3. The Eurodollar Market Eurodollar deposits arise when a U.S. exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank. The Eurodollar market began to be important in the 1950s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks. Other factors, such as the oil shocks in the 1970s, increased Eurodollar holdings.
4. The Significance of Eurodollar Markets The rise of Eurodollar markets has significantly increased the international mobility of financial capital. This means that interest rates have been increasingly linked across countries, and have moved toward each other. One drawback is that financial problems quickly spread worldwide, such as happened in 2008.
5. The International Bond Market (Debt Securities) Government and corporations can borrow money by issuing bonds. Bonds have a face value – this is the amount that will be paid to the lender when the bond matures. Foreign bond markets and eurobond markets together comprise the international bond market. The stock of this sort of debt was $23.9 trillion as of 2008.
6. Significance of the International Bond Market As with the Eurodollar markets, the increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other. This increased interdependence also helps spread financial problems.
7. International Stock Markets Ownership in companies (common stock) is another asset that is traded internationally. Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased. This may create a tendency for movements of stock prices across countries to become more similar to each other.
8. Significance of the Rise of International Stock Markets The increasing importance of international stock markets has facilitated the flow of financial capital to its most productive use. This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008.
9. Basic International Financial Linkages: Review Investors will be indifferent between domestic and foreign investment when (ihome – iforeign) ≈ p = xa – RP Where p is the forward exchange rate premium.
10. Basic International Financial Linkages: An Example How does the Eurodollar market change our understanding of financial linkages? Suppose (yearly figures)
11. Basic International Financial Linkages Home = NY Foreign = London If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3-month rate we get (ihome – iforeign) ≈ p (0.07 -0.08)/4 ≈ (1.687 – 1.691)/1.691 -0.0025 ≈ -0.0025.
12. Basic International Financial Linkages What happens if the Federal Reserve raises U.S. interest rates by ½ of a percentage point? Now, the eurodollar deposit rate will rise to 6% and the eurodollar lending rate will rise to 7%. We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates)
14. International Financial and Exchange Rate Adjustments The higher interest rate in New York increases demand for eurodollars. This will put upward pressure on the eurodollar rate.
16. International Financial and Exchange Rate Adjustments The higher U.S. interest rate leads to an increased supply of pounds on the spot market This additional supply is hedged in the forward market.
17. S£ e$/£ S'£ Spot market e$/£ e'$/£ D£ £ International Financial and Exchange Rate Adjustments
18. St€ e$/£ Forward market e'$/£ e$/£ D'£ D£ € International Financial and Exchange Rate Adjustments
19. International Financial and Exchange Rate Adjustments Further adjustments might occur in the U.K.’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this.
20. Hedging Eurodollar Interest Rate Risk New instruments, called derivatives, have emerged to hedge interest rate risk. Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc.
22. The Current Global Derivatives Market Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new. However, in the past 25 years there has been an explosion in the use of global derivatives. Annual growth rates have been in the range of 20%-30%.
24. The Current Global Derivatives Market Why have derivatives become so important? Participants in the international financial markets have discovered that derivatives can increase their returns and/or lower their risk. Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk.
25. The Current Global Derivatives Market However, as the global financial crisis of 2007-08 has shown, derivatives cannot eliminate risk.
26. the Monetary And Portfolio Balance Approaches to External Balance
27. the Monetary Approach to the Balance of Payments BOP is mainly a monetary phenomenon. This approach requires us to consider a country’s supply of and demand for money.
28. Monetary Approach to the BOP: the Supply of Money The money supply (Ms) can be seen either in terms of central bank liabilities: Ms = a(BR + C), where BR = reserves of commercial banks C = currency held by nonbank public a = the money multiplier Or central bank assets Ms = a(DR + IR), where DR = domestic reserves IR = international reserves
29. Monetary Approach to the BOP: the Supply of Money The money multiplier refers to the notion of multiple deposit creation. If the reserve requirement is 10%, a new deposit of $1,000 creates $900 of excess reserves, which can be lent out. The loan recipient deposits the $900 in her bank; this creates $810 of excess reserves which can be lent, etc. The money multiplier is 1/r or 10.
