S. money supply is Mys and its growth rate is uygi Therefore, the growth rate of P.,g = Myxg/LysYys equals the money supply growth rate 4,5 minus the real income growth rate g;;g Musin Mus, The growth rate of P,,, is the inflation rate 7, Thus, we know Husa Mus that: iO OR Tusa F Hus: usi 64) The growth rate of real income in the U.S. is gig: The rate of change of the Furopean price level is calculated similarly: Vissa Fura S Ao Bevi GS When money growth îs higher than income growth, we have “more money chasing fewer goods” and this leads to inflation Combining (3-4) and (3-5), we can now solve for the inflation differential in terms of monetary fundamentals and compute the rate of depreciation of the exchange rate: AF; sie = (bus: = 85) (en = E218:) 69 ti eci A Ratei Sepa ton i ihenoeinalenciimoe ne osa Dita sonia] mene opp resoupu remore pronihinea The intuition behind Equation (3-6) is as follows: * If the United States runs a looser monetary policy in the long run measured by a faster money growth rate, the dollar will depreciate more rapidly, all else equal. *Ifthe U.S. economy grows faster in the long run, the dollar will appreciate more rapidly, all else equal. 3. The monetary approach — implications and evidence When we use the monetary model for forecasting, we are answering a hypothetical question: What path would exchange rates follow from now on if prices were flexible and PPP held? Forecasting Exchange Rates: An Example: Assume that U.S. and European real income growth rates are identical and equal to zero (0%). Also, the European price level is constant, and European inflation is zero. Based on these assumptions, we examine two cases. Case 1: A one-time increase in the money supply. Case 2: An increase in the rate of money growth. Case 1: A one-time increase in the money supply. a) There is a 10% increase in the money supply M. b) Real money balances M/P remain constant because real income is constant. c) These last two statements imply that price level P and money supply M must move in the same proportion, so there is a 10% increase in the price level P. d) PPP implies that the exchange rate E and price level P must move in the same proportion, so there is a 10% increase in the exchange rate E Case 2: An increase in the rate of money growth. At time T the United States will raise the rate of money supply growth to rate of pu + Au from a steady fixed rate 1. a) Money supply M is growing at a constant rate. b) Real money balances M/P remain constant, as before. c) These last two statements imply that price level P and money supply M must move in the same proportion, so P is always a constant multiple of M. d) PPP implies that the exchange rate E and price level P must move in the same proportion, so E is always a constant multiple of P (and hence of M). 6 Ho ey Sap Before time /, {6 oe ny ep ni money, prices, and - * BRA the exchange rate all EEE NO EMERSO level of real money Foreign prices are talnce male 5 constant. In panel (a), I e we suppose at time 7° me 7 iui there is an increase Au in the rate of growth of home ‘money supply M. FIGURE 3-6 (3 0f 4) | FIGURE 3-6 (4 of 4) Game one opp 08) dono Bi one Bac 4? | Aftertime { if real (6) ee ne Sup, (0) ire mes iney tane /7 | PPP and un assumed x money balunces stable foreign price (MP) are constant, level imply that the then money M and exchange rate will prices P still grow al follow a path similar the same rate, which to hat of the Te is now + Ag, so the to ea ne € ee Gimp an e "7 | domestic price level, rale ol'inflation rises , s0 E also grows at by Ag, as shown in cia the new rate u + A4, padia ; and the rate of depreciation rises by Au, as shown in punel (d). 5. Monetary regimes and exchange rate regimes The Long Run: The Nominal Anchor An overarching aspect of a nation’s economic policy is the desire to keep inflation within certain bounds. * To achieve such an objective requires that policy makers be subject to some kind of constraint in the long run. Such constraints are called nominal anchors. * Long-run nominal anchoring and short-run flexibility are the characteristics of the policy framework that economists call the monetary regime. * The three main nominal anchor choices that emerge are exchange rate target, money supply target, and inflation target plus interest rate policy. Exchange rate target: Ty = AE, + n, Werelabel the countries Home (H) and Foreign (F) instead of United States and Europe. pi Fa E 2 Relative PPP says that home inflation equals the rate of depreciation plus foreign inflation. A Maio anno Lo simple rule would be to set the rate of depreciation equal to a constant. a soa Anchor variable Money supply target: . . . A simple rule of this sort is: set the growth rate of the money supply equal to a Ta = Un 7 LH constant, say, 2% a year. n _ _ Again the drawback is the final term in the previous equation: real income growth Inflation Money supply growth Red output growth can be unstable. In periods of high growth, inflation will be below the desired level. In periods of low growth, inflation will be above the desired level. Anchor variable Inflation target plus interest rate policy: ae i - ,« The Fisher effect says that home inflation is the home nominal interest rate minus the foreign lisa ue vio Feal interest rate. If the latter can be assumed to be constant, then as long as the average home °" nomina 1 rca —mominal interest rate is kept stable, inflation can also be kept stable. o This type of nominal Interest. anchoring framework is an increasingly common policy choice. Assuming a stable world real interest rate