International trade and Exchange Rates
International Trade and exchange rate behavior
... losing the balance
(c) 2007-2011 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author.
Exports vs. Imports (Millions $: 19751975-2010) 3,000,000
2,500,000
Imports: $2.32 trillion 2,000,000
Deficit: $490 billion
1,500,000
1,000,000
Exports: $1.83 trillion
500,000
0 1975
1980
1985
1990 Imports
1995
2000
2005
2010
Exports
Source: Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1
1
Merchandise Trade (Goods) Deficit 1975--2010 1975
$ billions 900,000
$647.077 billion in 2010
800,000 700,000 600,000
Question: Is this necessarily bad?? 500,000 400,000 300,000 Source: Bureau of Economic Analysis, Table 1 Interactive tables
200,000 , 100,000 0 -100,000 1975
1980
1985
1990
1995
2000
2005
2010
Services Surplus 1975--2010 1975
$ billions 160,000
$151.350 Billion in 2010
140,000 120,000 100,000 80,000
Includes shipping, insurance, financial and legal services, education, consulting
60,000 Source: Bureau of Economic Analysis, Table 1 Interactive Tables
40,000 20,000 0 1975
1980
1985
1990
1995
2000
2005
2010
2
Major U.S. Trading Partners Annual 2010, $ millions (Goods and Services) Country/Region European Union China Canada Mexico Memo: OPEC Japan MidEast India
Exports 416,338 113,099 299,046 186,288 78,541 108,199 69,596 29 924 29,924
Imports -460,274 -375,770 -306,077 -246,760 -164,557 -149,440 -94,540 -43,227 43 227
Balance -43,936 -262,671 -7,031 -60,472 -86,016 -41,241 -24,944 -13,303 13 303
OPEC: Algeria, Angola, Ecuador, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE, Venezuela. Source: Bureau of Economic Analysis, Table 12 Interactive Tables
$ millions
What goods do we export? 2010
445,910 405,231 Agricultural Products
450,000
Industrial Supplies Capital Goods
400,000 00,000
Automotive Consumer Goods
350,000
Other Goods
300,000 250,000 200,000
165,754 118,961
111,858
Our strength is is capital goods, which includes aircraft.
150 000 150,000 52,212
100,000 50,000 0 Source: Bureau of Economic Analysis, International Economic Accounts, Table 2a.
3
What goods do we import?
$ Millions
2010
700,000
Foods, Feed, Beverages
622,327
Industrial Supplies (1) Capital Goods Automotive Vehicles & Parts
600 000 600,000 486,212
449,710
Consumer Goods Other Goods
500,000
(1) Petroleum products were $354.7 of this category.
400,000 225,110
300,000 200,000
Compare consumer goods and vehicles to exports.
91,721 60,659
100,000 0 Source: Bureau of Economic Analysis, International Economic Accounts, Table 2a.
What Services Do We Export?
$ millions 200,000
2010 180,000
Travel and Transportation Business, Professional, Technical
174,215
Royalties and License Fees 160,000
Financial Services Other
140,000
Education
128,297
Insurance Services
120,000
100,000
Telecommunications 95,807
80,000
60 000 60,000
58,003
40,000 23,822 20,000
21,690 14,558
10,201
0
Source: Bureau of Economic Analysis, International Economic Accounts, Table 3a.
4
What Services Do We Import?
$ millions 160,000
151,685
Travel and Transportation
2010
140,000
Business, Professional, Technical Insurance Services Royalties and License Fees
120,000
Financial Services Telecommunications Education
100,000 89,514
Other
80,000
56,454
60,000
40,000 29,227
20,000
15,796 7,541
5,960
2,455
0
Source: Bureau of Economic Analysis, International Economic Accounts, Table 3a.
Trade and "Current Account" Goods and Services deficit Trading Partners
... must be offset by financial flows going the opposite way
When the U.S. runs a large goods and services deficit with the rest of the world, the $$ cash that accumulates overseas must eventually find an outlet back in the U.S. in the form of foreign purchases of U.S. businesses, investment in the U.S. stock/bond markets, or through purchase of U.S. Treasury Securities.
United States
"We are going to owe the rest of the world forever," Warren Buffett on CNBC, March 20, 2006.
