International Finance ACFI260

BOP equation

(X-M) + (CI - CO) + (FI - FO) + FXB = BOP

X (BOP)

exports of goods and services

M (BOP)

imports of goods and services

CI (BOP)

capital inflows

CO (BOP)

capital outflows

FI (BOP)

financial inflows

FO (BOP)

financial outflows

FXB (BOP)

official monetary reserves such as foreign exchange and gold

GDP equation

C + I + G + X - M

C (GDP)

consumption

I (GDP)

capital investment spending

G (GDP)

government spending

X (GDP)

exports of goods and services

M (GDP)

imports of goods and services

GDP

gross domestic product

law of one price

If the same product is sold in two markets, with no restrictions and equal transport costs, the price should be the same in both once you convert currencies.

absolute vs relative PPP

PPP = purchasing power parity (the idea that exchange rates should adjust so that the same basket of goods costs the same in different countries once you convert the prices into one currency.)

Absolute PPP = If the law of one price held for everything, you could work out the PPP exchange rate from any single set of prices.

Relative PPP (RPPP) = Relaxes the assumptions. It doesn't tell you today's spot rate, but says the difference in inflation between two countries drives the change in the exchange rate over time.

• Inflation differences tend to be offset over the long run by an equal and opposite move in the spot rate.

• Formula idea: % change in spot = % change in home prices − % change in foreign prices

when does PPP work well and when doesn't it

• It holds well over the very long run, but poorly in the short run.

• It works better for countries with high inflation and underdeveloped capital markets.

Define pass-through and how it links to elasticity

Pass-through = how much import/export prices respond to exchange rate changes.

It depends heavily on price elasticity of demand:

• Inelastic (|elasticity| < 1): customers barely react to price rises, so firms can pass the full change on. High pass-through.

• Elastic (|elasticity| > 1): customers drop out if prices rise, so firms hold prices down. Low/partial pass-through, and the firm absorbs the difference in its margins.

Explain the Fisher effect and the international Fisher effect

Fisher effect

Nominal interest rate = real rate + expected inflation.

• i = r + π(expected)

• Tends to hold for short-term government securities (T-bills, notes).

International Fisher effect ("Fisher-open")

The spot rate should change by an amount equal to the interest rate difference, but in the opposite direction. Higher interest rate currency is expected to depreciate.

Why? Investors have to be compensated for expected currency moves. Otherwise they'd just invest wherever rates are highest.

State the two conditions for the international Fisher effect to hold continuously

Only if:

1. Capital is perfectly mobile (no restrictions, investors can switch instantly), and

2. Bonds are equally risky.

Calculate a forward rate and the annualised forward premium/discount