Exchange Rates & International Trade

Currency Markets

Purchasing Power Parity

Interest Rate Parity

Central Bank Intervention

International Monetary Fund

Capital Controls

Optimum Currency Area

Currency and International Trade

The concept of “money” is essential to the efficient functioning of the global economy. Money is not a resource (like land, labor and capital), instead it is a tool used in trading and placing a value on resources. There is no official global currency. Each nation has its own form of money. However, some currencies (dollar, euro, yen) are so commonly used in trade that they serve as real global currencies. For example, global oil markets are priced in dollars.

Not all trade in currencies is about trade, it is also about investment. In some parts of the world people have savings and in others people want to borrow use the money. Global financial markets move savings from one part of the world to where people want to borrow money in other parts of the world. Trade in resources and capital (investments) take place in major financial markets. A lot of the financial markets are based on lending and borrowing money for trade and investment. These markets facilitate the trade in money around the world.

Currency Markets & Exchange Rates

Because there is no global currency, in order for there to be global trade and investment people around the world need to exchange currencies. Currency markets are where people buy and sell the currencies they need to conduct trading or investment opportunities in foreign countries.

The reality of currency markets (and exchange rates) means that when a person buys something in another country (or sells or invests) they need to recognize that there are engaging in two transactions, which each have a price: •First, there is the actual price of the good (given in the local currency). •Second, there is the exchange rate (the price paid to buy the local currency).

This reality means that, even if the actual price of the good stays the same, if the exchange rate changes, the effective price paid can change.

Exchange Rates

There are no fixed or absolutes in exchange rates. For example, just because the exchange rates from dollars to euros is $1.29: €1 does not mean the euro is more valuable than the dollar. What really matters is how much you can buy with the currencies at the exchange rate. Comparing currencies is a bit like comparing inches to centimeters. Measuring something in centimeters will yield a higher number, but the height is still the same.

The exchange rate between currencies can have two relational situations:•Fixed or “Pegged” – The value of the exchange rate is set by a government that controls the amounts and rates of exchange.•Floating - The value of currency exchange rates are based on the supply and demand of currencies on world currency markets.

Currency Markets & Setting Exchange Rates

Currency markets are simply a market where people buy and sell a currency – they work like any other market in how they work.

Demand in the market are people who want to buy a currency for either trade or investment reasons.

Supply are people who want to sell (or buy a different currency) for trade or investment reasons.

The tricky part of the market is that the price is done in another currency – this is the exchange rate. For example the price in the euro market shown to the right is in dollars – this is the dollar to euro exchange rate.

Changes in Exchange Rates

When something changes in either the willingness or ability of people to demand or supply a currency to the currency markets, it will shift the demand or supply for the currency , which will change the exchange rate.

In the chart to the right, the demand for euros has increased, which has increased the price of euros (in dollars)

Two factors that effect supply and demand for currencies:•Purchasing Power Parity – Trade in Goods - The idea is that in the long-run, exchange rates will settle at a point where the price of an item is the same in different countries (there is no gain in trading the good)•Interest Rate Parity – Trade in Investments - The idea is that in the long run, exchange rates should balance interest rate differences.

Exchange Rates & Trade

Exchange rates can have a big impact on trade between nations. The absolute exchange rate between countries does not matter. For example, if the exchange rate is $ 1: .8 €, it does not matter as long as relative prices between countries are the same. A pair of jeans in America priced at $100 are the same price as a pair of jeans in Europe priced at € 80 (The best way to think of it as measuring in inches vs. centimeters).

However, a change in the exchange rate can have an impact on the relative prices of goods. For example, if the exchange rate changes to be $ 1: € 1 (the dollar rises in value), then jeans are cheaper in Europe – and more jeans will be bought in Europe. Thus a decline in the value of a currency can help that country’s exports (and hurt their imports).