is not a bad assumption. inverese rare raro Anchor variable TABLE 3-2 Exchange Rate Regsines and Nominal Anchors This table Ilustrates he possible exchange rate regimes that are consistent with various types of nomina] anchers. Countries that are dollaized orin a currency union have a “superfixed” exchanye rate target. Pegs, bands, and cravls also target the exchange rate. Manoged floats have no prese path for the exchange me, which allows other targets 0 be employed. Countries ut Must fcely or independently nc judge 1 pay no scrious attention to exchange rate tergets: if they have anchors, they will involve monctary dargets or inlatin targets wilran interest rate policy, The counties with “Ireely falling” exchange rates have no serious target and have higl rates of'inflation and depreciation. It should be noted nat many countries engage in implicit targeting (eg. inDaticn tergerine) wikoot announcing an caplici target and that some countrics may usc a mix of more {han ene target. Global Disinflarion Cross-country data from 1980 to 201? show the gradual reduction in te annual rate oL'inflation around the world. This disinlation process bear in the advanced economies in the carl 1980s. The emerging markets and developing countries sufered from even higher rates ofinflation, although these finally began to fall in the 19905. ANNUAL INFLATION RATE (%) 1980 = 1968= 1990- 1995 2000 2005-2010 1984 1969 19% 19 2004 2009 moi? COMPATIBLE EICHANGE RATE RECDNES 11h ds 104 sa 39 “o sa Guanti toni frety 8 19 se 20 è so ti tamoncy et rag) tati (pi Tape of Morino Anchor Tie um __Bend;/romls _ Managed Fosting _Fely Hosting _depreiton) v , v did so n sa sé 65 té v # tit tit Gu tr te plc) v v Nominal Anchors in Theory and Practice * An appreciation of the importance of nominal anchors has transformed monetary policy making and inflation performance throughout the global economy in recent decades. * In the 1970s and 1980s, most of the world was struggling with high inflation. * In the 19905, policies designed to create effective nominal anchors were put in place in many countries. * Most of those policies have turned out to be credible, too, thanks to political developments in many countries that have fostered central- bank independence. * Lecture 4— Exchange rates in the short run * Deviations from purchasing power parity (PPP) occur in the short run: the same basket of goods generally does not cost the same everywhere at all times. * Short-run failures of the monetary approach prompted economists to develop an alternative theory to explain exchange rates in the short run: the asset approach to exchange rates. * The asset approach is based on the idea that currencies are assets. * The price of the asset in this case is the spot exchange rate, the price of one unit of foreign exchange. 1. Exchange Rates and Interest Rates in the Short Run: UIP and FX Market Equilibrium Risky Arbitrage The uncovered interest parity (UIP) equation is the fundamental equation of the asset approach to exchange rates. (Ese-Es) i; i + = x Es Interest rate Interest rate on dollar deposits on eura deposits Fxpected rate of depreciation of the dollar Dollar rate ofrewm — — on dollar deposirs Expecced dollar rare of return on euro deposits Equilibrium in the FX Market: An Example [TABLE 4-1 | FIGURE 41 Interest Rates, Exchange Rates, Expectec Returns, ard EX Market Equiliorium: A Numerica! Home Foreign Example The forcign exchange (FX) market is in cquilibrium when the domestic and forcign retums are equal. In this cemple, the dollar interest rate is 5%, the curo interest rate is 3%, and the Nominal Eipected future omar expected future exchange rate (one year ahead) is = 1.224 S/E. The equilibrium is highlighred in Tout oftte model: — ESA exchange rate, interest rate, iS (exogenous variables) 6 Sale " Output of the modei unknown variab!es (erdogenous variables) Building Block: Uncovered Interest Parity_ The Fundamental Equation of'the Asset Approach In this model, the nomina interest rate and expected future exchange rate are treated as known exogenous veriables (in green). The model uses these variables to predict the unknown endogenous variable (in red), the current spot exchange rate. Equilibrium in the FX Market: An Example PI Marcet FX Market Ecuilibrium: A Especied 0.15 Numerical Example Equi: whan he comest olerretum equi the na pid frigo deli ctr, creme ret o halo. ‘The return calcalated in Table. 010 Ln.16,,065) / dimesiceun, —4-lareplottedinthis figure | Changes in Domestic and Foreign Returns and FX Market Ls È The dollarinterest rate is 5%, | Equilibrium se diari E To gain greater familiarity with the model, let's see how the FX o and the expected future Done _ va R esichange rate is 1224 SI. market example shown in Figure 4-2 responds to three separate shocks: * A higher domestic interest rate, i$ = 7% Forget, VIET 122% The foreign exchange market “o na 0 dd 1 is in equilibrium at point 1, nesti ‘i Today dollaro where the domestic retums DR | * A lower foreign interest rate, i€ = 1% Spot ocienee Male ly ‘and expected foreign retums | * A lower expected future exchange rate, Ee $/€= 1.20 $/€ FR are equal at 5% and the spot exchange rate is 1.20 S/€. Changes in Domestic and Foreign Retums and FX Market Equilibrium di a Changes in Domestic and Foreign Returns and FX Market Equilibrium A Change in the Domestic Interest Rate td A Change in the Foreign Interest Rate | FIGURE 4-3 (1 of 3) 19) A Change in the Hi . @) Pi adet e 0) Fr arte (b) A Change în the Foreign ai Interest Rate A rise in che i .._... eta 04 IR dollar interest rate from 5% 0 ||| PRECIEE 015" i rene in theses sh che e cune up, ming dci denis more attractive. 