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Foreign Trade and Exchange Rates

Lecture 11

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Foreign Trade and Exchange Rates

Key Concepts to Master

– Exports and imports within the circular flow of the economy

– The key drivers of exports and imports

– Interest rate parity and exchange rates

– The J-Curve

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Exports and imports within the circular flow of the economy

GNP= C + I + G + X - M Exports are an addition to the flow of spending created by

domestic income– i.e. exports are purchases by foreign buyers of the same

types of goods as C,I,G and add to US production (GDP)

Imports are a subtraction, a leakage, from the circular flow– i.e.imports are all components of C, I, G, and even X

and substitute for / subtract from US production (GDP)

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The Circular Flow--in a closed economy

Spending onPurchasesof Goods

Productionof Goods

Excise Taxes

Wages, Profits, Rents

Payroll & Income Tax

Saving

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The Circular Flow--in an open economy

Spending onPurchasesof Goods

Production of Domestic Goods

Excise Taxes

Wages, Profits, Rents

Payroll & Income Tax

Imported GoodsImported Goods

Export DemandsExport Demands

SavingSaving

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The key drivers of exports and imports

Imports are all components of C, I, G, and even X– This country’s income, production and policy choices

drive our imports--all of the concepts discussed in the lectures and reading on these domestic sectors

Exports are simply another country’s imports, thus part of its C, I, G, X– That country’s income and production and policy

choices drive our exports The share of any country’s C,I,G,X grabbed by imports

depends on relative prices, tastes, quotas, and other market restrictions

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Interest rate parity and exchange rates

A simple relationship should hold among exchange rates and interest rates in any pair of countries:

– the percentage difference between the exchange rate today and the expected future exchange rate is the difference between today’s interest rates in the two countries for the same future time horizon

– For example, the number of dollars the market will pay for 100 yen today equals the expected dollars a yen will cost next year minus the percentage difference between today’s one-year interest rates in Japan and the US. For example,

» If 100 yen are expected to cost $1.05 next year, and the US 1-year rate is 6% while the Japanese is 1%, the market will only pay $1.00 today for 100 yen: thus relatively high interest rates produce a strong currency, other factors equal

» $1 invested in the US today will be worth $1.06 or 101 (=$1.06 x 100 / $1.05) yen next year

» 100 Yen invested in Japan today will be worth 101 yen next year

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Interest rate parity and exchange rates: Complications in the simple story

But what determines the expected value a year from now? Will purchasing power parity for a broad range of goods and assets prevail then? What is purchasing power parity?

The expected future exchange rate depends on the expected future demand for each currency, hence a long list of drivers:– future monetary and fiscal policies affecting interest rates at that time – current goods and asset prices in both countries and expected inflation

and appreciation rates– the relative stages of the business cycles hence levels of trade deficits

and hence the immediate flow of a currency in or out of a country versus the existing stock

– future trade policies

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More Complications in the simple story

In some very long run, perhaps ten to twenty years out, purchasing power parity might be expected to roughly prevail, out of ignorance of what other factors would be in force in either direction.

Biases due to uncertainty or irrationality or lack of information also can break up the basic simple relationship.

However, the fundamental premise is pretty strong: the higher a country pushes its interest rates today, the stronger will be that country’s exchange rate today.

And, the stronger the exchange rate is, the weaker its export quantities and the stronger its import quantities, hence the weaker its real (inflation-adjusted) net exports .

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– Relative Inflation Rates / Price Levels Affect Long-Run Trends

– Investment Opportunities Drive Short-Run Cycles

» Bond-Yield Differentials Dominate

» Business Cycle Impacts on Equity Returns are also Important

Exchange Rate Drivers for Mature Nations

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1.3

1.8

2.3

2.8

3.3

3.81

97

0

19

72

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74

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76

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84

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98

DM

/ $

Historical View of the German Exchange Rate

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1.3

1.8

2.3

2.8

3.3

3.8

19

70

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72

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74

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76

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80

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82

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84

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86

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Real and Nominal Exchange Rates: Much of the Historic DM Appreciation Has Been an Adjustment for Price Levels

Nominal

Real

DM

/ $

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-10

-5

0

5

10

15

20

25

19

70

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72

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74

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76

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78

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80

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82

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84

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86

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88

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90

19

92

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94

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96

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98

A Comparison of Wholesale Price Inflation Rates

Reveals a Strong Tendency for Lower German Inflation,

Except in Periods of Exceptional Dollar Strength

Spread=Germany-US

Germany

United States

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-10

-5

0

5

10

15

20

19

70

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72

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74

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80

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82

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84

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86

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98

Bond Yields Are Another Substantial Driving Force

Spread=Germany-US

Germany

United States

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1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

2.8

3

3.2

3.4

1981 1983 1985 1987 1989 1991 1993 1995 1997

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

The Real Exchange Rate (DM per $US) Rises / Falls with the Bond Yield Spread (US minus German)

Real Exchange Rate

10-Year Bond Yield Spread

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1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

1981 1983 1985 1987 1989 1991 1993 1995 1997

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

Interest Spread

Real Exchange

Rate

The Correspondence is Near-Perfect if Allowance is Also Made for Inflation Differentials

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Benefits of a strong currency

But a strong exchange rate does have some positive effects in the short- and the long-run.

It does mean a country can buy other countries goods, services, and assets more cheaply, raising its own relative and absolute standard of living.

It may also mean a temporarily higher nominal (non-inflation-adjusted) trade deficit.