However, these cheap prices should not last. As people sell dollars and buy euros (so they can buy cheap jeans), the value of the dollar will decline and the euro will rise, until the effective prices are the same. Link to Big Mac Index

Interest Rates & Exchange Rates

Central banks (Like the Federal Reserve) often adjust interest rates to affect a country’s economy – higher rates to fight inflation and lower rates to fight unemployment. While these policies are focused on domestic issues, there can be “spill over” effects due to how interest rates affect exchange rates. Interest rates have a large affect on exchange rates because it will affect how much people will want to invest in a country.

If a country has high interest rates, people will want to invest in the country. They will have to sell their currency to buy the currency of the currency of the other country. This will increase the value of the other currency.

In general, a higher interest rate will cause a currency to increase in value while a lower interest rate will cause a currency to decline in value.

So, if the ECB sets European interest rates above American interest rates, it will cause the euro to rise in value and the dollar to decline in value – this can affect the flow of trade between these regions.

If there is a decrease in the value of a currency, it will make the relative prices in a country lower and foreigners will buy things from that country. This increase in net exports would shift the aggregate demand curve to the right, which would result in higher GDP and a higher price level (inflation).

The price for increasing exports, to increase GDP, through lowering the value of the currency is inflation.

A increase in the value of a currency will cause a decline in net exports and would have the opposite effect on inflation and GDP.

Exchange Rates to Aggregate Demand

Affect of Exchange Rates on Trade

A change in exchange rates can also effect the net exports of a country, which in turn affects aggregate demand, GDP and inflation in that country. This is because the change in exchange rates changes the relative prices in one country compared to another country.

The chart above shows how the appreciation or depreciation of a currency will move the Aggregate Demand Curve – to effect the inflation and GDP in a country.

Affect of Exchange Rates on Trade

A change in exchange rates can also effect the Aggregate Supply curve for a country. This is because the change in exchange rates will effect the price producers pay for resources.

If the currency goes up in value, prices of imported goods are less, which makes it more profitable to produce the good, which will push out the supply curve.

However, if the currency depreciates in value, then resources become more expensive, which reduces profit margins and the supply curve will shift inwards.

Net Effect of Currency Changes

The top graph shows the net effect of a currency depreciation – note the changes to price level (inflation) and GDP (expansionary).

The bottom graph shows the net affect of a currency appreciation – note the changes to the price level (deflationary) and GDP (contractionary).

It should be noted that the policy of keeping a currency at an artificially low level can have adverse effects on an economy – namely inflation (which can result in lower investment and lower future economic growth)

Exchange Rates and Trade

Economists believe that in the long-run exchange rates should settle at a point where prices and interest rates are equal between countries.

If, after adjusting for exchange rates, a country has lower prices than another, then more people will want to buy from that country, which should increase the value of its currency until there is no more price advantage.

Instead of having lower prices, a country could just have a currency that has a lower value, which would cause more people to buy from that country.

Sometimes countries (China) pursue a policy of keeping its exchange rate low (or weak) compared to other countries to makes its products cheaper compared to the identical products in other countries – this will help its balance of trade.

China has been able to develop its economy by exporting to the rest of the world. China is able to do this by keeping it currency undervalued (keeping its domestic prices low and its wages internationally competitive) by not converting all of the dollars and euros it is paid into its own currency (the Renminbi). As a result of this policy, China has been building up large reserves of foreign currencies.

Federal Reserve and Exchange Rates

The Federal Reserve generally does not intervene in currency markets to affect the value of the dollar – it treats the value of the dollar with a policy of “benign neglect”. The Fed sets its interest rate policies based on conditions in the American economy.

However, Fed policies do have an effect on the value of the dollar on global trade. The Fed’s policy of Quantitative Easing in which the Fed was buying U.S. government bonds to lower long-term interest rates. In response to this policy, many investors began to move money to “risky” emerging market economies in order to earn a higher rate of return, which caused these economies to grow and their currencies to rise in value.

Over the past few months, the Fed has begun to cut back on Quantitative Easing, which many investor took as signal for higher interest rates in the U.S. As a result, they began to pull money out of “risky” emerging markets, which has caused their currencies to depreciate and forced these countries to raise their interest rates to maintain the value of their currencies and keep investment money.

