ECOS!3007:!INTERNATIONAL)MACROECONOMICS!

Topic!1:!BOP!and!FOREX!Markets!1. BOP 2. Composition of BOP and its economic significance:

a. The BOP, demands and supplies of FOREX and the value of currency b. The BOP and domestic liquidity

3. Exchange rates 4. Covered interest parity 5. Forward rates and the expected spot rate 6. Uncovered interest parity 7. Purchasing power parity

Balance!of!Payments!

• BOP summarises transactions b/w residents and non-residents during a period • 3 basic accounts:

o Current account – record of flows of goods, services and incomes b/w residents and non-residents.

o Capital account o Financial account – net acquisition and disposal of financial assets and liabilities

• Sum of balances on Current and Capital a/cs represents the net lending (surplus) or net borrowing (deficit) by the economy with the rest of the world.

• Conceptually equal to the net balance of the fin a/c ! how lending/borrowing is financed o Ie. net lending (borrowing) must entail an " (#) in eco’s stock of fin (assets – liab)

• Eco interest in composition behind the ‘balance’ of (Cu + Ca a/c) and Fin a/c • Eg. $ in central bank’s stock of forex reserves ! $ in dom money supply • $ in dom money supply and CB’s stock of forex reserves reconciles private sector demands

for forex (in exchange for $A, eg. importers, purchases of assets from non-residents) and private sector supplies of forex (in exchange for $A eg. exporters and non-resident purchases of domestic currency denominated assets)

• Absence of this role of forex reserves ! value of dom currency in terms of forex (ie. nom exchange rate) would fluctuate because of a mismatch of D and S of forem in terms of $A

Exchange!Rates!

• Nominal exchange rate (E) – foreign currency price of A$1 (eg. US cents per $A) • Real exchange rate (ε) – rate of exchange of dom for foreign goods

o Depends on E, dom and foreign price levels

! = !!∗ !

= !.!!∗

Where; P = dom prices, P* = foreign prices; in their own currency

o An " (#) in ε ! " (#) in relative price of dom goods in terms of foreign goods. Ie.

real appreciation (depreciation)

Interest!Parity!• Can distinguish two relations b/w interest rates (foreign & dom) and exchange rates:

covered vs. uncovered interest parity • Each condition implies that comparable dom and foreign currency assets earn the same

expected rate of return • Uncovered interest parity – assumes expected returns are based on expected future ‘spot’

exchange rates • Covered interest parity – considers future returns calculated using a known ‘forward’

exchange rate • Forward exchange rate (F) – eg. forex equivalent of a unit dom currency delivered in 3

months time. o Often quoted as premium, or discount, to the spot exchange rate.

• Forward premium (FP) on domestic currency:

!" = !! − 1

Covered!Interest!Parity!(CIP)!

• (r) = dom int rate • (r*) = foreign int rate • Two alternatives for ‘pure abitrageur’ holding x units of dom currency:

i. Invest x for 3 months domestically ! x(1+r) units of dom currency return in 3mnths ii. Convert x units to x.E units of forex spot and invest for 3mnths at (r*) and agree to

sell foreign currency return for dom currency at current forward rate:

• Dom currency value of the return (from investing in the foreign currency asset) in 3mnths is: !.! 1+ !∗ . !!)

• Hence, buy forex spot and sell forex forward if:

!.! 1+ !∗ . 1! > !. (1+ !) 1+ !∗(1+ !) >

!!

• Condition for pure arbitrageur to buy forex spot and sell forex forward becomes:

1+ !∗(1+ !) − 1 > !"

or approx: ! ∗−!! > !"

• For pure arbitrageur to be indifferent between the two cases

!.! 1+ !∗ . 1! = !. (1+ !)

!" = !∗ − !(1+ !)

Covered interest parity = !∗!!

(!!!) • Ie. lower domestic interest rates vis a vis ROW ‘must’ be compensated by a forward

premium

o Forex is more expensive spot than forward o $A is more expensive forward than spot o Loss on forward sale of forex for domestic currency compensates for higher (r*)

• Consider r* = r, and that a forward premium exists so that F > E and return is:

!.! 1+ !∗ . 1! = !.! 1+ ! . 1! < !. (1+ !) • For the returns to be equal it would require r* > r

Foreign!Exchange!Expectation!Relation!

• The forward int rate, quoted at time t for delivery at time t+1 is equal to the expected value of the spot exchange rate at time t+1

!! !!! = !!!!!

!! !!!!!

− 1 = !"! =!!!!! − !!

!!

