International Finance - Lecture VI Notes

International Finance

Lecture VI - March 25th

• Vilém Semerák, Ph.D.
• vilem.semerak@fsv.cuni.cz
• IES FSV UK - Spring 2025

Outline

• Assignments and quizzes
• Finishing the PPP and UIP issues:
  • (International) Fisher effect
• Explaining the deviations from the PPP and trend in exchange rates
  • Reminder: empirical evidence
  • Balassa-Samuelson model
  • Other explanations: Bhagwati
• Empirical issues:
  • CEE countries and real appreciation
  • Real convergence in the EU
• Effects of misalignments
  • GDR as a case study?
• Wider debate: can undervaluation be beneficial for less developed countries?

Course Outline (Changes Possible)

1. Introduction to international finance. History of international finance. Foreign exchange market: basic features. Sources of data. (February 18th)
2. Balance of payments structure and national income accounting for open economy. International investment position. February 25th)
3. Guest lecture (March 4th) - Prof. Talluri, Michigan State University. Room 109
4. Introduction to exchange rate determination: asset approach. Covered and uncovered interest rate parity (March 11th)
5. Prices and exchange rates: purchasing power parity. Long run aspects of exchange rate determination. First assignment due. (March 18th)
6. Fischer effect. Nominal and real exchange rates. Exchange rates and competitiveness. Balassa-Samuelson effect. (March 25th)
7. Nominal and real convergence in the EU. Introduction to the AA-DD model. (April 1st)
8. The AA-DD model: additional details. Application on policy analysis. (April 8th)
9. Fixed exchange rates: macroeconomic implications. Interventions and sterilization. Policy trilemma. Policy options for reaching internal and external balance. Swan diagram. (April 15th)
10. Monetary integration: costs and benefits. (April 22th)
11. Monetary integration: effects – empirical research. Equilibrium exchange rates: FEER. (April 29th)
12. A brief introduction into the models of balance of payments crises. Debts and developing countries. (May 6th)
13. Holiday – Dean’s day (May 13th)
14. Make up class. Forex forecasting: fundamental approaches versus alternatives. A brief overview of technical analysis. The future of IMS? Second assignment due. (May 20th)

Assignments/Teams, Quizzes

• Assignment results.
• Quizzes.
• Last quiz: 50 participants.
• The next quiz will be opened tonight, with the deadline of Monday, March 31st midnight.

Quiz #4: 47 Participants

• The slide presents a bar graph showing the distribution of participants' scores in Quiz #4. The x-axis represents score ranges, and the y-axis represents the number of participants. The data indicates the number of participants who scored within each specified range.

Reading for the Next Session:

• Maurer (2023): The Divergence of Price Levels in the European Union
• Krugman & Obstfeld & Melitz: International Economics (chapter 17)
• WB ICP: https://databank.worldbank.org/source/icp-2021/.

How about combining some of the parities?

• International Fisher Effect

(International) Fisher Effect (1)

• Linking relative PPP and interest rates.
• Condition of interest rate parity between dollar and euro asset: R$ = R€ + (E^{e}{$/€} - E{$/€}) / E_{$/€} (1)
• This should hold in both the long and short run.
• Long run: relative PPP should hold too: \frac{E{$/€,t} - E{$/€,t-1}}{E{$/€,t-1}} = \pi{US,t} - \pi_{EMU,t}

(International) Fisher Effect (2)

• If the original relative PPP holds it should also hold for expected inflation rates: \frac{E^{e}{$/€} - E{$/€}}{E{$/€}} = \pi^{e}{US} - \pi^{e}_{EMU} (2)
• Combining (1) and (2) leads to:
  • R$ − R€ = π^{e}{US} − π^{e}{EMU}
• Long run relationship between ongoing inflation and interest rates:
• Ceteris paribus, a rise in a country’s expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.
• Similarly, a fall in the expected inflation rate will eventually cause a fall in the interest rate.

(International) Fisher Effect (3)

• Implications of Fisher effect:
  • If US inflation were to rise permanently from a constant level of 5% per year to a constant level of 10% per year, dollar interest rates would eventually catch up with the higher inflation (and increase by 5 percentage points).
  • The real rate of returns on dollar assets (measured in US goods and services) would be unchanged!
• Interesting aspect:
  • A currency depreciates if its interest rates rise relative to foreign interest rates.
  • Why?
  • Long run equilibrium: a rise in the difference between home and foreign interest rates occurs only when expected home inflation rises (relative to the foreign interest rates).

Empirical Motivation

• This section likely motivates the empirical analysis and relevance of the topics being discussed, possibly with real-world examples or data observations.

