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Lecture 12

ECON 2105 Lecture 12: The International Economy

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ECON 2105
Till Schreiber

ECON 2105 - Lecture 12: The International Economy Exchange Rates - One US dollar buys 109 Japanese Yen: 109 JPY/USD - One US dollar buys 0.94 Euros: 0.94 EUR/USD • But the Euro-USD exchange rate is most often quoted as per one Euro, so 1.06 USD/EUR - How many Euros do you get for US $2000? • $2000*0.94 Euros = 1880 Euros - This does not tell us about purchasing power! - Exchange rates that you read about are nominal exchange rates - Exchange rates are determined by supply and demand • Some US businesses sell goods or services overseas and sell Euros and buy dollars, while some European businesses do the opposite • Households go on vacations and need foreign currency • Dwarfed by financial flows: speculation about future exchange movements and attractive investment opportunities abroad - main source of action in the foreign exchange market, more so than previous 2 (those make up less than 1% of action in the foreign exchange market) - The equilibrium exchange rate equalizes currencies bought and sold; it holds for all currencies in all countries • Sometimes not everyone can buy and sell currency freely (ex. China) • The government (Central Bank) may also be a major buyer or seller (ex. China) • Equilibrium implies that payments to the ROW = payments from the ROW - Appreciation: if one of the currencies can buy more of the other than it previously could, it has appreciated • The other currency has depreciated • If the USD/EUR exchange rate rises to 1.3 from the 1.06 it is today, the Euro appreciates and the USD depreciates - Weaker exchange rate may help exporters (when your own currency is weaker relative to other currency, foreigners will purchase goods from your country) - Euro has depreciated in recent years Law of One Price: idea that a good should sell for the same price everywhere - Is approximate due to transportation costs, trade barriers, and tariffs - Arbitrage: exploiting a difference in price • Buy where the price is low and sell where the price is high • Enforces the law of one price - How well does law of one price hold for: U.S. Treasury bonds? Perfectly • Gold? Physical delivery has shipping costs, otherwise there is one global price • Haircuts? Does not hold at all for services • Land? Cannot be traded internationally; does not hold at all • Prescription drugs? Trade barriers; does not hold • Big Macs? Identical good worldwide - Poorer countries have cheaper labor and rents, thus usually lower prices - If you buy stuff in the country where goods are cheaper, there will be a higher demand for that country’s currency = the currency will appreciate and the goods will balance in price - Law of one price implies that the cost of the market basket in the U.S., converted to Euros, should be the same as in Germany • If goods costing $2500 in the U.S. cost 2000 Euros in Germany, then the exchange rate should be $1=0.8 EUR (1.25 USD/EURO); this would make the basket of goods cost the same • Assume the U.S. price level doubles and the market basket now costs $5000, but Germany has no inflation (inflation = less purchasing power domestically and in foreign exchange market) - The law of one price implies that the dollar must fall to 0.40 USD/EUR because that equalizes the cost of the market baskets Purchasing Power Parity (PPP) - When exchange rates adjust to equate costs there is purchasing power party (PPP) • If PPP holds, differences in inflation rates account for all changes in exchange rates - Exchange rates equalize trade and financial flows internationally • A strong USD makes exports costly and imports cheap, resulting in a large trade deficit • ROW savings then balances the Federal deficit - Today, capital/asset flows are more important than trade flows for determining many exchange rates • Foreigners (China, oil exporters, etc) want to buy U.S. assets • Our “exports” of assets necessitates the trade deficit - When a currency is weak, the central bank may boost interest rates to 
 “defend” it • This happened when crises occurred in many emerging markets in the 1990s and Russia in 2015 - Today, some central banks don’t want their currency to become to
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