• What is the basis, if any, for supposing that there should be a connection b/w forward and

spot exchange rates? • Consider the case of speculation on the difference b/w expected spot rate and current

forward rate: • In case of holder of x units of dom currency – assume expected spot exchange rate in

3mnths is lower than 3mnth forward rate o Forex equiv of x in 3 mnths time < forex obtainable in 3mnths w forward purchase

• If expected spot rate < forward rate ! demand for forward forex by speculator • Eg. $A spot is US$1.08; 3 month forward rate is US$1.05c but spot rate is expected to fall

over three months so that spot $A is expected to be US$1 • Speculator buys $US forward for 3mnths with $100A at forward rate ! agrees to deliver

$100A in 3mnths time in exchange for $105US • Suppose speculator is correct, $A depreciates to US$1 in 3 mnths time.

o Speculator can exchange $105US paid with $100A obtainable on forward contract for $105A at current spot rate of US$1/$A.

• If spectator incorrect, $A spot in 3mnths appreciates to US$1.10: o Speculator has to deliver $100A on forward K for US$105. o US$105 only buys spot A$95 ! Loss.

• Pure speculator’s demand for forex forward depends positively on the difference b/w current forward rate and expected spot rate ! pressure on F to follow expected E

• Suggests linkages between forward and spot rates, specifically between forward and the expected spot exchange rate

Exchange!Rate!Expectations!and!Uncovered!Interest!Parity!

• Consider the return on the foreign currency asset in the absence of forward transactions o Instead of:

!.! 1+ !∗ . 1! o The return is:

!. !!!!!!! . 1+ !∗

o Equality of returns requires:

Uncovered interest parity: 1+ ! = !!!!!!! . 1+ !∗

or approx: ! = ! ∗− !!!!! !!!!!

• Consider the uncovered interest parity condition written as:

1+ !! = 1+ !!∗ .!!!!!!!

• With a constant Ee :

1+ !! = 1+ !!∗ .!!!!

!! =1+ !!1+ !!∗

.!!

• As r rises, (given r*) domestic assets become more

attractive ! for equ, a larger fall in E must be anticipated ! larger E (given Ee)

Suppose'a'fall'in'the'expected'exchange'rate'Ee''

• At each level of E, " expected future depreciation of $A ! effective dom currency return from holding foreign assets " ie. r must be higher at each E, given r*

! = ! ∗+! − !!

!

• With UIP at A with !!!, #in !! to !!! !! initially a larger expected dep in $A • At initial E, r must rise to r1, or increased demand for forex will push E down

r* and Ee are given

Topic!2:!OpenJEconomy!Macroeconomics!I!1. External balance, the interest rate and income - the BP relation 2. Perfect and imperfect capital/financial mobility, the BP relation and the UIP relation 3. The traditional Mundell-Fleming model with fixed prices

a. Adjustment to external shocks b. Macroeconomic policy in an open-eco setting

4. The impossible trinity and MP independence External!Balance,!The!Interest!Rate!and!Income!J!The!BP!Relation!

• For simplicity, ignore throughout items on the capital a/c !"#! !"! − !"# !!!!"!!"#$%= ! + ! + !"#$%&'"%!!"#$!!/! + !"#!!"#!!"!!""#$"!!"#$!!"!!!"#$%"&'# − !(!+ !!!"#!!"#$%&'"%!!"#"$%"&!!"#$!!/!!+ !!"#!!"#!!"!!"#$",!"#!!"#$!!!!"!!"!!"#)

• NRFAB = Fin a/c Balance excluding $ in CB reserves • Ignoring also Y and transfers in Current a/c • Net non-reserve D for forex = net rundown in CB reserves = M – X + NRFAB • Alternatively, net accumulation of forex reserves by CB:

= !!!– !!!+ !!"#!!"#!!!"#!– !!"#!!"#!!""#$"!(!"#!!"#$.!!!"!!"#)!= !!!– !!!– !!"#$%!

• If current a/c is in def (M>X) for a zero net $ in CB forex reserves net acq liab must > net acq assets not incl. $ CB forex reserves.

• Ie. NRFAB must show a deficit ! implications?

!"!!!– !!!– !!"#$%! > !0!• Excess S of forex in exchange for $A ! must be absorbed by the CB or pressure for "$A

!"!!!– !!!– !!"#$%! < !0!• Excess D for forex in exchange for $A ! must be met by the CB or pressure for #$A

• What factors govern the size of the current a/c balance and size of NRFAB? • Assume current a/c (CA) depends on E and Y • CA’(Y) < 0, CA’(E,ε) < 0

!"! = !!! −!.! − !. !

• Assume flows behind NRFAB respond to differential b/w domestic and foreign int rates

!"!"# = !. !∗ −!!!! − !

Where f is a constant > 0

• BOP equilibrium – no pressure on the exchange rate or $ in CB forex reserves • Since net forex accumulation ($ reserves) = X – M – NRFAB, then

!!"# = !! −!.! − !. ! − !. !∗ −!!!! − !

• !!!"#! = !0 and zero excess private sector demand for forex (ie. NX – NRFAB = 0) • !! ! > 0