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The J-Curve

This name refers to the shape of a graph depicting changes through time in a country’s nominal net exports after a depreciation of that country’s currency

Change inNominal Net ExportsRelative toa Baseline

Time Elapsed After Depreciation

0

0

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An Example of the J-Curve

Assume a 10% Devaluation of the dollar Assume the export and import demand equations reflects lagged response to relative prices as follows:log (Q) = constant+ sum ( b(j)*log(foreign price in period j/US price in period -j))b(lag j)=incremental elasticity of demand with a lag of "j" periods

b(j) follows a smooth, 2nd order polynomial: b(j)=a0 x j squared + a1 x j + a2constraints: b(0) = 0 no immediate impact

b(4)=0 no aditional impact after 3 yearstherefore: a2 = 0 ; a1= -4 x a0 (prove this through substituition)

the sum of b(j) =long run elasticity = a0 x sum ( j squared - 4 j ) = -10 a0-1.0 = Assumed long-run export demand elasticity -1.0 = Assumed long-run import demand elasticityb(j) lag b(j) lag-0.3 1 -0.3 1-0.4 2 -0.4 2-0.3 3 -0.3 3

Exports ImportsTime Elapsed

YearsExchange

Rate US Price Foreign

Cost Quantity Export Value

Foreign Price US Price Quantity

Import Value

After a Devaluation Net Trade

DM per $US $ per ton DM per ton Tons" DM $US per Ton per Ton Tons DM $US $US DM

1 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 2 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 3 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 4 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 5 1.60 $40 64 DM 519 33,241 DM 20,776$ 75.0 DM 46.88$ 739 55,450 DM 34,656$ 1 (13,880)$ 22,209$ 6 1.60 $40 64 DM 547 35,000 DM 21,875$ 75.0 DM 46.88$ 702 52,663 DM 32,915$ 2 (11,040)$ 17,664$ 7 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 656 49,165 DM 30,728$ 3 (7,297)$ 11,675$ 8 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 4 (4,513)$ 7,221$ 9 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 5 (4,513)$ 7,221$

10 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 6 (4,513)$ 7,221$ 11 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 7 (4,513)$ 7,221$ 12 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 8 (4,513)$ 7,221$ 13 1.60 $40 64 DM 617 39,474 DM 24,671$ 75.0 DM 46.88$ 623 46,694 DM 29,184$ 9 (4,513)$ 7,221$

Both price elasticities = -1

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An Example of the J-Curve

Changes in Nominal and Real Trade:Example in which both price elasticities = -1

$(15,000)

$(10,000)

$(5,000)

$-

$5,000

$10,000

$15,000

$20,000

$25,000

0 0 0 0 1 2 3 4 5 6 7 8 9

Years after $US Appreciation

$U

S o

n D

M

-300

-200

-100

0

100

200

300

400

500

To

ns $US

DM

Tons

German Trade Surplus in DM

US Trade Surplus (Deficit) in $US

(US Trade Deficit = German Surplus, in tons)

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An Example of the J-Curve

Evaluate the impact of a dollar deprecitation.Assume the export and import demand equations reflects lagged response to relative prices as follows:log (Q) = constant+ sum ( b(j)*log(foreign price in period j/US price in period -j))b(lag j)=incremental elasticity of demand with a lag of "j" periods

b(j) follows a smooth, 2nd order polynomial: b(j)=a0 x j squared + a1 x j + a2constraints: b(0) = 0 no immediate impact

b(4)=0 no aditional impact after 3 yearstherefore: a2 = 0 ; a1= -4 x a0 (prove this through substituition)

the sum of b(j) =long run elasticity = a0 x sum ( j squared - 4 j ) = -10 a0-0.7 = Assumed long-run export demand elasticity -0.1 = Assumed long-run import demand elasticityb(j) lag b(j) lag

-0.21 1 -0.03 1-0.28 2 -0.04 2-0.21 3 -0.03 3

Exports ImportsTime Elapsed

YearsExchange

Rate US Price Foreign

Cost Quantity Export Value

Foreign Price US Price Quantity

Import Value

After a Devaluation Net Trade

DM per $US $ per ton DM per ton Tons" DM $US per Ton per Ton Tons DM $US $US DM

1 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 2 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 3 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 4 1.90 $40 76 DM 519 39,474 DM 20,776$ 75.0 DM 39.47$ 739 55,450 DM 29,184$ 0 (8,408)$ 15,976$ 5 1.60 $40 64 DM 519 33,241 DM 20,776$ 75.0 DM 46.88$ 739 55,450 DM 34,656$ 1 (13,880)$ 22,209$ 6 1.60 $40 64 DM 538 34,463 DM 21,539$ 75.0 DM 46.88$ 736 55,164 DM 34,478$ 2 (12,939)$ 20,702$ 7 1.60 $40 64 DM 565 36,161 DM 22,601$ 75.0 DM 46.88$ 730 54,787 DM 34,242$ 3 (11,641)$ 18,625$ 8 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 4 (10,634)$ 17,015$ 9 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 5 (10,634)$ 17,015$

10 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 6 (10,634)$ 17,015$ 11 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 7 (10,634)$ 17,015$ 12 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 8 (10,634)$ 17,015$ 13 1.60 $40 64 DM 586 37,490 DM 23,431$ 75.0 DM 46.88$ 727 54,505 DM 34,066$ 9 (10,634)$ 17,015$

Both price elasticities are small

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An Example of the J-Curve

Changes in Nominal and Real Trade :Example in which both price elasticities are small

$(15,000)

$(10,000)

$(5,000)

$-

$5,000

$10,000

$15,000

$20,000

$25,000

0 0 0 0 1 2 3 4 5 6 7 8 9

Years after $US Appreciation

$U

S o

n D

M

-300

-200

-100

0

100

200

300

400

500

To

ns $US

DM

Tons

German Trade Surplus in DM

US Trade Surplus (Deficit) in $US

(US Trade Deficit = German Surplus, in tons)