Big Mac Indices and the GDP?

• The slide presents a scatter plot comparing Big Mac Index data (presumably as a measure of currency valuation) against GDP in USD. A linear regression is fitted to the data, with the equation y = 0.0007x - 50.416 and an R-squared value of 0.5553. This seems to analyze the relationship between the Big Mac Index and GDP, where the R-squared value indicates the proportion of variance in GDP that is explained by the Big Mac Index.

GDP Price Level Index

• The GDP price level index and PPP-based GDP per capita are plotted for different economies. The size of the bubble indicates the relative size of PPP-based GDP for each economy. The axes are presented in logarithmic scales. Used for comparing price levels and GDP per capita across different countries, adjusted for purchasing power parity (PPP).

Real Exchange Rates vis-à-vis Germany

• The slide contains multiple time-series graphs displaying real exchange rates vis-à-vis Germany for various Central and Eastern European countries, including Croatia, Poland, Estonia, Czech Republic, Hungary, Slovakia, Latvia, Lithuania, and Slovenia. The graphs show eerercpi and eererppi over time.

Balassa-Samuelson Effect

• Harrod-Balassa-Samuelson effect
• Ricardo-Viner-Harrod-Balassa-Samuelson-Penn-Bhagwati effect

International Price Differences

• Example from 2005…
• The slide presents a figure (Figure 7) illustrating cross-country differences in price level indexes by product groups, using the coefficient of variation as the metric. Various categories of goods and services are compared, including:
  • Machinery and equipment
  • Food and nonalcoholic beverages
  • Furnishings, household equipment, and maintenance
  • Recreation and culture
  • Other products
  • Clothing and footwear
  • Transport
  • Communication
  • Restaurants and hotels
  • Miscellaneous goods and services
  • Alcoholic beverages, tobacco, and narcotics
  • Construction
  • Housing, water, electricity, gas, and other fuels
  • Health
  • Education

Balassa-Samuelson Effect

• Balassa (1964), Samuelson (1964)
• Explains (some of) the problems of the simple PPP
• Basic assumptions:
  • Two types of goods (and services): Tradables and non-tradables!
  • PPP (absolute) holds only for tradables
  • Price of non-tradables depends on domestic wages
  • Domestic wages are determined in the tradable sector
  • Poorer countries have lower productivity in the tradable sectors (than rich countries), but similar productivity in non-tradable sectors

Equations of the Balassa-Samuelson Effect

• Tradables: Foreign price ($P<em>f^T$) x Exchange rate (S) = Domestic price ($P</em>d^T$)
• Wage: Domestic price ($P<em>d^T$) x Productivity in tradable sector ($a^T$) = Wages in tradables ($w</em>d^T$)
• Nontradables: Wages ($w<em>d^T$) = Wages in non-tradables ($w</em>d^N$) : Productivity in non-tradables ($a^N$) = Balassa – Samuelson Effect Domestic price ($P_d^N$)

Our Country: Lower Productivity in Tradables ($a_d^T$)

• Prices of tradables: identical (by assumption $P<em>d^T = S P</em>f^T$ (PPP holds for tradables)
• Wages in our country: lower foreign wages: $w<em>f^T = a</em>f^T P<em>f^T$ our wages: wd^T = ad^T Pd^T = ad^T S Pf^T = S ad^T Pf^T < S af^T Pf^T $w<em>d^T < w</em>f^T$
• Prices of non-tradables in our country: lower foreing NT prices: $P<em>f^N = w</em>f^N/ a<em>f^N = w</em>f^T/ a<em>f^N = a</em>f^T P<em>f^T/ a</em>f^N$ our NT prices: $P<em>d^N = w</em>d^N/ a<em>d^N = w</em>d^T/ a<em>d^N =$ $P</em>d^N = S a<em>d^T P</em>f^T / a<em>d^N < S a</em>f^T P<em>f^T/ a</em>f^N = P_f^N$
• Average price level in our country must be lower!

Implications:

• Existence of a systematic relationship between productivity in tradables (proxied by GDP per capita) and deviations from the PPP
• Practical issues:
  • Even if our employees in non-tradable sectors (e.g. services) the same productivity as in Germany, their wages will be lower…

But what if our productivity (tradables) starts to catch up with the foreign one?

• This is a transition to discussing the dynamic implications of productivity convergence on prices and exchange rates.

Dynamic Version: Our Productivity in Tradables Converges to Foreign and S=const.