Destabilizing Effects of Changes in Exchange Rates

The flow of trade around the world is measured in both the current account in goods and services and the capital account of investments. One troubling aspect of flexible exchange rates is that they can destabilize national economies.

For example, consider a country which is getting a lot of investments from abroad (running a capital account surplus) – the currency of the country will be higher in value. As a result, people in the country will be able to buy more from abroad and the country can start to run a current account deficit.

Suppose, without much warning, investor change their opinion about investing in the country and they start pulling their assets out of the country – this could cause the value of the country’s currency to plummet in value. This rapid withdraw of capital and the drop in the country’s currency could cause a financial crisis and drive a country into recession. This happened to the economies of Asia in 1997.

Central Banks and Currency Intervention

The central banks of many countries do intervene in currency markets to try to stabilize the currency of their country. This is because currency rate stability is an important way to support economic growth.

Central banks intervene in currency markets by buying and selling their own currency on international markets to keep their currency at a set value with other currencies (typically the dollar, euro or yen). Central bank typically build up reserves of other currencies to use in these market interventions (they use the other currencies to buy their currency to prop up the value of their own currency).

Central banks also set up “currency swaps” with other central banks so that they can use the borrowed currency to support their own financial systems during a crisis. For example, during the high points of the euro crisis in the past few years, the Fed has engaged in dollar-euro currency swaps with the European Central Bank (ECB) so the ECB could leaned the dollars to European Banks that needed them to meet their commitments.

Currency Crisis and the Asian Tigers

The Asian Crisis in 1997 was in part the result of a sudden change in the flows of investment capital. Throughout the 1980’s and 1990’s foreign investment poured into the “Asia Tiger” economies – this raised the value of their currencies, which led to people having larger debts and speculative investment. In 1997, the collapse of a property bubble in Thailand led to investors pulling their money out of the country, which involved selling the Thai currency (baht) – which collapsed. This caused a massive recession in Thailand.

Following the Thailand collapse a process of economic “contagion” spread across Asia as international investors pulled their investments out of other Asian economies (even if the economies were healthy overall), which caused their currencies to collapse as well, which lead to a recession across the entire region.

Basically, the massive inflow and outflow of investment destabilized the value of these countries’ currencies. The countries’ central banks exhausted their reserves trying to protect the value of their currencies, but failed. In the end, the IMF was forced to come in an rescue these economies – however, the necessary reforms required in return for IMF were often harsh and caused economic pain.

International Monetary FundThe International Monetary Fund (IMF) goal is to maintain stable currency exchange rates between countries.

Volatile exchange rates can discourage trade and distort prices. The IMF loans money (usually in dollars or euros) to countries dealing with a currency crisis (the sharp devaluation of their currency). This money can be used to stabilize the country’s currency and economy.

However, when the IMF loans money to a country, it also demands that the country engage in economic reforms that are intended to resolve the problems that caused the crisis and to prevent future crisis – meeting these demands is conditional to receiving more assistance from the IMF.

The IMF proscribed reforms are typically very unpopular because they often mean cuts in government spending and higher amounts of taxes (or better tax collection).

Build Up of ReservesIn the aftermath of the Asian Economic Crisis, many countries have moved to build up large amounts of foreign currency reserves in order to protect themselves from future currency crisis and needing to go the IMF for help. The central banks of these countries build up large amounts of foreign currency (in the form of government bonds) that can be used to buy their own currency during a crisis.

While this policy might make sense as a form of insurance against a crisis, there is a cost to this policy. These reserves generally earn a very low rate of interest – the money could be put to better use, especially in very poor countries.

The IMF has also tried to respond to the criticism by offering “flexible credit lines” to countries that have good macroeconomic policies but are hit by an unexpected economic shock – the thought is that this will discourage countries from building up excessive reserves.

Capital Controls – Slow the Global Movement of Capital

One solution to the destabilizing effects of the rapid move of capital and floating exchange rates is to impose “capital controls” that make it harder to move capital in and out of countries – and therefore less likely to cause instability. Under capital controls, investment money is subject to a special tax – which slows the speed at which investment money moves into an economy.