1% increases domestic returns, È cave devo, mot ol eps ne act. O di 4 \ gr, tonestenun | shifting be DA curve up from que x ponte so, 10Wers foreign expected dollar E ie SECOE i AEB retums, shifting the FR curve ui oreste eum sr DE ve down from FR; fo FR. At he a Fio At the initial equilibrium i 23 E, 1424. initial equilibrium exchange Nara exchange rate of 1.20 5/E on fa = rare oî 1.20 S/€ on FR), cl i 2 Fre 1224 DR domestic retums are as z n Ti fon 224. Foreign retums are below TI6 118/12 12 1% above foreign retums at point TI 18 / 189 122 124 domestic returns at point 6. 2. The delle apprecites; Today's dollar/euro 4. Dollar deposits are more 2. The doll appeciats; Today's dollar/euro Dollar depcri rev equina stan n sen st erchenge rat Ep leposits are more pla ot pit 5 pot exchange rate, Ex Re di RESRNBRENO spotexianee Ri4 ky attractive and the dollar appreciates from 1.20 $/€ to appreciates from 1.20 $/€ to 1.177 $/€. The new 1.177 S/€. The new oquilibrium is at point 5. equilibrium is at point 7. Change: Domestic and Foreign Returns and FX Market Equilil A Change in the Expected Future Exchange Rate (© Pe Martet (0) A Change in the Expected i . Forre Exchange Rate A fall in A dea i he pc ue cima ae Si : 20618 Give o ra sb i ve stive fhe expected future exchange sot 4 rate from 1224 to 1.20 lowers È 1 — femgdi tm foreign expected doller ci aa E returrs, shifting che FR curve o CEREA za down from FR to FR), Atthe om ® st initial equilibrium exchange cos Sroeinetar | rateof 1208/E0nFR, te 7/ e a a iO 2 it colposi Today” dollarfeuro domestic retums at point 6. Ter natinan 1007. pot exchange ate, Eye Dana i attractive and the dollar appreciates from 1.20 SIE to 1.177 $/E. The new. espuilibrium is at print 7. 2. Interest Rates in the Short Run: Money Market Equilibrium Money Market Equilibrium in the Short Run: How Nominal Interest Rates Are Determined The Assumptions In this chapter, we make short-run assumptions that are quite different from the long-run assumptions: * In the short run, the price level is sticky; it is a known predetermined variable, fixed at P= P (the bar indicates a fixed value). * In the short run, the nominal interest rate i is fully flexible and adjusts to bring the money market to equilibrium. The assumption of sticky prices, also called nominal rigidity, is common to the study of macroeconomics in the short run. ‘The Model The expressions for money market equilibrium in the two countries are as follows: Mis u Pe LIV da Pe TI delia US Tio slice baie = IG)XVaa 4» SES EIDE, RI Luropena demand for yug seal money balanoes alare Money Market Equilibrium in the Short Run: Graphical Solution Home Money Market. în The moncy market is equilibrium when the Riga Tano i LARE such that real moncy demand equal real money supply (point 1). At points 2 and 3, domandi does not equal supply and the interest rate will adjust until the money market returns to equilibrium. Real non demant Minds" 9) fn ni Real money ” balances, M,,/P, Changes In Money Supply and the Nominal Interest Rate Increase in Money Supply, MS Nomina rata i; Resi money balance, Mall Tn panel (2), with a fixed price level Pig, an increase in nominal money supply from Aiuto AF causes n increase in rel money supply from M/Plyst0 MPyyP"ys rum at point 2. The nominal interest rate falls from 2 ta #3 10 restore equi Another Building Block: Short-Run Money Market Equilibrium Home Foreign Money supp, Real'income, | (Money supply Real incoma, Ms ls Nan Vr Building Block: The Money Market Equilibrium in the Short Run In these models, the money supply and real income are known exogenous variables (in green boxes). The models use these variables to prediet the unknown endogenous variables (in red boxes), the nominal interest rates in cach country. ipsa of ihe mode nor erogrons veschi:) Bepatajthe made unico cisl andagonca vai) _Changes i si Money Supply and the Nominal Interest Rate C@) Increase in Money Supply, MS (b) Increase in Money Demand, MD Nomina rante Norrinal interest | rev interest rate, i, rate, hi, lo Air sl |; inten Sora. Aa ; i VARI ra a 3 re NORM N ces “i E "ume " Real money Ea ” felance, Malfa Mala In panel (b), with a fixed price level P!,,,, an increase in real income from Wyyto 2, causes real money demand to increase rom MD, to MD. To restore cquilibrium at point 2, the interest rate rises from is t0 85. pr Home Countiy Foreign Country Asset Approach n Shortrua modei of current exchange rate Current levels Current levels Levels at time t (current period) Money supply, Realircome, Money supply Real income, stia oo Ms Va ue Yen mlteteno Manta (5 squitonan parity G (Figure 4-1) ma Espected future ecchange rate. Ex {Forecast from menetary approach) Monetary Approsch Long.un mode! of future exchange rate Future levels futre levels Levels at time t+1 (future pericd) Money supply. Real income, |’. Money supply, | Real income, la Vos n Veve Long-run 7 money market." Mus/Usts aquibibrium n RE] nas purchasing power party fig Exa o (Finure i) MO (2) Short Run: Money Market. (b) Short Run: PX Market. Nomina 1. A pamevan în fapected 3. Omini ft nta Giai etorns diver resi; mesi mf ‘4A tre sr tin | Mo Mi Mi, Real money R6 0 RE balance», Mala In panel (a), the home price level is fixed, but the supply of dollar bulances inereuses and real money supply shifts out. To restore equilibrium at point 2, the interest ate falls from. 2 to 2. In panel (h), în the FX market, the hame interest rate falls, so the domestie return decreases and DR shifts down. In addition, the permanent change in the home money supply 1mplies a permanent, long-run depreciation of the dollar. A Complete Theory of Floating Exchange Rates: All the Building Blocks Together Inputs to the model are known exogenous variables (in green boxes). Outputs of the model are unknown endogenous variables (in red boxes). The levels of money supply and real income determine exchange rates. (a) Short Run: Money Market. (b) Short Run: PX Market Nomina! 