• Prices of our tradables: remain stable $P<em>d^T = S P</em>f^T$ (PPP holds for tradables)
• Wages in our country: increase and converge to foreign wages $w<em>f^T = a</em>f^T P<em>f^T$ (const.) $w</em>d^T =↑ a<em>d^T P</em>d^T = ↑ a<em>d^T S P</em>f^T= ↑ S a<em>d^T P</em>f^T → S a<em>f^T P</em>f^T$
• Prices of non-tradables: increase and converge to foreign prices of non-tradables $P<em>f^N = w</em>f^N/ a<em>f^N = w</em>f^T/ a<em>f^N = a</em>f^T P<em>f^T/ a</em>f^N$ $P<em>d^N = w</em>d^N/ a<em>d^N = w</em>d^T/ a<em>d^N = ↑ S a</em>d^T P<em>f^T / a</em>d^N → S a<em>f^T P</em>f^T/ a_f^N$
• Average price level in our country: increases
• We are experiencing inflation and real appreciation

Balassa-Samuelson Effect (2)

• Implications of the productivity growth in tradable sector
• Increasing wages in the tradable sector
• “Wage disease” will lead to increasing wages also in the non-tradable sector
• If productivity in non-tradable sector does not change, increasing wages will lead to higher prices of non-tradables
• Let us consider two scenarios:
  • I. Constant nominal exchange rate (e.g. pegged exchange rate)
    • Stable prices of tradables, increasing prices of non-tradables
    • There is inflation caused by increasing prices of non-tradables
  • II. Nominal appreciation
    • Prices of tradable (in domestic currency) decrease, prices of non-tradables are increasing (less than in the case I)
    • Average price level can be constant (zero overall inflation)

Productivity and Real Wages in Industry

• Graphs showing productivity and wage data for Croatia, Poland, Czech Republic, Hungary, Slovakia, and Slovenia.

Another (Version of the) Explanation:

• Bhagwati-(Kravis-Lipsey) Effect

Explanation via K/L Differences

• Poor countries have lower capital-labor (K/L) ratios than rich countries
• Marginal product of labor in poor countries is therefore lower, therefore wages are lower too
• The production of non-tradable goods (e.g. services) is labor-intensive
• Labor in poor countries is cheaper and because it is intensively used in the production of non-tradable goods → non-tradable goods should be cheaper in poor countries
• Even if PPP holds for tradables, the overall price level should be lower in poor countries
• Hence again correlation between CPL and GDP per capita

Empirical Relevance of Balassa & Samuelson

• This section will likely present empirical evidence supporting or refuting the Balassa-Samuelson effect.

BS Effect: Euro and Prices/Inflation in the CEE/Czechia

• Czechia indeed had very differences relative prices (e.g. relative to Austria)
• Czechia was indeed experiencing very different speed of price adjustments for different commodities/services

ICP 2021: Czechia v. Austria Austrian price level in each category = 100

• Graph comparing price levels between Czechia and Austria using data from the International Comparison Program (ICP) 2021. The Austrian price level in each category is set to 100, and the Czechia/Austria ratio is shown for various categories.

Non-tradable prices were really growing faster…

• Figure displays inflation differential between non-tradables and tradables from 1993-2000 for Czech Republic, Hungary, Poland, and Slovenia. It comes from Backe et al (2003) and is based on implicit sectoral deflators of gross value added.

But productivities do not predict it perfectly…

• Figure 5 shows relative prices (non-tradables/tradables) with a base year of 1992. The observed price ratios are compared against the price ratio implied by sectoral productivity developments. The graph covers the Czech Republic, Hungary, Poland, and Slovenia, using data from Backe et al (2003).

Empirical Tests

• ..the Balassa-Samuelson effect for the transition economies is ‘ now well established and powerful ’ (Begg et. al ., 2001: ix),
• Egert (2002): analysis of the role of the BS effect in the CR, Hungary, Poland, Slovenia, and Slovakia
  • In the case of CR and SR almost zero estimated impact on inflation differentials in relation to Germany, for Hungary and Poland at most 3.5 perc. points.
• Other estimates:
  • Sinn & Reutter (2001): 2.88% for the CR, 6.86% for Hungary

Newer Empirical Tests

• Chen, Choi & Devereux (2015):
  • We test Balassa-Samuelson by quantifying the contribution of non-tradables to cross-sectional price level variation for countries in the International Comparison Program (ICP).
  • Our results suggest that non-tradables explain up to two thirds of price level variation.
• Bordo et al (2017):
  • Historical data for over hundred years and 14 countries is used to estimate the long-run effect of productivity on the real exchange rate.
  • … the traditional Balassa-Samuelson model is not consistent with these results
  • … we argue that changes in trade costs over time may affect the impact of productivity on the real exchange rate over time

Some Other Contributions to the Discussion

• Cincibuch, Martin, and Jiří Podpiera. "Beyond Balassa–Samuelson: Real appreciation in tradables in transition countries 1." Economics of Transition 14.3 (2006): 547-573.
• Alexis Derviz, 2020. "Sovereign Capital, External Balance, and the Investment-Based Balassa-Samuelson Effect in a Global Dynamic Equilibrium," Working Papers 2020/4, Czech National Bank.