5
This all has to "balance": All U.S. International Transactions 2010 (preliminary) ($ millions) Goods and Services Exports Imports
1,834,166 -2,329,893
Financial Transfers US net investment abroad Foreign net investment in US US income on overseas assets Foreign income on US assets Unilateral transfers net US government holding of foreign assets Foreign holdings of US government assets Other and statistical discrepency Balance
-1,024,723 1,244,831 659,354 -488,040 -137,489 -1,834 298,042 -54 414 -54,414 0
SourceL BEA International Transaction, Table 1 Interactive Tables
These are all flow variables. The 1,233,831 means that $1.233 trillions was invested in the U.S. by overseas investors in 2010.
Notice how the gap in trade is offset by investment flows. Our $ are used to buy goods, those $ return to U.S. in the form of investment in U.S. assets, some financial assets and real estate, but a lot of US govt debt. These categories show earnings that are the result of investments in years past.
Where is the returned money invested? Foreign Net Investment in the U.S.
From the previous page:
2010 ($ millions) Total Foreign Investment in the U.S. S
1,244,831
Foreign Government U.S. Treasury Securities U.S. Bank Deposits Other
298,042 297,155 -9,340 10,227
Private Direct Investment U.S. Treasury Securities Other U.S. Government Securities U.S. Bank Deposits Other
946,789 194,464 306,407 175,415 49,962 220,541
About half is foreign g government, half foreign private. Typically it is spread out fairly evenly. But in this crisis, all the them emphasis is toward U.S. Treasury securities and away from everything thi else, l including bank deposits.
Source: BEA International Data, Table 1, Interactive Tables
6
Overseas Accumulations of Financial Assets (mostly dollars) When our overseas trading partners run trade surpluses with us, their financial assets accumulated by their governments are classified as foreign exchange yp y reserves, and are typically held as U.S. Treasury securities. For example, China's holdings have grown to $2 trillion. Wall Street Journal, March 24, 2009.
Who owns the U.S. Treasury Debt?
7
The Good and the Bad of the the Trade Deficit • The good ... – – – – –
keeps inflation in check very consumer-friendly encourages development in emerging nations encourages political alliances with the U.S. forces many domestic industries to be competitive
• The bad ... – dollar cash generated from these sales must be recycled back to the U.S., currently leaving us indebted to China, petro-nations and other nations – some industries are damaged and some jobs are lost
Exchange Rates ..determination, determination impact impact, and regulation
8
What are exchange rates? U.S. Dollar Exchange Rates February, 2011 Cost of one unit of the currency in $
Australian Dollar Canadian Dollar Chinese Yuan Euro Japanese Yen Mexican Peso Swiss Franc U.K. Pound
1.0084 1.0126 0.1521 1.3656 0.0121 0.0829 1.0526 1.6124
Inverse
0.9917 0.9876 6.5761 0.7323 82.5368 12.0649 0.9500 0.6202
Shading indicates the ratio that is typically quoted in foreign exchange quotes, which can be confusing. Source: Federal Reserve System G5/H10 Foreign Exchange Rates
Exchange rates are the ratios at which, in any given moment, one currency is exchanged for another. It is also the price of one currency in terms of another. For example, the exchange ratio of the Dollar to the Euro ($/€) is 1.36. We can also say that the Euro is worth $1 $1.36. 36 With the exception of the Yuan, these exchange rates are determined by market forces and fluctuate every moment.
$ to € and $ to ₤ Exchange Rates Monthly data, Jan 2000 – February 2011 2.50
2.00
Shown here is the $ price of the € and ₤, interpreted as “one Euro costs $1.34” and written as $/€ and $/₤.
Mar 27, 2011 €: $1.404 ₤: $1.601
1.50
1.00
0 50 0.50
This value rising (when $ is in the numerator) is regarded as a “depreciating” “d i ti ” or ““weaker” k ” dollar. d ll Imported I t d goods d cost more and our exports cost less overseas.
0.00
Euro
UK Pound
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
9
Yen (¥) to $ Exchange Rate Monthly data , Jan 2000 – February 2011 Shown here is the ¥ price of the $, interpreted as “one $ costs 82 ¥” and written as ¥/$. This convention is inverted from the manner in which the ₤ and € are conventionally quoted.
140 130 120
Mar 27, 2011 $: ¥81.567 implies ¥: $0.01226
110 100 90 80 70
This was 238 in 1985.
This value falling (when $ is in the denominator) is regarded as a “depreciating” or “weaker” dollar. Imported goods from Japan cost more and our exports to Japan cost less.
60
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
Chinese Yuan (元 )/Dollar Exchange Rate Monthly data, Jan 2000 – February 2011 Also called the Renminbi (RMB), the Yuan was fixed at 8.22 for many years, then under pressure, the government has let it decline It is still highly over decline. over-valued valued and the only major currency not free-floating.
