International Finance - Lecture VIII – April 8th

International Finance - Lecture VIII – April 8th

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

Tariffs and Exchange Rates

• Cole (2025): How Will President Trump’s Tariffs Affect the Value of the Dollar?
• A country that implements tariffs can sometimes expect its currency value to increase.
• An IMF study (1963-2014, 151 countries) showed that tariff increases led to real exchange rate appreciation, but only mild trade balance impacts.
• This aligns with economic theory on average, but isn't always true.
• Currency appreciation is a common impact of tariffs.
• The volatile nature of the regime might dampen the currency effect of tariffs.
• Other effects (such as the US becoming a less attractive place to invest) may dominate instead.

Market Response to New Tariffs

• New reciprocal tariffs announced on Wednesday, April 2nd.
• Very high and detached from existing trade policies.
• China retaliated on Friday, April 4th.
• Stock markets experienced a negative shock.
• Currencies were influenced, leading to dollar depreciation.
• Reuters: Dollar sinks as investors grapple with tariff aftermath.
• Uncertainty in the markets.

Stock Market Performance (April 7, 2025)

• S&P 500: 5,062.25 (9.84% decline in 1 month)
• Dow Jones Industrial Average: 37,965.60 (9.42% decline)
• Nasdaq-100: 17,430.68 (10.29% decline)
• Nasdaq Composite: 15,603.26 (10.68% decline)
• S&P/TSX Composite Index: 22,859.46 (6.24% decline)

Historical Comparison of S&P 500 Declines (Two-Day Period Ended)

• Oct. 19, 1987: -24.6%
• Oct. 20, 1987: -16.2%
• Nov. 20, 2008: -12.4%
• March 12, 2020: -13.9%
• April 4, 2025: -10.5%
• The S&P 500 decline on April 4, 2025, was a rare event, seen only 5 times in 80 years.

Exchange Rate Movements (as of April 8, 2025)

• USD to EUR: -1.48% (1W), 1 USD = 0.913761 EUR
• USD to JPY: -1.57% (1W), 1 USD = 146.863 JPY
• USD to CAD: -1.44% (1W), 1 USD = 1.4187 CAD

WSJ Headline

• Trump’s Tariffs Were Supposed to Boost the Dollar. Why the Opposite Happened.
• Long-term U.S. growth worries could matter more for the currency than the tariffs' mechanical impact.

Course Outline

• Assignments and quizzes.
• DD-AA model additional issues.
• Adding the XX Curve.
• Behind the XX curve: Marshall-Lerner condition.
• DD-AA-XX under floating.
• Policy experiments.
• DD-AA-XX under fixed exchange rates.

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. Next week: no class. Topic for the “midterm break”: Monetary integration: costs and benefits. (April 15th)
10. Monetary integration: effects – empirical research. Policy options for reaching internal and external balance. Swan diagram. Equilibrium exchange rates: FEER. (April 22nd)
11. Fixed exchange rates: macroeconomic implications. Interventions and sterilization. Policy trilemma. (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

• Next week: no lecture!
• Assignment results
• Quizzes
• Last quiz: 44 participants
• The next quiz will be opened by Thursday midnight, with the deadline of Monday, April 21st midnight

Reading for the Next Session and Next Week:

• Text related to AA-DD and exchange rates: KOM – chapter 18
• Texts on the OCA and EMU:
  • KOM - chapter 20: Optimum Currency Areas and the European Experience
  • De Grauwe (1991): Costs and Benefits of a Monetary Union
  • De Grauwe (2006): What Have we Learnt about Monetary Integration since the Maastricht Treaty?
• As a motivation: a few questions focused on the assigned reading might be added to the next quiz

Exchange Rate and Macroeconomics in the Short Run: DD-AA Model

• Based on official slides for the Krugman-Obstfeld-Melitz book.

Adding the Current Account (XX)…

Macroeconomic Policies and the Current Account

• XX schedule
• Shows combinations of the exchange rate and output at which the CA balance would be equal to some desired level.
• This desired level can be different; the XX curve does not have to go through the intercept of the DD and AA schedules.
• Some authors call it the Iso-CAB curve.
• It slopes upward because a rise in output encourages spending on imports and thus worsens the current account (if it is not accompanied by a currency depreciation).

XX Schedule

• It is flatter than DD.
• The DD curve represents equilibrium values of aggregate demand and domestic output, and moving along the DD curve to the right increases the current account.
• The XX schedule shows the combination at which the current account does not change.
• The marginal propensity to consume is less than one, not all the extra GNP will be spent on consumption goods; some will be saved. Nevertheless, aggregate demand must rise up to match the increase in supply.
• Since all the increase in demand cannot come from consumption, the remainder must come from the current account.

Behind the XX Curve

• Does nominal depreciation lead to real depreciation?
• Does real depreciation improve the CA?

Exchange Rate Pass-Through and Inflation

• The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.
• Degree of Pass-through
  • The percentage by which import prices rise when the home currency depreciates by 1%.
  • In the DD-AA model, the degree of pass-through is 1.
• Exchange rate pass-through can be incomplete because of international market segmentation.
• Currency movements have less-than-proportional effects on the relative prices determining trade volumes.

Marshall-Lerner Condition & J-Curve

J-Curve Effect

• Cause: Time lags in producer and consumer responses.