Balassa-Samuelson and Policy-Making

• Transition to the policy implications of the Balassa-Samuelson effect.

BS Effect: ERM2, Euro and Inflation

• A tight peg to the euro might produce an inflation rate above the Maastricht ceiling
  • This happened in pre-entry Estonia or post-entry Ireland
• Reasons to expect higher inflation rate also after the introduction of Euro
• But:
  • This type of inflation (in prices of non-tradables) does not have negative effect on competitiveness (it is caused by increasing productivity and productivity should be increasing faster than price level)
  • Inflation caused by this effect should not be too strong (upper limit given by the productivity differential)

Convergence Criteria for Euro Adoption

• Lists the criteria for Euro adoption including:
  • Price stability
  • Sound and sustainable public finances
  • Durability of convergence
  • Exchange rate stability
• Explains how each criterion is measured and what the specific convergence criteria are.

Effects of Misalignments

• Effects of Sudden Depreciations and Appreciations

Debate about Effects of Misalignments (1)

• Baldwin & Krugman (1989): large exchange rate shocks can have persistent effects!
  • Model in which large exchange rate fluctuations lead to entry or exit decisions that are not reversed when the currency returns to its previous level.
  • Hysteresis?
• Very interesting example of a rather significant shock (unfortunately “contaminated” with additional shocks):
  • East Germany in 1990/1991

East v. West Germany: Comparison (1988/89)

• Presents a table comparing East and West Germany in 1988/89 across several economic indicators:
  • Population
  • Work force
  • Participation rate
  • Unemployment
  • GDP
  • GDP per employed worker
  • Gross wage (monthly, with employer’s contrib. to social insurance)
  • Average monthly government pension

The End of GDR

• October 7th, 1989 – 40th anniversary of GDR celebrated
• October 9th , 1989 – large demonstration in Leipzig
• November 9th, 1989 – Berlin Wall brought down
• November 28th, 1989 – Helmut Kohl’s speech: 10 Points Plan for Germany Unity
• March 18th, 1990 – free election in GDR
  • Results: victory for “The Alliance for Germany”: 48%
  • Both main parties for reunification, but differed in opinions on procedural issues:
    • Conservative “Alliance for Germany” - promised fast reunification during which the East simply accedes to the West
    • Social Democrats (22%) – slower process with slightly bigger considerations for the GDR (common constitution,…)
• August 22nd, 1990 - the Volkskammer voted in favor of acceding to West Germany.
• October 2nd – the last session of East German Parliament
• October 3rd – the country ceased to exist…

Reunification: Economic Aspects

• May 18th, 1990 – treaty on Monetary, Economic and Social Union signed
• July 1st, 1990 – union came into effect (economic unification)
  • Monetary union: W. German currency replaced the original currency of GDR
  • Economic union: GDR lost its economic independence, started receiving assistance from W. Germany
• August 31st , 1990 – Unification Treaty signed
• October 3rd, 1990 – official unification, end of GDR
• Summary:
  • Full economic and political union (including mobility of labor and monetary integration) within one year, no real time for adaptation and convergence
  • Compare the speed with the lengthy preparation and stringent criteria for EMU

Exchange Rates Before the Monetary Union

• Exchange rates between the Marks during the times of GDR
• Official rate 1:1 (necessary for political reasons)
• Internal GDR rate for trade 4.4:1
• Black market exchange rates estimated to be between 5:1 – 15:1
• Other former CPEs experienced substantial initial devaluation that brought their exchange rates towards convertible currencies close to the original black market levels

Helmut Kohl in 1990

• Slogan for Parliamentary election:
  • „Nobody will be worse off and many will be better off“.

Conversion Rates

• For flows: 1 DEM per 1 DDM
• For assets:
  • German citizens – part of assets at 1:1, the rest at 2:1
    • 25 years and younger: 2000 DM at 1 DEM per 1 DM
    • 26 – 60 years old: 4000 DM
    • Above 60: 6000 DM
  • Assets held by non-residents accrued after 1989: 1 DEM per 3 DDM
  • Other assets: 1 DEM per 2 DDM (including e.g. debts of firms)
• Implications: conversion rates made the price of East German labor too high (relative to productivity) and debts of the firms too big

Trade Shock for Former GDR

• Graph showing trade shock for former GDR with billions of 1990: 2H deutsche marks, quarterly rated.