9.0
8.5
8.0
7.5
7.0
6.5
This amounts to a devaluation of the $ relative to the Yuan, which makes goods imported from China more expensive expensive.
Period of the “managed floating rate”
6.0
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
10
Exchange Rate Determination: What influences these rates? • Demand for the dollar (supply of other currency) – Our exports – Purchase of US financial assets from overseas – Foreign net direct investment in US
• Supply of the dollar (demand for other currency) – Our imports – Purchase of overseas financial assets – US net direct investment overseas (also repatriations, US military outlays overseas, etc.)
The YenYen-to to--$ (Yen/USD) exchange rate in 1985 ¥ price of $ ¥/$ Supply of $ (Demand for Yen) 238
Demand for $ (S (Supply l off Y Yen)) Volume The starting point: Notice how the Yen is quoted as the Yen price of the $, as though the $ is the commodity and the Yen is the price. A rise in this price represents a strong $, a fall is a weak (depreciating) $.
11
Factors that affect exchange rates (seen from the perspective of the U.S. $) Goods & Services side
Impact upon the Demand for the $
Surge in overseas demand for US products and services due to pricing, quality differentials, technology, new products, etc.
(+)
Surge in US demand for overseas products and services due to pricing, quality differentials, technology, new products, etc.
(-)
Financial / Investment side
(+) (-) (+)
Rising interest rates in U.S. relative to those overseas. Rising inflation rates in U,S, relative to those overseas. G General l perceptions ti off deltas d lt in i relative l ti economic i strength t th (vague but real). Flight to quality: In times of global crisis, money flows to U.S. and to U.S. Treasury securities in particular (robust).
(+)
Repatriations (money sent home).
(-)
The YenYen-to to--$ exchange rate: surge in US import demand 300
Yen price of $
250
238.47 Value for 2009 is for March 23.
200
150
97.07
S$1
100
50
0 1985
1990
1995
2000
2005
S$2 238 130
The dollar depreciates. Look at the Yento-Dollar exchange rate. This is an historical example.
D$1 Volume It's 1985. Suppose car buyers in the U.S. begin to shift their demand for autos to Japanese imports because of perceived differences in quality control. In this market, the supply of Dollars (demand for Yen) would rise.
12
Theoretical effects of exchange rate adjustments (goods/services only) •
A ddevaluation l i (decline (d li in i value) l ) off the h $ should h ld – –
encourage exports (our goods are cheaper) discourage imports (their goods are more expensive)
–
(The previous slide tells us that Hondas should be more expensive in the U.S. after 1985).
•
A revaluation (rise in value) of the $ should – –
encourage imports (their goods are cheaper) discourage exports (our goods are more expensive)
Why the devaluation is supposed to bring the trade back into balance: Assume that between 1985 and 1990, the cost including markup of making a H d iin Japan Honda J was 22,400,000 400 000 Y Yen and d th the costt off making ki a Buick B i k in i the th U.S. US was 12,000 Dollars. When sold overseas in 1985, each car would have the same price (assume the exchange rate to be 200 for simplicity. But by 1990, with the exchange rate at Yen-to-Dollar Honda Price in Buick Price in Year 150, the Honda Exchange Rate U.S. Japan should be more expensive p that the Buick in the 1985 200 $12,000 2,400,000 Yen U.S. and the Buick cheaper in Japan. 1990
150
$18,000
1,800,000 Yen
... but this didn't turn things around.
13
Why our trade deficit won't correct despite a historically weakening dollar • So much of the deficit is with China, which has a fixed exchange rate, and China refuses to let it float free • Petroleum imports are inelastic to price (we will pay whatever it takes) • Overseas partners are not using dollar reserves to buy US goods, they are buying US financial assets • This is the ultimate consumption economy, the more we consume, the more we import
International Financial Flows • When we run huge trade surplus, $$ accumulate in foreign accounts, some end up in foreign central banks, and some are reinvested in US Treasury securities (now the dominant force in Financial flows) flows). • Offshore investments of all types, whether financed by trade surpluses or not, are huge in scope ... – We in U.S. invest in overseas stock markets through mutual funds and ETFs mostly – Historically we took huge controlling interests in overseas corporations – Overseas investors now buy our Treasury securities, stocks, real estate and sometimes controlling interest in corporations
• These financial flows dwarf trade-based flows. • Exchange rate movements are determined by and determine changes in these financial flows.
14
The EUR/USD Exchange Rate $ price of Euro
This perspective treats the Euro as the commodity and the $ as the price.