30. Monetary Approach to the BOP: the Supply of Money Anything that increases the assets of the central bank (or equivalently, its liabilities) allows the money supply to expand via the multiplier process. Suppose the central bank buys government securities or foreign exchange – in either case the money supply is expanded.
31. Monetary Approach to BOP: the Demand for Money Money demand (L) is a function of several variables: L = f[Y, P, i, W, E(p), O] where Y = level of real income in economy P = price level i = interest rate W = level of real wealth E(p) = expected % Δ in price level O = other variables that may affect L
32. Monetary Approach to BOP: the Demand for Money L is a positive function of Y, due to the transactions demand for money. L is a positive function of P, since more cash is needed to make purchases when P rises. L is a negative function of I; i is the opportunity cost of holding money. L is a positive function of W; as a person’s wealth rises she will want to hold more money. L is a negative function of E(p); if a person expects inflation he will hold less money.
33. Monetary Approach to BOP: the Demand for Money Frequently a general expression for money demand is used: L = kPY Where P and Y are as discussed k is a constant embodying all other influences on money demand.
34. Monetary Approach to BOP: Monetary Equilibrium Money market equilibrium occurs when Ms = L or a(DR+IR) = a(BR+C) = f[Y,P,I,W,E(p),O] or Ms = kPY.
35. Monetary Approach to BOP: Monetary Equilibrium How can we understand balance of payments adjustments using money supply and demand? Let us assume a fixed exchange rate system. What happens when the central bank increases Ms, perhaps by purchasing government securities (increasing DR)? BR and/or C will increase, and there will now be an excess supply of money.
36. Monetary Approach to BOP: Monetary Equilibrium Current account excess cash balances imply individuals spend more, bidding up P. Y and W may rise. Higher P and Y will lead to lower exports (X) and higher imports (M). Therefore, the excess supply of money leads to a current account deficit. Private capital account excess cash causes individual to bid up price of financial assets; this drives down i. In the end, this causes a deficit in the private capital account.
37. Monetary Approach to BOP: Monetary Equilibrium Together, these effects indicate that Money supply increase leads to a balance of payments deficit. To summarize: Increase in Ms causes individuals to shift to non-money assets, including foreign goods and assets. This creates a BOP deficit.
38. Monetary Approach to the Exchange Rate When exchange rates are fixed, An increase in Ms leads to a BOP deficit. If the exchange rate is not fixed, BOP deficits and surpluses will be eliminated by exchange rate adjustments.
39. Monetary Approach to the Exchange Rate If Ms is increased Individuals wish to purchase non-money assets, including foreign goods and assets. This creates an “incipient” BOP deficit. The home country’s currency will depreciate to eliminate the BOP deficit. If Ms is decreased Individuals wish to sell non-money assets, including foreign goods and assets. This creates an “incipient” BOP surplus. The home country’s currency will appreciate to eliminate the BOP surplus.
40. Monetary Approach to the ER: A Simple Model If we assume that absolute purchasing power parity holds, then e = PA/PB Similarly, for Country B, MsB = kBPBYB It must be true that
41. Monetary Approach to the ER: A Simple Model For Country A, monetary equilibrium means that MsA= kAPAYA This means that Rearranging yields
42. Monetary Approach to the ER: A Simple Model This expression demonstrates that an increase in Ms by Country A will lead to a depreciation of the currency. Inflationary monetary policy only causes currency depreciation.
43. Portfolio Balance Approach to the BOP and the Exchange Rate The approach extends the Monetary Approach to include other financial assets besides money. In a two country model there will continue to be demand for money by each country’s citizens. Now there will also be demand for home-country bonds (Bd) and for foreign bonds (Bf). Bd yields interest return of id Bfyields a return of if
44. Portfolio Balance Approach to the BOP and the Exchange Rate The relationship between interest rates is as follows: id = if + xa – RP, where RP is the risk premium associated with the imperfect international mobility of capital xais the expected percentage appreciation of the foreign currency, or [E(e)/e] – 1
45. Portfolio Balance Approach to the BOP and the Exchange Rate Demand by home country individual for home money L = f(id, if, xa, Yd, Pd, Wd), where id = return on home-country bonds if = return on foreign-country bonds xa = expected appreciation of foreign currency Yd = home country real income Pd = home country price level Wd = home country real wealth
46. Portfolio Balance Approach to the BOP and the Exchange Rate Home money demand (L) will be inversely related to id. Inversely related to if. Inversely related to xa. Positively related to Yd. Positively related to Pd. Positively related to Wd.
