International Finance Notes

Reminders for Final Exam:

• Saturday, May 3rd, from 4:30 PM to 7:00 PM in the usual classroom.
• Bring a calculator.
• The exam consists of 50 multiple-choice questions.
• You are allowed a reference sheet: one side or both sides of a single sheet of paper, which can be typed, handwritten, or a combination of both.

Final Exam Reviews:

• Wednesday, 1-3 PM via Zoom
• Friday, 10 AM-12 PM in HUMN 1B50

Faculty Course Questionnaires (FCQs)

• FCQs are open for completion.

Module 15 – International Finance

• Big Questions & Learning Objectives:
  • What determines exchange rates?
  • Why do exchange rates rise and fall?
  • What is purchasing power parity?
  • What causes trade deficits?

From Last Time – International Trade

• International trade includes:
  • Goods and services
  • Assets
  • Currency
• The focus shifts from the trade of goods and services to the exchange of currency and assets.

International Finance – Exchange Rates

• The exchange of different currencies is vital for international trade.
• To purchase foreign goods and services, one must first acquire the respective currency.
• Exchange rates affect imports and exports, playing a crucial role in determining GDP.

International Finance – Exchange Rates

• Types of exchange rates:
  • Nominal Exchange Rate:
    • The number of units of foreign currency that one unit of domestic currency buys.
    • Example: Euros per dollar.

Changes in Exchange Rates

• Nominal exchange rates change rapidly due to factors like:
  • Demand for goods and services
  • Domestic monetary policy
  • Foreign monetary policy
  • Economic fluctuations
• Currency Appreciation:
  • Occurs when a currency becomes more valuable relative to other currencies.
  • Other currencies become relatively cheaper (easier to buy).
• Currency Depreciation:
  • Occurs when a currency becomes less valuable relative to other currencies.
  • Other currencies become more difficult to buy.

Changes in Exchange Rates

• Currencies tend to experience trends of appreciation or depreciation with variability.
• U.S. Dollar to Euro Exchange Rate Example: April 2024 – April 2025 (illustrative graph)

Changes in Exchange Rates

• Viewing exchange rates from the U.S. perspective for simplicity.
• Example:
  • Suppose the U.S. dollar can currently purchase 4 euros. $Nominal Exchange Rate = \frac{4}{1}$
  • If the U.S. dollar appreciates, it can buy more euros. $Nominal exchange rate increases à \frac{6}{1}$
  • If the U.S. dollar depreciates, it can buy fewer euros. $Nominal exchange rate decreases à \frac{2}{1}$

Foreign Exchange Market

• Exchange rates are a type of price.
• The prices of foreign currency are determined in foreign exchange markets.
  • Prices are determined by the supply and demand of each currency.
    • Supply: Determined by the central bank (or government).
    • Demand: Determined by the demand for that country’s goods and services on the world market.
      • Known as “Derived demand” because the demand for dollars is determined by the demand for U.S. goods across the rest of the world.

Demand for Foreign Currency

• Demand for currency is downward sloping.
• Determinants of currency demand:
  • The exchange rate
  • Demand for foreign goods and services
  • Demand for foreign financial assets

Demand for Foreign Currency

• Demand for currency is downward sloping.
• Determinants of currency demand:
  • The exchange rate
  • Changes in the exchange rate cause movements along the demand curve.
    • Increase in exchange rate (appreciation):
      • Easier to buy foreign currency.
      • Foreign goods become relatively cheaper.
      • Imports rise, exports fall.
      • Net exports fall.

Demand for Foreign Currency

• Demand for currency is downward sloping.
• Determinants of currency demand:
  • The exchange rate
  • Changes in the exchange rate cause movements along the demand curve.
    • Decrease in exchange rate (depreciation):
      • Harder to buy foreign goods.
      • Domestic goods become relatively cheaper.
      • Imports fall, exports rise.
      • Net exports rise.