Dollar-to-Euro Exchange Rate
Supply of Euro (Demand for $) 1.2545
A rise in this equilibrium price would represent a strong Euro and a weak $.
Demand for Euro (S (Supply l off $) Volume This model's equilibrium will be affected by major macroeconomic variables (relative) like interest rates, inflation rates, economic growth, changes in policy, trade status, and so forth.
What variables move these markets? After trading a lot in the FOREX, you teacher sees foreign exchange, in a modeling sense, as essentially two markets: (a) an intermediate to long-term market [[measured in weeks to months]] where fundamental textbook economic variables determine exchange rates, and (b) a very short term market [measured in minutes to days] that is hypersensitive and responds in a rational expectations format to minute data releases (globally), official speeches, rumors, or anything that might show that the longer term picture is changing, that monetary policy is changing, or that anything influencing interest rates is changing. Both markets are nominal-interest-rate-sensitive ... the short-term market on expectations, the longer-term market more on realizations. In general, emerging evidence of relative economic strength will strengthen a currency (partly because it raises the prospect of rising interest rates). The markets pay little attention these days to the U.S. trade position (our commodity gluttony is so habitual that it is universally expected).
15
Important question ... .. What impact does a change in interest rates and other market yields ields ha havee upon pon the exchange e change rate of a currency? c rrenc ? For example, what should happen to the Dollar price of the Euro if interest rates rose suddenly in the United States relative to those in the European Union? The FOREX is driven by rational expectations, so this effect will likely materialize even if tentative data emerges that this rise in rates is simply more likely (more probable)!
The Effect of a Rise in European Interest Rates $ price of €
Dollar-to-Euro Exchange Rate S2
The Supply of the € falls (less d demand d for f $) S1
1.4055
Jargon: Weaker dollar
1.3210 D1
Demand for the € rises D2
Volume There is a surge in the demand for Euro-denominated financial assets, which causes an increase in the demand of the Euro, a reduction in the supply, and a rise in the exchange rate (devaluation of the Dollar).
16
Exchange Rates and Inflationary Potential (for a highhigh-import nation)
U.S. Dollar Exchange g Rates February, 2011 Cost of one unit of the FOREX quote currency in $ (if Inverse)
Australian Dollar Canadian Dollar Chinese Yuan Euro Japanese Yen Mexican Peso Swiss Franc U.K. Pound
1.0084 same 1.0126 0.9876 0.1521 6.5761 1 3656 same 1.3656 0.0121 82.5368 0.0829 12.0649 1.0526 0.9500 1.6124 same
If the value in this column starts to rise, that would be a weaker (devaluing) dollar. That can contribute to U.S. inflationary ppressures for imports p from that country. That would also lower the yield on overseas investments here.
Will this be a problem in 2011?
Theoretical effects of exchange rate adjustments •
A devaluation (decline in value) of the $ should – – –
•
encourage exports (our goods are cheaper) discourage imports (their goods are more expensive) encourage capital inflows from overseas (purchases of US financial assets)
A revaluation ((rise in value)) of the $ should – – –
encourage imports (their goods are cheaper) discourage exports (our goods are more expensive) discourage capital inflows from overseas (or encourage our investments overseas
17
Topical: The Dollar Reacts to News 1.45
5
2 1.4
4
1.35
1.3
3 1.25
1.2
1
1 – 2: FRS in U.S. drops interest rates to essential 0% for shortmaturity Treasuries, $ weakens. 2 – 3: PIIGS (Portugal, Ireland, Italy, Greece, Spain) debt solvency problems emerge, sending flight-to-quality to $. 4 – 5: ECB announces plans to raise European interest rates.
1.15 2010‐09‐01 2010‐09‐23 2010‐10‐15 2010‐11‐05 2010‐11‐30 2010‐12‐21 2011‐01‐13 2011‐02‐04 2011‐02‐28
Topical:
Unbelievable rise in Yen on Wednesday, Wednesday March 16, 16 as it becomes clear that after the horrible 9.0 quake on Friday, March 11, 2011, triggered off a string of emergencies at the Fukushima Daiichi and other nearby nuclear power plants that seemed to be cascading out of control on this day. Likewise, the rescue effort from the quake seemed chaotic and inefficient, putting thousands of lives in jeopardy. It is also clear that the Japanese economy will suffer terribly. So why does the Yen strengthen? Repatriations and charitable contributions to Japan are sending demand for the Yen soaring. Inset: DJIA over same period. DJIA falls 242.12 on this day. Source: FOREX.com
18
... losing the balance
(c) 2007-2011 Gary R. Evans. May be used for non-profit educational purposes only without permission of the author.