47. Portfolio Balance Approach to the BOP and the Exchange Rate Demand by home country individual for home bonds Bd= h(id, if, xa, Yd, Pd, Wd), where Home bond demand will be Positively related to id Inversely related to if Inversely related to xa Inversely related to Yd Inversely related to Pd Positively related to Wd
48. Portfolio Balance Approach to the BOP and the Exchange Rate Demand by home country individual for foreign bonds (multiplied by e so that it’s in terms of domestic currency eBf = j(id, if, xa, Yd, Pd, Wd), where Foreign bond demand will be Inversely related to id Positively related to if Positively related to xa Inversely related to Yd Inversely related to Pd Positively related to Wd
49. Portfolio Adjustments: Example 1 Home country central bank sells government securities (i.e., decreases Ms and increase home bond supply). id should rise, resulting in decrease in home-country money demand, decrease in foreign bond demand, and increase in home bond demand. Foreign investors switch towards holding home-country currency.
50. Portfolio Adjustments: Example 1 Home country central bank sells government securities (i.e., decreases Ms and increase home bond supply). if should rise. The foreign currency depreciates (e falls), assuming flexible exchange rates. xa rises. There are therefore second-round effects, continuing until a new portfolio balance is attained.
51. Portfolio Adjustments: Example 2 Home country individual believe home inflation is likely in the future. Assume flexible exchange rates, xashould rise (that is, home citizens will expect a depreciation of the home currency), resulting in decrease in home-country money demand, decrease in home bond demand, and increase in foreign bond demand. The home country currency depreciates. So: the expectation of a depreciation leads to a depreciation.
52. Portfolio Adjustments: Example 3 An increase in home country real income, leading to a increase in home-country money demand. decrease in home bond demand. decrease in foreign bond demand. The home country currency appreciates under a flexible exchange rate system; a BOP surplus occurs under a fixed exchange rate regime.
53. Portfolio Adjustments: Example 4 An increase in home country bond supply causes increase in id, which causes a capital inflow and an appreciation of the home country currency. increase in wealth, which (among other things) causes an increased demand for foreign bonds and an depreciation of the home currency. On net, it is likely that the home currency appreciates.
54. Portfolio Adjustments: Example 5 An increase in home country wealth because of home-country current account surplus increase in money demand, leading to an increase in id. increase in demand for foreign bonds and for domestic bonds, both of which lead to a decrease in id. On net, it is not clear what will happen to the exchange rate.
55. Portfolio Adjustments: Example 6 An increase in supply of foreign bonds because of foreign government budget deficit causes an increase in the risk premium, and an appreciation of the home country currency.
57. Exchange Rate Overshooting Exchange rate overshooting occurs when, in moving from one equilibrium to another, the exchange rate goes beyond the new equilibrium before eventually returning to it. Assume: Country is small. Perfect capital mobility exists. Essentially, uncovered interest parity applies.
58. Exchange Rate Overshooting The relationship between the price level (P) and the exchange rate (e) should be negative because a higher price increases demand for money, so id will rise. The result is an appreciation.
59. Exchange Rate Overshooting: the Asset Market P A If from point B prices were to rise to P2, demand for money would rise, and the home currency would appreciate (i.e., e falls). P2 F P1 B A e2 e1 e
60. Exchange Rate Overshooting According to purchasing power parity, in the long run when a country’s currency depreciates its price level will increase proportionately. That is, there is a long run positive relationship between e and P.
62. Exchange Rate Overshooting An increase in the money supply shifts the asset curve from AA to A'A' This causes a relatively rapid depreciation of the home currency, from e1 to e2. Prices eventually will begin to rise due to excess demand for goods caused by the currency depreciation. Eventually, we reach a new equilibrium at E'
65. The Price Adjustment Process and the Current Account Under A Flexible Rate System A depreciation of the home currency causes foreign goods to become more expensive, reducing consumption of imports relative to domestic alternatives. A depreciation makes the home country’s exports seem cheaper, so the trading partner switches expenditure towards home products. This process is expenditure switching.