Demand for Foreign Currency

• Demand for currency is downward sloping.
• Determinants of currency demand:
  • Demand for foreign goods and services
    • Example: Demand for U.S. goods rises.
      • Consumers in other countries require more U.S. dollars to purchase U.S. goods.
      • Exports increase.
      • Net exports increase.
      • Shift to the right in demand curve.

Demand for Foreign Currency

• Demand for currency is downward sloping.
• Determinants of currency demand:
  • Demand for foreign financial assets
    • Example: Suppose the demand for U.S. financial assets increases (because the U.S. seems like a stable, low-risk investment).
      • Foreign investors require more U.S. currency.
      • Demand for U.S. dollar increases.

Foreign Exchange Markets - Supply

• The supply of a currency is set by the central bank (or central government).
• Similar to the Money Demand – Money Supply diagram, this implies that the supply of currency is fixed.
  • Vertical supply curve (does not depend on exchange rate).
  • Supply changes when the central bank (Fed) increases or decreases the money supply.

Foreign Exchange Markets - Supply

• The supply of a currency is set by the central bank (or central government).
• Similar to the Money Demand – Money Supply diagram, this implies that the supply of currency is fixed.
  • Vertical supply curve (does not depend on the exchange rate).
  • Supply changes when the central bank (Fed) increases or decreases the money supply.

Foreign Exchange Market – Determining Exchange Rates

• The nominal exchange rate works to balance out the forces of supply and demand for a country’s currency.
• In equilibrium, the quantity of currency demanded equals the quantity of currency supplied.

Foreign Exchange Market – Determining Exchange Rates

• Shifts in demand can cause a currency to appreciate or depreciate.
  • Increase in demand:
    • More people competing for a limited supply of dollars.
    • Price of the dollar in the exchange market increases.
    • Increases in demand cause appreciation.
  • Decrease in demand:
    • Fewer people require U.S. dollars abroad.
    • Price of the dollar in the exchange market falls.
    • Decreases in demand cause depreciation.

Foreign Exchange Market – Determining Exchange Rates

• Monetary policy can also be used to affect exchange rates by changing the supply of currency available on the exchange market.
  • Increases in Supply (expansionary monetary policy):
    • Dollars are more abundant.
    • The price of dollars decreases.
    • Depreciation.
  • Decreases in Supply (contractionary monetary policy):
    • Dollars are more scarce.
    • The price of dollars increases.
    • Appreciation.

Foreign Exchange Market

• There is no such thing as a “good” or “bad” exchange rate.
• Changes in exchange rates can cause changes in purchasing power, demand for foreign goods and services, and demand for foreign assets.
• In general:
  • Low exchange rates can sustain high demand for exports, making goods cheaper on the world market.
  • High exchange rates increase purchasing power for foreign goods, leading to a higher level of imports and fewer exports.

Foreign Exchange Market

• Most countries allow the value of their currency to fluctuate on the foreign exchange market i.e. a floating exchange rate – letting the exchange rate be determined by natural movements in supply and demand.
• Due to the effects on net exports (and therefore GDP), some countries choose to use monetary policy to manipulate their exchange rate i.e. a fixed exchange rate – holding your exchange rate constant with respect to another currency.

Foreign Exchange Market – Currency Manipulation

• Due to the effects on net exports (and therefore GDP), some countries choose to use monetary policy to manipulate their exchange rate.
  • Fixed exchange rate – holding your exchange rate constant with respect to another currency.
    • Example: China used to use monetary policy to hold the exchange rate between the yuan and USD at lower levels.
      • Result:
        • Higher international demand for Chinese goods and services.
        • China’s export sector boomed.

Purchasing Power Parity – Law of One Price

• The Law of One Price states that identical goods sold in different locations must sell for the same price.
• Example: Coffee in Boulder and Broomfield
  • Suppose that one pound of coffee sells for $10 in Boulder and $5 in Broomfield.
  • What do you expect to happen to the price of coffee in Boulder and Broomfield over time?