Exports vs. Imports (Millions $: 19751975-2010) 3,000,000
2,500,000
Imports: $2.32 trillion 2,000,000
Deficit: $490 billion
1,500,000
1,000,000
Exports: $1.83 trillion
500,000
0 1975
1980
1985
1990 Imports
1995
2000
2005
2010
Exports
Source: Bureau of Economic Analysis, U.S. International Transactions Accounts Data, Table 1
1
Merchandise Trade (Goods) Deficit 1975--2010 1975
$ billions 900,000
$647.077 billion in 2010
800,000 700,000 600,000
Question: Is this necessarily bad?? 500,000 400,000 300,000 Source: Bureau of Economic Analysis, Table 1 Interactive tables
200,000 , 100,000 0 -100,000 1975
1980
1985
1990
1995
2000
2005
2010
Services Surplus 1975--2010 1975
$ billions 160,000
$151.350 Billion in 2010
140,000 120,000 100,000 80,000
Includes shipping, insurance, financial and legal services, education, consulting
60,000 Source: Bureau of Economic Analysis, Table 1 Interactive Tables
40,000 20,000 0 1975
1980
1985
1990
1995
2000
2005
2010
2
Major U.S. Trading Partners Annual 2010, $ millions (Goods and Services) Country/Region European Union China Canada Mexico Memo: OPEC Japan MidEast India
Exports 416,338 113,099 299,046 186,288 78,541 108,199 69,596 29 924 29,924
Imports -460,274 -375,770 -306,077 -246,760 -164,557 -149,440 -94,540 -43,227 43 227
Balance -43,936 -262,671 -7,031 -60,472 -86,016 -41,241 -24,944 -13,303 13 303
OPEC: Algeria, Angola, Ecuador, Iran, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE, Venezuela. Source: Bureau of Economic Analysis, Table 12 Interactive Tables
$ millions
What goods do we export? 2010
445,910 405,231 Agricultural Products
450,000
Industrial Supplies Capital Goods
400,000 00,000
Automotive Consumer Goods
350,000
Other Goods
300,000 250,000 200,000
165,754 118,961
111,858
Our strength is is capital goods, which includes aircraft.
150 000 150,000 52,212
100,000 50,000 0 Source: Bureau of Economic Analysis, International Economic Accounts, Table 2a.
3
What goods do we import?
$ Millions
2010
700,000
Foods, Feed, Beverages
622,327
Industrial Supplies (1) Capital Goods Automotive Vehicles & Parts
600 000 600,000 486,212
449,710
Consumer Goods Other Goods
500,000
(1) Petroleum products were $354.7 of this category.
400,000 225,110
300,000 200,000
Compare consumer goods and vehicles to exports.
91,721 60,659
100,000 0 Source: Bureau of Economic Analysis, International Economic Accounts, Table 2a.
What Services Do We Export?
$ millions 200,000
2010 180,000
Travel and Transportation Business, Professional, Technical
174,215
Royalties and License Fees 160,000
Financial Services Other
140,000
Education
128,297
Insurance Services
120,000
100,000
Telecommunications 95,807
80,000
60 000 60,000
58,003
40,000 23,822 20,000
21,690 14,558
10,201
0
Source: Bureau of Economic Analysis, International Economic Accounts, Table 3a.
4
What Services Do We Import?
$ millions 160,000
151,685
Travel and Transportation
2010
140,000
Business, Professional, Technical Insurance Services Royalties and License Fees
120,000
Financial Services Telecommunications Education
100,000 89,514
Other
80,000
56,454
60,000
40,000 29,227
20,000
15,796 7,541
5,960
2,455
0
Source: Bureau of Economic Analysis, International Economic Accounts, Table 3a.
Trade and "Current Account" Goods and Services deficit Trading Partners
... must be offset by financial flows going the opposite way
When the U.S. runs a large goods and services deficit with the rest of the world, the $$ cash that accumulates overseas must eventually find an outlet back in the U.S. in the form of foreign purchases of U.S. businesses, investment in the U.S. stock/bond markets, or through purchase of U.S. Treasury Securities.
United States
"We are going to owe the rest of the world forever," Warren Buffett on CNBC, March 20, 2006.