The way to think about capital controls is to imagine the internal bulkheads in an oil tanker – they keep the oil from sloshing around inside the tanker, which can keep it from capsizing.

The downside of capital control policies is that it might make it harder for developing countries to attract capital, which will slow their development.

Optimal Currency Area

The world has many different monetary systems because of the wide variations of economies and flows of trade. While a single world currency might have some benefits, it would create many more problems – chiefly, there might be shortages of money in some parts of the world that will discourage economic growth or too much in one place, which would cause inflation. Different national currencies give governments the power to control the money supply, to affect the economy.

Countries can join together to form a “currency area” by either using the same currency or having their currencies “pegged” to each other. The advantage of this is that these countries can gain from easier trade relations. The disadvantage is that the countries lose control of their monetary policy.

The difficulty is knowing how large of an area should be tied together by the same currency. In general, economists believe that the optimal size for a currency area is determined by the amount of trade within an area, and the freedom of movement for labor and capital within an area.

The Impossible Trinity

Economist Robert Mundell stated the choices made in forming a currency union as the “impossible trinity” or the “trilemma”. He said a country can only have two of the three goals.

The three legs of the trilemma are economic goals:

•Monetary Independence means the central bank has freedom to set interest rates as part of managing the economy.•Exchange rate stability means having a currency that does not change in value in relation to other currencies, which makes trade easier.•Financial Integration means that the country’s financial markets (used for investment) are tied to other financial markets.

Basically, Mundell said countries need to choose between having an independent macroeconomic policy (manage inflation & unemployment) or have stable exchange rates (international trade).

Euro Zone as Optimal Currency Area

In 1999, many of the countries of western Europe moved from having their own currencies into sharing the new currency of the euro. In doing this, the countries gave up monetary policy independence, and the European Central Bank (ECB) had control of setting monetary policy (interest rates) for all of the euro countries.

Whether the eurozone is an optimal currency area is a point of debate. While the implementation of the European Union created the legal openness to form an optimal currency area, the linguistic and cultural differences in Europe make it hard to implement. Since the formation of the Single Market trade in goods and movement of investment capital has increased. However, labor mobility and trade in services has not grown very much.

There are still large differences between national economies within the eurozone which make it hard to have one monetary policy for the whole region. This is because the different regions are operating on different business cycles – hence one interest rate is not appropriate for the whole region.

Euro Crisis

The euro crisis is often presented as a debt crisis in specific countries (Greece), a problem of slow growth (Spain) or a weak banking system (Ireland). While these are problems, they are exacerbated and made more difficult by the existence of the euro. Being part of the euro has turned difficult problems into severe recessions.

All three countries could solve their problems if they were able to control their own monetary policy (lower interest rates and devalue their currencies). However, because they are part of the euro, the ECB sets the interest rate for the whole eurozone, which means balancing the needs of countries in crisis with those that are doing well (such as Germany which does not want lower rates).

The countries of the eurozone have dealt with the crisis by working with the IMF to loan money to the countries in trouble and force them to adopt economic policies aimed at reforming their economies – cutting government spending and raising taxes – that have made the crisis worse. The ECB has also enacted policies to keep down the borrowing costs of these country’s debts.

Is the Euro Doomed?

The euro is here to stay – changing a currency is an expensive and difficult process. The question is how will the euro change to make it a stable currency. The basic set up of having a currency area that covers a large area divided into different regions with different business cycles does not have to be a fatal flaw if there is something to balance out the differences across the currency area.

For example the United States is a large currency area with different business cycles. It works because the Federal government works to balance out economic differences between regions by transferring money (through taxes and spending).

Most economists believe that in order to become an optimal currency area the euro zone must:•Develop a stronger federal system to conduct transfer payments between eurozone countries. The big question is how this will affect non-eurozone European Union members (like England & Poland).•Develop more labor mobility so workers can easily move from areas of high unemployment to areas of low unemployment.