2A prnanane ns i Eapectedi interest 3h 1.5. money sup returns tate, i, s6f 1 7 Real money da Bn 8 Baiano lance, 5. i pes rate, Ex tela ta dl dp pesi Hence, there is also a permanent rise in £yg, which causes a permanent increase in the foreign return i5+ (Py > Fs) Egg all else equal: FR shifis up from FR, to FR, The simultaneous fall in DR and rise in FR cause the home currency to depreciate steeply, Jeading to a new cquilibrium at point 2° (and not at 3, which would be the equilibrium if the policy were temporary). (©) Long Run: Money Market. (d) Long Runs FX Market Nominal (Prc ie i he Lim tu val Expected 8 Forget rev bile interest. On Su esito e al vet. elums apt ture orange roca rate, i, — i permarentty high). #5 dai no NÉ Real money Ha Fix Exchange Pa dolances, 10, he dl now cpprsciate:” rete, Eu Mus/Pos 10 Ît mo Long rv deve Long-Run Adjustment: n panel (€), in the long run, prices are flexible, so the home price Jevel and the exchange rate both rise in proportion with the money supply. Prices rise to Pag and real money supply returns to is original level A1Î,,4/2, x; The money market eradually shifts back (0 equilibrium at point 4 (the same as point 1) (€) Long Run: Money Market (d) Long Run: FX Market Nominal € Pe ein the eng ro, mol Erpected rig et en niger interest sine spp ‘tu 5 chi lm, etums (emettd fim mcg ile i sermenanty higher). i ei Ea i A, nei i % Reatmones Exchange Pica RE Ab Balance — menti ii rate sn na “i; Ma/Ps (ato nev amp end Long-Run Adjustment (continued): In panel (d), in the FX market, the domestic retum DR, which equals the home interest rate, gradually shifts back to îts original level. The foreign retum curve 7A does not move at all: there are no forther changes in the Foreign interest rate orin the future expeeted exchange rate. The FX market cquilibrium shifts gradually to point 4 The exchange rate falls (and the dollar appreciates) from 27, t0 £*,. Arrows in both graphs show the path of grndual adjustment. Overshooting [ FIGURE 4-13 (1 of; () ome Money Suppis, # (0) Home Rest Money Balance, 1/7 nd Momina Inerse Rate (0 Home Eschange Rate, E Ti panel (a) here isa on-tine permanent incrvase i home (U.S) nominal money supplyattime P Ti panel (B), pres are sticky în {be short ru, so dere sa shor-ru increase în die real money suppîy und a fall in he here interes rate. tn pan ci the lm run, prices rise i he same proporti as dhe money supp tn pan (ein he shore um, e exchange rate overshon i longer value (the dollar depreistes by lange amo), buia he ong up, fe exchange rate wi have rise cn in proporti 1 changes n money and pics. Time î rime The exchange rate and the trade balance Consider è two-country, to-good world and denote with: Pig is the foreign price of importerl goods Pex is the domestic price of exported goods ; ; + mor i Let us denote the trade balance (evaluated in domestic currency) E is the nominal exchange rate (price of foreign currency în Sr terms of domestic currency). TB = Pex- Qex — E- Pira Qua Then, let IMPLE + Pi) be the domestic demand of imparted goods: and consider the effect of a change in the nominal exchange rate IM5(Pijy) be the foreign supply of imported goods (assuming with no loss of generality that Prx = Pix = 1). EX"(Prx/E) be the foreign demand of exported goods; EXS(Prx) be ie domestic supply of exported goods The Marshall-Lerner Condition The effect of a change in the exchange rate on the trade balance can be written as: dTB dQex E Qex -dQm E Qm de — de Qex E de Que Defining nex = GE L-(> 0) and my — GEL (> 0), we get dTB_ _Qx E ISTE + Ali 1) Suppose that inizially TB = 0, then: 928 — Qum(nex + ua — 1) Just for completeness, consider the case in which initially 78 #0 In this situation we observe Lhal dIB ine BE de 70 (Mex Egg, + im -1)>0 It îs important to notice that the more £ < 1 (i.e. the larger the initial deficit), the harder is to fulfill the M L condition. Price effect and volume effect According to the M-L condition, a (real) depreciation of the domestic currency leads to a trade surplus (assuming that initially TB = 0) if and only if the sum of the elasticities is greater than one. The economic intuition of the M-L condition deeply relies on two opposite effects: the price effect and the volume effect. Real depreciation >reduction in the cost of exports and increase in the cost of imports >increase in the demand for exports and decrease in the demand for imports > improvement of the trade balance (volume effect). At the same time, real depreciation >higher cost for each unit of imports >negative effect on the trade balance (price effect). => Ifthe M-L condition is satisfied the volume effect dominates the price effect and real depreciation leads to a trade surplus. Depreciation and supply with infinite elasticity: a graphical illustration Pim] P, \ 1 1 “ Ex DID Pra Pex ape, 1 8° Pîu Sw _ Sig Pluto Sex Step nni Pl vr ng Ù ; ci Div i Drm Tu Bus dik ddr dex Qu Qu A qb Short and Long run: the J curve If the volume of imports and exports is fixed in the short run, a depreciation ofthe domestic cumency: will not affect the volume of imports and exports, but will increase the value/price of imports