5
This all has to "balance": All U.S. International Transactions 2010 (preliminary) ($ millions) Goods and Services Exports Imports
1,834,166 -2,329,893
Financial Transfers US net investment abroad Foreign net investment in US US income on overseas assets Foreign income on US assets Unilateral transfers net US government holding of foreign assets Foreign holdings of US government assets Other and statistical discrepency Balance
-1,024,723 1,244,831 659,354 -488,040 -137,489 -1,834 298,042 -54 414 -54,414 0
SourceL BEA International Transaction, Table 1 Interactive Tables
These are all flow variables. The 1,233,831 means that $1.233 trillions was invested in the U.S. by overseas investors in 2010.
Notice how the gap in trade is offset by investment flows. Our $ are used to buy goods, those $ return to U.S. in the form of investment in U.S. assets, some financial assets and real estate, but a lot of US govt debt. These categories show earnings that are the result of investments in years past.
Where is the returned money invested? Foreign Net Investment in the U.S.
From the previous page:
2010 ($ millions) Total Foreign Investment in the U.S. S
1,244,831
Foreign Government U.S. Treasury Securities U.S. Bank Deposits Other
298,042 297,155 -9,340 10,227
Private Direct Investment U.S. Treasury Securities Other U.S. Government Securities U.S. Bank Deposits Other
946,789 194,464 306,407 175,415 49,962 220,541
About half is foreign g government, half foreign private. Typically it is spread out fairly evenly. But in this crisis, all the them emphasis is toward U.S. Treasury securities and away from everything thi else, l including bank deposits.
Source: BEA International Data, Table 1, Interactive Tables
6
Overseas Accumulations of Financial Assets (mostly dollars) When our overseas trading partners run trade surpluses with us, their financial assets accumulated by their governments are classified as foreign exchange yp y reserves, and are typically held as U.S. Treasury securities. For example, China's holdings have grown to $2 trillion. Wall Street Journal, March 24, 2009.
Who owns the U.S. Treasury Debt?
7
The Good and the Bad of the the Trade Deficit • The good ... – – – – –
keeps inflation in check very consumer-friendly encourages development in emerging nations encourages political alliances with the U.S. forces many domestic industries to be competitive
• The bad ... – dollar cash generated from these sales must be recycled back to the U.S., currently leaving us indebted to China, petro-nations and other nations – some industries are damaged and some jobs are lost
Exchange Rates ..determination, determination impact impact, and regulation
8
What are exchange rates? U.S. Dollar Exchange Rates February, 2011 Cost of one unit of the currency in $
Australian Dollar Canadian Dollar Chinese Yuan Euro Japanese Yen Mexican Peso Swiss Franc U.K. Pound
1.0084 1.0126 0.1521 1.3656 0.0121 0.0829 1.0526 1.6124
Inverse
0.9917 0.9876 6.5761 0.7323 82.5368 12.0649 0.9500 0.6202
Shading indicates the ratio that is typically quoted in foreign exchange quotes, which can be confusing. Source: Federal Reserve System G5/H10 Foreign Exchange Rates
Exchange rates are the ratios at which, in any given moment, one currency is exchanged for another. It is also the price of one currency in terms of another. For example, the exchange ratio of the Dollar to the Euro ($/€) is 1.36. We can also say that the Euro is worth $1 $1.36. 36 With the exception of the Yuan, these exchange rates are determined by market forces and fluctuate every moment.
$ to € and $ to ₤ Exchange Rates Monthly data, Jan 2000 – February 2011 2.50
2.00
Shown here is the $ price of the € and ₤, interpreted as “one Euro costs $1.34” and written as $/€ and $/₤.
Mar 27, 2011 €: $1.404 ₤: $1.601
1.50
1.00
0 50 0.50
This value rising (when $ is in the numerator) is regarded as a “depreciating” “d i ti ” or ““weaker” k ” dollar. d ll Imported I t d goods d cost more and our exports cost less overseas.
0.00
Euro
UK Pound
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
9
Yen (¥) to $ Exchange Rate Monthly data , Jan 2000 – February 2011 Shown here is the ¥ price of the $, interpreted as “one $ costs 82 ¥” and written as ¥/$. This convention is inverted from the manner in which the ₤ and € are conventionally quoted.
140 130 120
Mar 27, 2011 $: ¥81.567 implies ¥: $0.01226
110 100 90 80 70
This was 238 in 1985.
This value falling (when $ is in the denominator) is regarded as a “depreciating” or “weaker” dollar. Imported goods from Japan cost more and our exports to Japan cost less.
60
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
Chinese Yuan (元 )/Dollar Exchange Rate Monthly data, Jan 2000 – February 2011 Also called the Renminbi (RMB), the Yuan was fixed at 8.22 for many years, then under pressure, the government has let it decline It is still highly over decline. over-valued valued and the only major currency not free-floating.