East-German Industry

• Graph showing East-German industry 1985 = 100, and 1990 = 100, manufacturing industry output.

Employment

• Presents a figure illustrating the U-curve of employment in Eastern Germany. The graph shows employed persons, labour force, Residual, Emigrants and commuters, Registered unemployed, Short-time workers.

How about an initial devaluation instead?

• This is a discussion point regarding alternative economic policies for the GDR.

Czechoslovakia, 1991

• Graph displaying exchange rates (CZK/EUR, CZK/USD) and PPP rates for Czechoslovakia from 1990-2008.

Exports and Imports

• Graph presents exports and imports of goods in EUR mn for Czechoslovakia from 1990-2006.

Implications

• Import prices increase
• Inflation increases
• Real exchange rates will be catching up quickly
• Temporary positive effects on the economy?
• “Transformation cushions”
• Possibility of negative effects of deep devaluations?
  • Lower quality of information due to inflation
  • Structural effects?
  • Motivational effects – effects on labour markets?

And how about less extreme versions of the policies?

• This suggests considering moderate policy interventions as opposed to extreme measures.

Debate about Effects of Misalignments (2)

• Rodrik (2008) tests effects of undervaluation (misalignments) for growth?
  • Gist of the approach:
  • Conclusion?
  • Undervaluation good for growth?
• Newer results:
  • Cuestas et al (2020): Real exchange rate misalignments in CEECs: Have they hindered growth?
    • Exchange rate overvaluation has a negative impact on economic activity.
    • The effect of misalignments on economic activity seems to be nonlinear, as overvaluation has a stronger effect than undervaluation.
• $lnRER<em>{it} = α + βlnRGDPC</em>{it} + f<em>i + u</em>{it}$
• $lnUNDERVAL<em>{it} = lnRER</em>{it} − lnRER̂_{it}$
• $growth<em>{it} = α + βlnRGDPC</em>{i,t−1} + δlnUNDERVAL<em>{it} + f</em>i + f<em>t + u</em>{it}$

Rodrik (2008) Regression Results

• Presents regression results from Rodrik (2008) on the effects of undervaluation on economic growth. The table shows various regression specifications with different samples of countries (all, developed, developing) and time periods.

Debate about Effects of Misalignments (2)

• Rodrik (2008) tests effects of undervaluation (misalignments) for growth?
  • Gist of the approach:
  • Conclusion?
  • Undervaluation good for growth?
• Newer results:
  • Cuestas et al (2020): Real exchange rate misalignments in CEECs: Have they hindered growth?
    • Exchange rate overvaluation has a negative impact on economic activity.
    • The effect of misalignments on economic activity seems to be nonlinear, as overvaluation has a stronger effect than undervaluation.
• $lnRER<em>{it} = α + βlnRGDPC</em>{it} + f<em>i + u</em>{it}$
• $lnUNDERVAL<em>{it} = lnRER</em>{it} − lnRER̂_{it}$
• $growth<em>{it} = α + βlnRGDPC</em>{i,t−1} + δlnUNDERVAL<em>{it} + f</em>i + f<em>t + u</em>{it}$

Thank you for Your Attention!

• This is a concluding slide, expressing gratitude to the audience.

References and Sources of Data

• KOM – chapter 16
• Backe et al (2003): Price Dynamics in Central and Eastern European EU Accession Countries. Emerging Markets Finance and Trade.
• Balassa (1964): The Purchasing-Power Parity Doctrine: A Reappraisal. JPE
• Samuelson (1964): Theoretical Notes on Trade Problems, Review of Economics and Statistics
• Bordo et al (2017): The real exchange rate in the long run: Balassa-Samuelson effects reconsidered. Journal of International Money and Finance Volume 75, July 2017, Pages 69-92
• J. von Hagen, R.R. Strauch, G. Wolff (2002): East Germany: Transition with Unification, Experiment and Experiences. ZEI working paper B19/2002
• Economist (2015) – Germany’s reunification 25 years on
• Economist (2019) - Thirty years after the Berlin Wall fell Germans still don’t agree on what reunification meant
• Rogoff (1996): The Purchasing Power Parity Puzzle. Journal of Economic Literature, Vol. 34, No. 2 (Jun., 1996), pp. 647-668