66. Demand for Foreign Goods and Services and the Foreign Exchange Market Demand for foreign exchange is derived from demand for goods and services. Demand for imports depends on price of foreign goods or services, tariffs or subsidies, prices of domestic substitutes and complements, domestic income, and tastes. Demand for foreign currency by home country is also supply of foreign currency to the foreign country.
67. Demand and Supply of Foreign Exchange S$ e$/£ S£ e£/$ 1.2 0.83 D$ D£ £ $
68. Demand and Supply of Foreign Exchange With normally shaped supply and demand curves, the market for foreign exchange is stable. If U.S. income rises, demand for imports rises so does demand for foreign exchange. The rightward shift of the demand for foreign exchange creates a current account deficit and an increase in the price of pounds (a depreciation of the dollar).
69. Demand and Supply of Foreign Exchange S$ e$/£ S£ e£/$ e'eq eeq eeq D$ D'£ D£ £ $
70. Demand and Supply of Foreign Exchange If U.S. prices increase relative to British prices: U.S. consumers demand more British products increasing demand for pounds. British consumers demand fewer U.S. products decreasing the supply of pounds. The overall effect is an increase in the dollar price of pounds.
71. Demand and Supply of Foreign Exchange S' £ S £ e$/£ S£ E$/£ e'eq e'eq eeq eeq D' £ D £ D'£ D£ £ £
72. Market Stability and the Price Adjustment Mechanism This price adjustment depends on the slope of the supply and demand curves for foreign exchange. Supply curves can be backward-sloping. If supply curve is steeper than demand curve, the market is still stable. If supply curve is flatter than demand curve, the market is unstable.
73. Demand and Supply of Foreign Exchange e$/£ e£/$ S£ S$ D$ D£ £ $ In this case, if e is too high, there is an excess supply and e will fall. In this case, if e is too high, there is an excess demand and e will rise.
74. Explaining the Backward-Sloping Supply Curve As the dollar becomes more expensive, two effects happen: More pounds are required to buy each unit of imports from the U.S. The number of units imported falls due to the increase in price in terms of pounds. It’s easy to see these effects by considering the price elasticity of demand
75. Explaining the Backward-Sloping Supply Curve Example: Suppose the depreciation of the dollar causes the U.K. price of the imported good to increase from £16 to £22, and this causes quantity demanded to fall from 120 units to 100 units. If foreign demand for home goods is inelastic, supply of foreign exchange is downward-sloping.
76. Exchange Market Stability: The Marshall-Lerner Condition If home-country demand is elastic, a depreciation will improve the current account balance. The increased price of imports reduces total expenditures on imports and the reduced price of exports to foreigners causes an increase in their expenditures. If home-country demand is inelastic, a depreciation will have an ambiguous effect on the current account balance. The increased price of imports will increase total expenditures on imports, possibly offsetting the foreign country’s increased expenditures on exports.
77. Exchange Market Stability: The Marshall-Lerner Condition The Marshall-Lerner Condition: The foreign exchange market will be stable as long as where X = expenditures on exports M = expenditures on imports ηDX = price elasticity for home exports ηDM = price elasticity for imports.
78. Exchange Market Stability: The Marshall-Lerner Condition Some empirical studies suggest these demand elasticities may be low. However, the general consensus is that these elasticities are large enough that the foreign exchange market is stable.
79. Price Adjustment Process: Short Run vs. Long Run When the Marshall-Lerner condition holds, changes in the exchange rate bring about appropriate switches in expenditures between domestic and foreign goods. A home currency depreciation leads to a substitution of domestic goods for imports. A home currency depreciation causes foreigners to switch to home country exports.
80. Price Adjustment Process: Short Run vs. Long Run Short-run elasticities of supply and demand tend to be smaller in absolute value than long-run elasticities. Consumers don’t adjust immediately to relative price changes; it’s not unusual for the quantity demanded of imports and the amount of foreign exchange needed to not respond to changes in the exchange rate. The supply of exports may not adjust immediately in response to changes in exchange rates due to lags in recognition, decision-making, production, and delivery.