9.0
8.5
8.0
7.5
7.0
6.5
This amounts to a devaluation of the $ relative to the Yuan, which makes goods imported from China more expensive expensive.
Period of the “managed floating rate”
6.0
Source: Federal Reserve System G5/H10 data Foreign Exchange Rates
10
Exchange Rate Determination: What influences these rates? • Demand for the dollar (supply of other currency) – Our exports – Purchase of US financial assets from overseas – Foreign net direct investment in US
• Supply of the dollar (demand for other currency) – Our imports – Purchase of overseas financial assets – US net direct investment overseas (also repatriations, US military outlays overseas, etc.)
The YenYen-to to--$ (Yen/USD) exchange rate in 1985 ¥ price of $ ¥/$ Supply of $ (Demand for Yen) 238
Demand for $ (S (Supply l off Y Yen)) Volume The starting point: Notice how the Yen is quoted as the Yen price of the $, as though the $ is the commodity and the Yen is the price. A rise in this price represents a strong $, a fall is a weak (depreciating) $.
11
Factors that affect exchange rates (seen from the perspective of the U.S. $) Goods & Services side
Impact upon the Demand for the $
Surge in overseas demand for US products and services due to pricing, quality differentials, technology, new products, etc.
(+)
Surge in US demand for overseas products and services due to pricing, quality differentials, technology, new products, etc.
(-)
Financial / Investment side
(+) (-) (+)
Rising interest rates in U.S. relative to those overseas. Rising inflation rates in U,S, relative to those overseas. G General l perceptions ti off deltas d lt in i relative l ti economic i strength t th (vague but real). Flight to quality: In times of global crisis, money flows to U.S. and to U.S. Treasury securities in particular (robust).
(+)
Repatriations (money sent home).
(-)
The YenYen-to to--$ exchange rate: surge in US import demand 300
Yen price of $
250
238.47 Value for 2009 is for March 23.
200
150
97.07
S$1
100
50
0 1985
1990
1995
2000
2005
S$2 238 130
The dollar depreciates. Look at the Yento-Dollar exchange rate. This is an historical example.
D$1 Volume It's 1985. Suppose car buyers in the U.S. begin to shift their demand for autos to Japanese imports because of perceived differences in quality control. In this market, the supply of Dollars (demand for Yen) would rise.
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Theoretical effects of exchange rate adjustments (goods/services only) •
A ddevaluation l i (decline (d li in i value) l ) off the h $ should h ld – –
encourage exports (our goods are cheaper) discourage imports (their goods are more expensive)
–
(The previous slide tells us that Hondas should be more expensive in the U.S. after 1985).
•
A revaluation (rise in value) of the $ should – –
encourage imports (their goods are cheaper) discourage exports (our goods are more expensive)
Why the devaluation is supposed to bring the trade back into balance: Assume that between 1985 and 1990, the cost including markup of making a H d iin Japan Honda J was 22,400,000 400 000 Y Yen and d th the costt off making ki a Buick B i k in i the th U.S. US was 12,000 Dollars. When sold overseas in 1985, each car would have the same price (assume the exchange rate to be 200 for simplicity. But by 1990, with the exchange rate at Yen-to-Dollar Honda Price in Buick Price in Year 150, the Honda Exchange Rate U.S. Japan should be more expensive p that the Buick in the 1985 200 $12,000 2,400,000 Yen U.S. and the Buick cheaper in Japan. 1990
150
$18,000
1,800,000 Yen
... but this didn't turn things around.
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Why our trade deficit won't correct despite a historically weakening dollar • So much of the deficit is with China, which has a fixed exchange rate, and China refuses to let it float free • Petroleum imports are inelastic to price (we will pay whatever it takes) • Overseas partners are not using dollar reserves to buy US goods, they are buying US financial assets • This is the ultimate consumption economy, the more we consume, the more we import
International Financial Flows • When we run huge trade surplus, $$ accumulate in foreign accounts, some end up in foreign central banks, and some are reinvested in US Treasury securities (now the dominant force in Financial flows) flows). • Offshore investments of all types, whether financed by trade surpluses or not, are huge in scope ... – We in U.S. invest in overseas stock markets through mutual funds and ETFs mostly – Historically we took huge controlling interests in overseas corporations – Overseas investors now buy our Treasury securities, stocks, real estate and sometimes controlling interest in corporations
• These financial flows dwarf trade-based flows. • Exchange rate movements are determined by and determine changes in these financial flows.
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The EUR/USD Exchange Rate $ price of Euro
This perspective treats the Euro as the commodity and the $ as the price.