in domestic currency and worsen the current account. On the contrary, the value of exports in domestic currency does not change. Implication: the current account could immediately fall after a currency depreciation, then gradually increase as the volume effect begins to kick in and dominate the price effect. Short and Long run: the J curve (cont.) domesti outpui unita) ì ' I I I ' L T T Time Resi depreciaton — Endat.Lcune tas piace arc sore bogin Exchange rate pass-through and the M-L condition The exchange rate pass-through the elasticity of local-currency import prices with respect to the exchange rate. In other words, it measures the percentage by which import prices change when the value of the domestic currency changes by 1%. So far, we assumed that producers fix their prices in their domestic currency (producer currency pricing). But, in the real world, exporters often fix export prices in local (i.e. foreign) currency, according to the local currency pricing. => What does local currency pricing imply in terms of pass-through and real depreciation effects? Pass-through Pia Let us assume now that A° — 0 and w' — 0. where x = dx/dt. ‘ Then, the previous equation becomes: If we assume that foreign praducers set their price according to the following relation Piu= 044) — use wage and K is mark-up, We can now define tha pass-through coefficient as: 5 = ÈM/E where A denotes labor productivity, w we obtain Pr È Equivalentiy, $I& = E Pm È Pra E We can identify three different cases: 1. The price expressed in the producer’s currency, P #IM, is kept constant following a real depreciation. Asa consequence, Py /Pm= E./Eandy=1. Depreciation is entirely transferred to the local (importer) price, i.e. the increase in import prices is proportional to the level of devaluation. This is the same case we studied in the elasticities (Marshall-Lemner) approach: indeed, consumption is reallocated towards local goods. 2. Intermediate case: 0 < SM < È. Thus, 7 < 1 di Depreciation partially alf'ects the mark-up and prices denominated in the producer's currency. Formally: é,_Le6_W È pipi Here we have an incomplete pass through and a partial consumption reallocation. 3. Import price Pjy is kept constant following the depreciation. Thus, += Formally: P E _k Pi til n co nu Pim ETC 7 Ply In this case, depreciation is entirely transferred to the producer's price (i.e. the increase in producers' prices is proportional to devaluation), implying a reduction in the mark-up k. Consequently, there is no induced reallocation Lowards domestic goods. period. How can this be? * The only way a net debtor can eam positive net interest income is by receiving a higher rate of interest on its assets than it pays on its liabilities. * In the 1960s French officials complained about the United States” “exorbitant privilege” of being able to borrow cheaply while earning higher returns on U.S. external assets. “Manna from Heaven” (assumption 5) The U.S. enjoys positive capital gains, KG, on its external wealth. These large capital gains on external assets and the smaller capital losses on external liabilities are gains that cannot be otherwise measured, so their accuracy and meaning is controversial. * Some skeptics call these capital gains “statistical manna from heaven.” * Others think these gains are real and may reflect the United States acting as a kind of “venture capitalist to the world.” *As with the “exorbitant privilege,” this financial gain for the United States is a loss for the rest of the world. Summary When we add the 2% capital gain differential to the 1.5% interest differential, we end up with a U.S. total retum differential (interest plus capital gains) of about 3.5% per year since the 1980s. For comparison, in the same period, the total retum differential was close to zero in every other G7 country. We incorporate these additional effects in our model as follows: AW,= W,-MW,, = TBy + Wi, + (-r)L + KG Ra I ta e Changein catemal wcalth ibis period this period | onlast period’ ertemal wealth tointerest rate differential Conventional eficets Additional efTects APPLICATION — | FIGURE 6-2 a How Favorakle Interest Rates and averige Capital Gains on Extemal Wealth sir 1 Help the United Stetes The total change in 2 uslortemai n average annual change in U.S. enti peiod external wealth each period is 15) n shown by the dark pink columns. è Ban Negative changes were offset in Bal part by two positive effects. One o effect was due to the favorable interest rate differentials on U.S. assets (high) versus lisbilities (low). The other effect was due to favorable rates cf capital gains on U.S. assets (high) versus liabilitios (low). Without these two offsetting effects, the declines in U.S. external wealth would have been much bigger. rota cinge mete ci Sie Agetoni cange im The Difficult Situation of the Emerging Markets The United States borrows low and lends high. For most poorer countries, the opposite is true. Because of country risk, investors typically expect a risk premium before they will buy any assets issued by these countries, whether government debt, private equity, or FDI profits. APPLICATION — In a sudden stop. a borrower country sces its financial account APPLICATION —_ Gears are at the top of the chart. Their credit ratings (vertical axis) do not drop very much in response fo an increase in debt leve!s (horizontal axis). And ratings are always high investment grade. The emerging markets and developing countries (orange) are a the bottom of the graph. Their ratings are low or junk, and their ratings deteriorate as debr levels rise. a " È Sovereign Ratings and Public surplus rapidly shrink. da Debi Levels: Advanced Countries Versus Emerging Markets and rei Developing Countries The data LEISURE n shown are for the period from Number of 6 1995 to 2005. countries ulecie The advanced countries (green) SPENTA emergina markets “sudden stop" , 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Sudden Stops in Emerging Markets On occasion, capital flows can suddenly stop, meaning that those who wish to borrow ancw or roll over an cxisting loan will be unable to obtain financing. These capital market shutdowns occur frequently in emerging maricets 2. Gains from Consumption Smoothing In this section, we use the long-run budget constraint and a simplified model of an economy to examine the gains from financial globalization. We focus on the gains that result when an open economy uses extemal borrowing and lending to eliminate an important kind of risk, namely, undesirable fluctuations in aggregate consumption. The basic model We now examine the gains from external borrowing and lending, allowing an economy to eliminate fluctuations in aggregate consumption. We adopt some additional assumptions: * GDP (denoted Q) is produced using labor as the only input. Production of GDP may be subject to shocks; depending on the shock, the same amount of labor input may yield different amounts of output. * We use the terms “household” and “country” interchangeably. Preferences of the country/household are such that it will choose a level of consumption C that is constant over time. This level of smooth consumption must be consistent with the LRBC. * For now, we assume consumption is the only source of demand. Both investment I and government spending G are zero, therefore GNE equals personal consumption expenditures C. * Our analysis begins at time 0, and we assume the country begins with zero initial wealth inherited from the past, so that W-1 is equal to zero. * We assume that the country is small and the rest ofthe world (ROW) is large, and the prevailing world real interest rate is constant at r*. In the numerical examples that follow, we will assume r* = 0.05 = 5% per year. These assumptions give us a special case of the LRBC that requires the present value of current and future trade balances to equal zero because initial wealth is zero): 0 = Present value of 7B = Present value of Q - Present value of C du esenti Vaie vsstriazoro rene © PismemalieotGNE or equivalently, Present value of Q = Present valueof € (6-4 Present vale of GP Present value of GN Closed Versus Open Economy: No Shocks If this economy were open rather than closed, nothing would be different. The LRBC is satisfied because there is a zero trade balance at all times. The country is in its preferred consumption path. There are no gains from financial globalization and it has no need to borrow or lend to achieve its preferred consumption path TARLE GA Present rerioe Value Gata 606 a od N00 s00 10 190 10 Uipendiue EC 260 100 109 190 190 100 Trade balance (TA do00090 00 a 0 A Clossd or Open Eeonoriy with No Sheeks Oupur equas consumprian. Trade balance is zero. Cansumprin i «mont. Closed Versus Open Economy: Shocks Suppose there is a temporary unanticipated output shock of -21 units in year 0. Output Q falls to 79 in year 0 and then retums to a level of 100 thereafter. The change in the present value of output is simply the drop of 21 in year 0. The present value of output falls from 2,100 to 2,079, a drop of 1%. TABLE 6-2 Present period Vale 01203 4 s (008) Curgut G0P a # 10 10 1 100 2079 Escpenditure UE C ® 109 10 10 100 2008 Trade bolo TB 9 0 90 8 0 o 4 Closed Evonouny viti Tempaxary Shecks Ounpur cquals consumption. Trade balance is et. Comumpiion is value. The present value of output Q has fallen 1% (from 2,100 to 2,079), so the present value of consumption must also fall by 1%. How will this be achieved? Consumption can remain smooth, and satisfy the LRBC, if it falls by 1% (from 100 to 99) in every year. We compute the present value of C, using the perpetual loan formula: 99 + 99/0.05 = 99 + 1,980 = 2,079 TABLE 6-3 present Value 0 120304 5 (F-008) prer è 7 109 109 10 10 0 209 Espercitue GNE c s0 00 08 90 06 s8 208 Trade balerce to 20 A A 4 4 ° Current acconti. a 209 9 8 ed i Ctrl colt v 20-20-20 20 2 20 - An Open Economy with Temporary Shocks A trade deficit is run when output is temporarily low. Consumprion is smooth. The lesson is clear. When output fluctuates, a closed economy cannot smonth consumption, but an open one can Generalizing * Suppose, more generally, that output Q and consumption C are initially stable at some value with Q = C and external wealth of zero. The LRBC is satisfied. * If output falls in year 0 by AQ, and then retums to its prior value for all future periods, then the present value of output decreases by AQ. * To meet the LRBC, a closed economy lowers its consumption by the whole AQ in year 0. * An open economy can lower its consumption uniformly (every period) by a smaller amount, so that AC < AQ «A loan of AQ — AC in year 0 requires interest payments of r*(AQ — AC) in later years. * If the subsequent trade surpluses of AC are to cover these interest payments, then we know that AC must be chosen so that: Px(AQ-AC) = AC tradi» Amin ermetici ta year — #4 Interest duc in Subsequent years + Rearranging to find AC: , AC= A Ire Q Smoothing Consumption When a Shock Is Permanent With a permanent shock, output will be lower by AQ in all years, so the only way either a closed or open economy can satisfy the LRBC ‘while keeping consumption smooth is to cut consumption by