Consumo Espontáneo

 Trade competitive can be measured in a number of ways: o Bilateral nominal exchange rate (e.g. $USD/$AUD)

 A bilateral nominal exchange rate does not fully reflect a country’s trade competitiveness because it omits:

 The nominal exchange rates against other trading partners

 The differences in price levels

o Trade weighted index (TWI) = a measure of the value of a currency against a basket of the currencies of the country’s main trading partners

 The basket of currencies will change over time as country’s change their trading partners and the weight of each currency will change depending on how much a country trades with another currency

 A country’s bilateral nominal exchange rate and TWI are not the same but will move closely with each other

 A country’s TWI graph does not tell us everything  e.g. Australia may not trade with Brazil but Australia is still a trade competitor of Brazil. Thus, if the Brazilian currency depreciates it will undercut Australian sales. However, as Brazil is not a main trading partner, the effect is not captured on the TWI graph

o Real exchange rate (RER) = the price of domestic goods and services in terms of foreign goods and services

 RER = nominal exchange rate x

Exchange Rate Systems

 There are four main types of exchange rate systems:

o Floating exchange rate system = the exchange rate is determined by the demand and supply of the currency in the FX market

 The central bank only intervenes when the currency is excessively volatile on under/overvalued

 There is no ‘pure’ floating exchange rate regime  the IMF used the term ‘independently floating regime’

 E.g. Australia, Mexico, USA

o Managed floating exchange rate system = the exchange rate is determined mostly by market demand and supply, but with frequent central bank intervention

 E.g. Argentina, Singapore, Papua New Guinea

o Fixed exchange rate system = countries agree to keep the

exchange rate fixed

55 o Pegged exchange rate system = a country unilaterally agree to peg their currency (home currency) against another currency

(anchor currency)

 E.g. The Bahamas and China peg their currency against the $USD

 The Bahamans and China are the home currency and the USA is the anchor currency

 Regardless of the exchange rate system, the exchange rate will be determined by the FX market  the central bank will intervene in the market to maintain the target exchange rate

Appreciation/Depreciation vs Revaluation/Devaluation

 Appreciation = the value of a floating currency rises relative to another currency

 Depreciation = the value of a floating currency falls relative to another currency

 Revaluation = the value of a fixed/pegged currency is raised relative to the anchor currency

 Devaluation = the value of a fixed/pegged currency is lowered relative to the anchor currency

Fixed/Pegged Exchange Rate System

 Benefits of a fixed/pegged exchange rate system:

o Facilitate international investment and trade, especially with the anchor currency

o Fix foreign debt levels and repayments o Reduce fluctuations in import prices

o Prohibit the central bank from printing money excessively

 Costs of a fixed/pegged exchange rate system:

o Countries lose monetary policy independency (e.g. if the US increases interest rates, Malaysia will have to increase interest rates (even if the conditions in the country do not warrant it) o Countries are open to speculative currency attack when the

currency overvalues

Currency Attack

 Traders can make money from speculating

o E.g. – Thailand/USA – before the peg is broken, the trader will borrow 25 baht and sell the 25 baht in the FX market for $1. After the peg is broken, the trader will sell the $1 in the FX market and get 33 baht. The borrower will repay 25 baht and make an 8 baht profit. This not the complete story – selling the 25 baht increases the money supply in the FX market. This leads to an excess supply of baht. The central bank needs more foreign reserves to increase the demand for baht. This raises interest rates, which causes the baht to depreciate more. This means that the profits of the trader will be even larger. This creates an incentive to attack currency.

The US-China Exchange Rate Dispute

 China started to peg the yuan to the $USD in 1994

 The US argues that the “artificially low value” of the yuan give China producers “unfair advantages” over the US producers, causing a large trade deficit of the US against China

The Big Mac Index

 The Big Mac index shows the $USD price of a Big Mac in different countries and the implied over, or under, valuation of their currencies against the $USD

Currency Attack:

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 Law of one price (LoP) = with the absence of transportation costs and trade barriers, a product should be sold at the same price everywhere when expressed in the same currency

o Otherwise, traders will profit from shipping the product from countries of a lower price to those of a higher price until the prices are equalised

Long Run Exchange Rate

 Purchasing Power Parity (PPP) = in the long run, the exchange rate moves to equalise the purchasing power of different currencies

o Long run nominal exchange rate =

o Long run real exchange rate = LRNER x

= 1 o If this was to hold, in the long run, a basket of goods and services

that costs $520 USD in the USA and that $520 USD were then converted into Yuan, thus amount would buy the same goods and services in China

 Factors that affect the relative price levels affect the long run nominal exchange rate:

o Relative money supply growth o Relative productivity

 PPP does not hold in reality because:

o Some goods and services are not traded internationally by nature (e.g. house) or due to high transportation costs (e.g.. car repairing services)

o Product and consumer preferences are different across countries, so the basket of goods and services are identical