81. Price Adjustment Process: The J-Curve If the short-run elasticities are low, the market for foreign exchange may be unstable. A depreciation may initially lead to a further depreciation, since demand for the foreign currency outstrips supply. Therefore the current account deficit worsens. Eventually, the current account deficit shrinks and a new equilibrium is attained.
82. The J-Curve X-M point of depreciation (X-M) = f(e,time) time
83. Price Adjustment Mechanism in a Fixed Exchange Rate System Rather than allowing the foreign exchange market to determine the value of foreign exchange, countries sometimes fix or “peg” the value of their currencies.
84. Price Adjustment Mechanism with the Gold Standard From 1880 to 1914, countries pegged their currencies to gold. This fixes countries’ exchange rates with each other. For example, if the dollar is fixed at $100 per ounce The pound is fixed at £50 per ounce The “mint par” exchange rate is $2/£. Governments must be prepared to maintain the gold price by buying and selling gold at the set price.
85. Price Adjustment Mechanism with the Gold Standard Since the exchange rate is fixed, some other mechanism must be in force to balance demand for and supply of foreign exchange. These “rules of the game” are assumed to hold: no restraints on buying/selling gold within countries; gold can move freely between countries, money supply is allowed to change if a country’s gold holdings change, and prices/wages are flexible.
86. Price Adjustment Mechanism with the Gold Standard Suppose an increase in U.S. income causes an increased demand for pounds. There will be upward pressure on the exchange rate to eliminate the excess demand for pounds. Buyers/sellers know that governments stand ready to buy/sell pounds at mint par, using gold as medium of exchange. Since it is costly to ship gold, the exchange rate can vary slightly from mint par.
87. Foreign Exchange Market Under a Gold Standard e$/£ S£ S£ e$/£ $2.04 $2.00 $2.00 Mint par $1.96 D'£ D£ D£ £ £ Assuming transactions costs represent 2% of par value, the exchange rate can vary between $1.96 and $2.04.
88. Price Adjustment Mechanism with the Gold Standard Americans never need to pay more than $2.04/£, since an unlimited supply of pounds can be obtained at this price. This price is called the gold export point. The British never need to receive fewer than $1.96/£, since at that point gold will begin to move to the U.S. to be exchanged for dollars. This price is called the gold import point.
89. Price Adjustment Mechanism with the Gold Standard The exchange rate can vary in between these narrow bands. Prices cannot adjust through exchange rate changes. Instead, prices adjust through changes in the money supply.
90. Price Adjustment Mechanism with the Gold Standard Assuming the quantity theory holds, Ms = kPY. If gold leaves the country, Ms falls and prices must fall in response. Assuming demand for tradable goods is elastic, This should reduce spending on imports and increase receipts from exports.
91. Price Adjustment Mechanism with the Gold Standard The price adjustment mechanism under the gold standard is triggered by changes in the money supply related to flows of gold. This adjustment depends on flexible wages and prices – any rigidities will hinder adjustment. Other adjustment may occur due the effects of changes in the money supply on interest rates and income. The gold standard works to keep inflation in check.
93. Price Adjustment Mechanism with a Pegged Rate System A country can also fix its exchange rate without reference to the value of gold. The central bank must be ready to buy foreign currency when the domestic currency is strong, and sell foreign currency when the domestic currency is weak. Central banks must hold a sufficient supply of foreign currencies.
94. Price Adjustment Mechanism with a Pegged Rate System The adjustment effects of such a system are similar to a gold standard. Upward pressure on the exchange rate caused by an increase in demand for foreign exchange will cause the central bank to sell foreign exchange. This reduces the money supply, thereby triggering adjustments to interest rates, income, and prices.
95. Price Adjustment Mechanism with a Pegged Rate System Similarly, downward pressure on the exchange rate caused by an increase in the supply of foreign exchange will cause the central bank to buy foreign exchange. This increases the money supply, thereby triggering adjustments to interest rates, income, and prices.
96. Price Adjustment Mechanism with a Pegged Rate System For these adjustments to occur, the central bank must allow the actions taken in the foreign exchange markets to affect the domestic money supply. Bottom line: when a country adopts a fixed exchange rate system, its central bank loses effective control over the money supply as a policy tool.