AC = AQ in all years. Comparing the results for a temporary shock and a permanent shock, we see an important point: * consumers can smooth out temporary shocks—they have to adjust a bit, * but the adjustment is far smaller than the shock itself—yet they must adjust immediately and fully to permanent shocks. Summary: Save for a Rainy Day Financial openness allows countries to “save for a rainy day.” Without financial institutions, you have to spend what you eam each period. * Using financial transactions to smooth consumption fluctuations makes a household and/or country better off. *In a closed economy, Q = C, so output fluctuations immediately generate consumption fluctuations. * In an open economy, the desired smooth consumption path can be achieved by running a trade deficit during bad times and a trade surplus during good times APPLICATION Consumption Volatility and Financial Openness Does the evidence show that countries avoid consumption volatility by embracing financial globalization? * The ratio of a country’s consumption to the volatility of its output should fall as more consumption smoothing is achieved. * In our model of a small, open economy that can borrow or lend without limit this ratio should fall to zero when the gains from financial globalization are realized. * Since not all shocks are global, countries ought to be able to achieve some reduction in consumption volatility through extemal finance. n vi Average degree o Finacial opemese "cron by country group (deciles) cone Consumptin 200 volatility relative ati vl (n) Consumption 200% volatility relative to output volatitity (%) werage degree of financial openmess -—|“| %ai see 5 country group (eil) asi Fora very lange semple of 170 countries ever the period 1995 (0 2004, we compie the ratio of consumption volatility to output volatility, expressed as a percentage. A ratio less than 100% indicates thar some consumption smoothing has been achieved. Countics are then [rotipad finta bei grip (deci) crdered fran cad finarciiiyoper (1) 6 ct finarciaiy open (10) The average volatili in such group ix shown. Only ile mont Financialiy open countries have volatili ris ls tan 100% The fig atto in groups 1108 shows, perverse; that consumption is even more volatile than output in these countri, The lack of evidence suggests that some of the relatively high consumption volatility must be unrelated to financial openness. Consumption-smoothing gains in emerging markets require improving poor governance and weak institutions, developing their financial systems, and pursuing further financial liberalization. Precautionary Saving, Reserves, and Sovereign Wealth Funds * Countries may engage in precautionary saving, whereby the government acquires a buffer of external assets, a “rainy day” fund. * Precautionary saving is on the rise and takes two forms. The first is the accumulation of foreign reserves by central banks, which may be used to achieve certain goals, such as maintaining a fixed exchange rate, or as reserves that can be deployed during a sudden stop. * The second form is called sovereign wealth funds, whereby state-owned asset management companies invest some of the government savings. variation is undesirable. TABLE 68 (1013) On average, GDP cquals 100, but in the good state, GDP is 110, and in thc bad state it is only 90, Thus, world GDI ané GNI altvays equal 200, world labor incomz is always 120, and world capital income is always 80. Whca cach country holds only its own assets as in panel (a), GNI equals GDP and is very volatile. (3) When Countries Hold 100% Home Portfolioe och Country Ouns 100% of Its Ovm Capital COUNTRY A counme worLd dor cop oe Capital Labor = Copital Labor Capital Labor Income Income GHI Income Income GAI Income Income _ NI si Ho s6 30 4 66 19 80° 120 200 state 2 MO 066 110 36 54 99 80 220 20 Variati abuut mean 78 #10 = 26 #0 0° 0° 0 World Portfolios * Two countries can achieve partial income smoothing if they diversify their portfolios of capital assets. * For example, each country could own half of the domestic capital stock, and half of the other country's capital stock. Indeed, this is what standard portfolio theory says that investors should try to do. * The results of this portfolio diversification are shown in Table 6-6, panel (b). * Capital income for each country is smoothed at 40 units, the average of A and B capital income in panel (a). TABLE 6-6 (2083) When each country holds a 50% shure of the world portfolio as in panel (b), GNI Volatility decreascs because capital income 13 now smoottcd. (b) When Countries Hole World Portfalios och Country Ovms 505% A Capita and 50% B Copitol with Payajfs as în Ponel (0) countRY A countRe È WORLD 60p cop cor Capital Labor = Capital Labor ‘= Capital Labor = Income Income GNI Income Income GIU Income Income GAI deo se 96 40 66 8° 120 200 SO 85 106 40 SE 80 120 200 0 #6 36 0 se o 0 0 TABLE 6-6 (3.0f9) When each country holds a portfolio made up only af the other country's capital as in panel (€), GNI volatility falls even further by making capital income vary inversely with labor income. (©) When Countries Hold 100% Foreign Portfatias Each Country Owns 100% of the Other Country Capital with Poyoffs es 1n Panel (c) counTaY A countav 8 worip cop cor cop Capital Labor = Capita! Labor = Capital Labor Income Income GNI Income Income GN Income Income GMT State 1 d4 O 56 (9B 36 66 102 BO I29 200 660 108 46 56 98 BOO 120 200 36082 36 26 2000 0 * How does the balance of payments work when countries hold the world portfolio? * Consider country A. In state 1 (bad for A, good for B), A’s