Purchasing Power Parity – Law of One Price

• The Law of One Price states that identical goods sold in different locations must sell for the same price.
• Example: Coffee in Boulder and Broomfield
  • Suppose that one pound of coffee sells for $10 in Boulder and $5 in Broomfield.
  • What do you expect to happen to the price of coffee in Boulder and Broomfield over time?
    • Suppliers will increase supply in Boulder à more supply decreases the price.
    • Suppliers will decrease supply in Broomfield à less supply increases the price.
    • Eventually, the prices will equate.

Purchasing Power Parity – Law of One Price

• The Law of One Price states that identical goods sold in different locations must sell for the same price.
• After accounting for transportation costs and trade barriers, this should hold true across international borders as well.
• Purchasing Power Parity:
  • The idea that a unit of currency should be able to buy the same quantity of goods and services in any country.
  • The Real Exchange Rate must equal one. $\frac{ePh}{Pf} = 1$

Purchasing Power Parity – Law of One Price

• Purchasing Power Parity – the idea that a unit of currency should be able to buy the same quantity of goods and services in any country.
  • The Real Exchange Rate must equal one $\frac{ePh}{Pf} = 1$
• If Purchasing Power Parity holds true, then $e = \frac{Pf}{Ph}$

Purchasing Power Parity – Law of One Price

• Purchasing Power Parity – the idea that a unit of currency should be able to buy the same quantity of goods and services in any country.
  • The Real Exchange Rate must equal one
• Under Purchasing Power Parity
  • The nominal exchange rate perfectly balances out the difference in price level across countries
• Do we expect Purchasing Power Parity to hold?

Purchasing Power Parity – Law of One Price

• Do we expect Purchasing Power Parity to hold?
  • Probably not
• In the short-run, Purchasing Power Parity (PPP) does not hold
  • In the long-run, prices do adjust to move toward PPP
• Reasons why PPP does not hold:
  • Goods and services must be identical
  • Some services are not tradeable
  • Trade barriers may permanently prevent PPP

The Big Mac Index

• Economists developed a unique (and fun) way to analyze real exchange rates called the Big Mac Index.
  • Allows people to track the price of a Big Mac in U.S. dollars.
  • After exchanging your currency into local currency, a Big Mac should cost the same in every country according to PPP.

The Big Mac Index

• Economists developed a unique (and fun) way to analyze real exchange rates called the Big Mac Index.
  • Allows people to track the price of a Big Mac in U.S. dollars.
  • After exchanging your currency into local currency, a Big Mac should cost the same in every country according to PPP.

Connecting the Dots

• Because the demand for foreign goods and services requires converting currencies, international trade and finance are linked together.
• Balance of Payments – method of tracking payments across borders
  • Current Account – tracks payments for goods and services, current income from investments
    • U.S. has a deficit (inflows > outflows)
  • Capital Account – tracks payments for real and financial assets, extensions of international loans
    • U.S. has a surplus (outflows > inflows)

Current Account Transactions versus Capital Account Transactions

• The Balance of Payments keeps track of all transactions that cross international borders
  

• The current and capital accounts must balance out
• Current Account Balance + Capital Account Balance = 0
• If the current account is in a deficit, the capital account must be in surplus (and vice versa)

Balance of Payments Identity

• The current and capital accounts must balance out
• Example: Suppose that the trade deficit is zero $(NX=0)$
• Then the capital account must be balanced too Suppose you buy a $40,000 Japanese car:
  • Imports increase by $40,000
  • Current Account Balance = -$40,000
  • You exchanged $40,000 (U.S. financial asset) for the car
  • Capital account balance: $40,000

Current and Capital Balances - US

• The current and capital accounts mirror each other
• As a trade deficit grows (current account becomes more negative), the capital account surplus increases (becomes more positive)