Dollar-to-Euro Exchange Rate
Supply of Euro (Demand for $) 1.2545
A rise in this equilibrium price would represent a strong Euro and a weak $.
Demand for Euro (S (Supply l off $) Volume This model's equilibrium will be affected by major macroeconomic variables (relative) like interest rates, inflation rates, economic growth, changes in policy, trade status, and so forth.
What variables move these markets? After trading a lot in the FOREX, you teacher sees foreign exchange, in a modeling sense, as essentially two markets: (a) an intermediate to long-term market [[measured in weeks to months]] where fundamental textbook economic variables determine exchange rates, and (b) a very short term market [measured in minutes to days] that is hypersensitive and responds in a rational expectations format to minute data releases (globally), official speeches, rumors, or anything that might show that the longer term picture is changing, that monetary policy is changing, or that anything influencing interest rates is changing. Both markets are nominal-interest-rate-sensitive ... the short-term market on expectations, the longer-term market more on realizations. In general, emerging evidence of relative economic strength will strengthen a currency (partly because it raises the prospect of rising interest rates). The markets pay little attention these days to the U.S. trade position (our commodity gluttony is so habitual that it is universally expected).
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Important question ... .. What impact does a change in interest rates and other market yields ields ha havee upon pon the exchange e change rate of a currency? c rrenc ? For example, what should happen to the Dollar price of the Euro if interest rates rose suddenly in the United States relative to those in the European Union? The FOREX is driven by rational expectations, so this effect will likely materialize even if tentative data emerges that this rise in rates is simply more likely (more probable)!
The Effect of a Rise in European Interest Rates $ price of €
Dollar-to-Euro Exchange Rate S2
The Supply of the € falls (less d demand d for f $) S1
1.4055
Jargon: Weaker dollar
1.3210 D1
Demand for the € rises D2
Volume There is a surge in the demand for Euro-denominated financial assets, which causes an increase in the demand of the Euro, a reduction in the supply, and a rise in the exchange rate (devaluation of the Dollar).
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Exchange Rates and Inflationary Potential (for a highhigh-import nation)
U.S. Dollar Exchange g Rates February, 2011 Cost of one unit of the FOREX quote currency in $ (if Inverse)
Australian Dollar Canadian Dollar Chinese Yuan Euro Japanese Yen Mexican Peso Swiss Franc U.K. Pound
1.0084 same 1.0126 0.9876 0.1521 6.5761 1 3656 same 1.3656 0.0121 82.5368 0.0829 12.0649 1.0526 0.9500 1.6124 same
If the value in this column starts to rise, that would be a weaker (devaluing) dollar. That can contribute to U.S. inflationary ppressures for imports p from that country. That would also lower the yield on overseas investments here.
Will this be a problem in 2011?
Theoretical effects of exchange rate adjustments •
A devaluation (decline in value) of the $ should – – –
•
encourage exports (our goods are cheaper) discourage imports (their goods are more expensive) encourage capital inflows from overseas (purchases of US financial assets)
A revaluation ((rise in value)) of the $ should – – –
encourage imports (their goods are cheaper) discourage exports (our goods are more expensive) discourage capital inflows from overseas (or encourage our investments overseas
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Topical: The Dollar Reacts to News 1.45
5
2 1.4
4
1.35
1.3
3 1.25
1.2
1
1 – 2: FRS in U.S. drops interest rates to essential 0% for shortmaturity Treasuries, $ weakens. 2 – 3: PIIGS (Portugal, Ireland, Italy, Greece, Spain) debt solvency problems emerge, sending flight-to-quality to $. 4 – 5: ECB announces plans to raise European interest rates.
1.15 2010‐09‐01 2010‐09‐23 2010‐10‐15 2010‐11‐05 2010‐11‐30 2010‐12‐21 2011‐01‐13 2011‐02‐04 2011‐02‐28
Topical:
Unbelievable rise in Yen on Wednesday, Wednesday March 16, 16 as it becomes clear that after the horrible 9.0 quake on Friday, March 11, 2011, triggered off a string of emergencies at the Fukushima Daiichi and other nearby nuclear power plants that seemed to be cascading out of control on this day. Likewise, the rescue effort from the quake seemed chaotic and inefficient, putting thousands of lives in jeopardy. It is also clear that the Japanese economy will suffer terribly. So why does the Yen strengthen? Repatriations and charitable contributions to Japan are sending demand for the Yen soaring. Inset: DJIA over same period. DJIA falls 242.12 on this day. Source: FOREX.com
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