income or GNI exceeds A°s output. The extra income is net factor income from ‘abroad, which is the difference between the income eamed on A°s external assets and the income paid on A°s external liabilities. * With that net factor income, country A runs a negative trade balance, which means that A can consume more than it produces. * Adding the trade balance of -4 to net factor income from abroad of +4 means that the current account is 0, and there is still no need for any net borrowing or lending. Generalizing Let us generalize the concept of capital income smoothing through diversification. * Each country’s payments to capital are volatile. A portfolio of 100% country A°s capital or 100% of country B's capital has capital income that varies by plus or minus 4 (between 36 and 44). But a 50-50 mix of the two leaves the investor with a portfolio of minimum, zero volatility (it always pays 40). * In general, there will be some common shocks, which are identical shocks experienced by both countries. In this case, there is no way to avoid this shock by portfolio diversification. * But as long as some shocks are asymmetric, the two countries can take advantage of gains from the diversification of risk [ FIGURE 6-10 (1 012) (I Aspmmetre output Stock: Perfect Megative Corazon (2) The chart plot the volatility afespital income agains= the share ofthe portfatia devonad to fareien capital. The nwo countries are identica] in size and experience shoelks of similar amplitude. In panel (a), socks are perfectly asymmetrio (conelatioa =—1), capita income in the tun comnies % perlecly reguuive!y correlated. Risk can be climinated by olding the world portfolio. and there re large grins from diversificaion Limits to Diversification: Capital Versus Labor Income FIGURE 6-10 (2 012) (8) symmetre Output (5) Syrmetrc Oetput. 6 Other Cose Stack Pertct Negative | Shocist Perfect Positive | Combined Symmetrie and comelation (=) ometation (01) “emme Spock Gee Rn La panel (b), sbocks are perfectly symmetrie (corrlation = 11), capital income n the 1wo Sauarrcs is perfciy posiivelo conelated. Risk cannot he radiiced. and these are no gaine from diversificltom. In pani (e), when bell Iypes ol shock ans present, (he comclafin is nither perfecd negative nor positive, Risk can be parally climinaizd by holding the world portfolio, ct ere ae ll serre guins fem divesiicaion ina fl * Labor income risk (and hence GDP risk) may not be diversifiable through the trading of claims to labor assets or GDP. * But capital and labor income in each country are perfectly correlated, and shocks to production tend to raise and lower incomes of capital and labor simultaneously. * This means that, as a risk-sharing device, trading claims to capital income can substitute for trading claims to labor income. APPLICATION - The Home Bias Puzzle In practice, we do not observe countries owning foreign-biased portfolios or even the world portfolio. Countries tend to own portfolios that suffer from a strong home bias, a tendency of investors to devote a disproportionate fraction of their wealth to assets from their own home country, when a more globally diversified portfolio might protect them better from risk. FIGURE 6-11 (1 0f2) Mean and 16% standard.) deviation of pate ica total ich PO USO ii portfolio rota retum 15 Standard devizzio ofteral return (% per year) 14 Mean Sf total portfolio return ° za #0 #0 Di T00Y: Fortion of wealth allocated to toreign portfolio (%) The figure shows the retum (mean of monthly return) and risk (standard deviation of monthly retum) for a hypothctical portfolio made up frem a mix of'a pure home US. portfolio (the S&:P 500) and a pure foreign portfolio (the Morgan Stanley EAFK) using data from the period 1970 to 1996. | FIGURE 6-11 (2 0f 2) Mean and 15% standard | deviation of!” total 16 us. Minimum portfolio petto voleriity retum 15 portfolio Gtanderd deviation ot total portfolio return ( per year) 14 ci Man of total portfosio return o Ù o Di #0 100% Portion of wealth allocated to foreign portfolio (%) US. investore wir a 0% weight on the overseas portisTio (point 4) couli have raise that veciglit as lipli as 39% (point C) and still raised the return and lowered risk. Even moving fo the right of C (toward D) would make sense, though how far would depen investor viewed the risk-retum trade-off. The actual weight sccn was extremely low st just 8%% (point 8) and was considered a puzzle. ori how the Summary: Don't Put All Your Eggs in One Basket If countries were able to borrow and lend without limit or restrictions, they should be able to cope quite well with the array of possible shocks, in order to smooth consumption. * In reality, as the evidence shows, countries are not able to fully exploit the intertemporal borrowing mechanism. * In theory, if countries were able to pool their income streams and take shares from that common pool of income, all country-specific shocks would be averaged out, and the sole undiversifiable shocks would be common global shocks. Financial openness allows countries—like households—to follow the old adage “Don't put all your eggs in one basket.” * In practice, however, risk sharing through asset trade is limited. The market for claims to capital income is incomplete because not all capital assets are traded (e.g., many firms are privately held and are not listed on stock markets), and trade in labor assets is legally prohibited. * Investors have shown very little inclination to invest their wealth outside their own country, although that may be slowly changing in an environment of ongoing financial globalization.