Devaluations and Trade Balance? Marshall-Lerner Condition

• Elasticity approach to balance of payments
• Alfred Marshall, Abba Lerner, J. Robinson, F. Machlup
• Central question:
  • How does devaluation affect the current account?
  • Does the devaluation of a currency improve the country’s balance of trade?
• M-L condition:
  • Condition that guarantees that devaluation will improve the current account
  • The condition is based on elasticities
• Price elasticity shows the sensitivity of an economic variable to a change in price
• E.g. price elasticity of demand for exports: η_x = \frac{dS}{S} / \frac{dX}{X}

ML Condition - Mathematics

• Normalize P and P* to 1
• Elasticities: Additional assumption: Balanced trade
• CA = P \cdot Xv - S \cdot P^* \cdot Mv
• CA = X − S \cdot M
• dCA = dX − dS \cdot M − S \cdot dM
• \frac{dS}{dS} \frac{dM}{M}
• S \frac{dS}{S} \frac{dX}{X} η_x =
• S \frac{dS}{S} \frac{dM}{M} η_m = −
• \frac{M}{M} \frac{S}{X} \frac{dS}{dS}
• dCA = dX − dS \cdot M − S \cdot dM
• dCA = dX - \frac{dS}{S} X ηx + \frac{dS}{S} M ηm
• = \frac{dS}{S} M (ηm + ηx -1)
• \frac{M}{X} = 1
• S \cdot M = X
• \frac{dS}{dCA} = \frac{M}{X} \cdot (ηm + ηx -1)

ML Condition - Interpretation

• Devaluation will improve the trade balance only if:
  • this means that export and import must be sufficiently elastic with respect to price!
• ηx + ηm > 1

Empirical Evidence on Elasticities

• Elasticities on 2-3 year period, 1969-1981, data from Pilbeam (1992), resp. Gylfasson (1987)
  

• Rose (1991) The Role of Exchange Rate in a Popular Model of International Trade: Does the “Marshall-Lerner” Condition Hold?
• A variety of parametric and non-parametric techniques used on data for five OECD countries
• “There is little evidence that the exchange rate significantly affects the trade balance”.
• Many simpler and single-country-focused papers can be found
• Results?

Summary

• A temporary increase in the money supply causes a depreciation of the currency and a rise in output.
• Permanent shifts in the money supply cause sharper exchange rate movements and therefore have stronger short-run effects on output than transitory shifts.
• If exports and imports adjust gradually to real exchange rate changes, the current account may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.

Traditional Policy Applications of the DD-AA Model

How Macroeconomic Policies Affect the Current Account

Macro Policies and the Current Account

• Monetary expansion causes the CA balance to increase in the short run.
• Expansionary fiscal policy reduces the CA balance.
• If it is temporary, the DD schedule shifts to the right.
• If it is permanent, both AA and DD schedules shift.

Complete Adjustment (Expansionary Monetary Policy with Floating Exchange Rates)

• The money supply increases.
• Real money supply will exceed real money demand in the economy.
• Households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets.
• This raises the supply of long-term deposits and the amount of funds available for banks to loan.
• More money to lend will lower our interest rates
• Since RoRCZK < ROREUR now, there will be an immediate increase in the demand for foreign currency, thus causing an appreciation of the euro and a depreciation of the CZK.
• The exchange rate (ECZK/EUR) rises (point 2 on the AA-DD diagram).
• The AA curve has shifted up to reflect the new set of asset market equilibria corresponding to the higher Czech money supply.
• Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new A′A′ curve for very long.

Complete Adjustment (2)

• Nominal exchange ↑ → real exchange rate↑
• Foreign goods and services are relatively more expensive
• Demand for our exports decreases, our imports decrease
• CA increases, aggregate demand exceeds Y
• Inventories fall → signal to increase domestic production
• Shift to the right of point 2
• Rising Y → growing money demand → higher interest rates
• Reversal: CZK rates higher than EUR, CZK appreciation required
• This moves the economy downward, back to AA’
• Remember: asset markets respond quickly
• This process continues until we converge to point 3.

Expansionary Monetary Policy with Floating Exchange Rates

• Implications:
  • Output increased.
  • Overshooting happened.
  • Currency depreciated.
  • CA improved.

Expansionary Fiscal Policy with Floating Exchange Rates

Complete Adjustment (Expansionary Fiscal Policy with Floating Exchange Rates)

• Increase in G (or TR, or reduction in T)
• Increase in aggregate demand
• Declining inventories → Y starts increasing
• Economy moves to the right of point 1
• Increasing Y → increasing money demand
• Returns on CZK increase, CZK appreciates
• Economy moves downwards (returns to AA)
• This process continues until we converge to point 2

Expansionary Fiscal Policy with Floating Exchange Rates

• Implications:
  • Output increased
  • Currency appreciated
  • CA got worse

Summary of the Previous Examples: Under Floating…

• Expansionary monetary policy (↑MS) causes an increase in GNP and a depreciation of the domestic currency in the short run.
• Contractionary monetary policy (↓MS) causes a decrease in GNP and an appreciation of the domestic currency in the short run.
• Expansionary fiscal policy (↑G, ↑TR, or ↓T) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policy (↓G, ↓TR, or ↑T) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.

Additional Simple Examples

• How would a negative shock in the demand for Czech exports influence the Czech exchange rate and Czech current account?
• How can the government respond to such a shock?

Another (and Less Likely) Example: Liquidity Trap

• 0 = R^* + (E_e – E)/E
• E = E_e / (1 - R^*)

Liquidity Trap: Explanation

• Liquidity trap occurs at a situation when the central bank is not able to lower the interest rate because it is already set to zero.
• In such a case, monetary policy is totally ineffective. Why?
• An increase in the money supply shifts the AA schedule to the right, and the equilibrium still remains at point 1, i.e., output is still below its full employment level
• A key assumption for the theory of liquidity trap is the fixed level of expected exchange rate Ee.
• If the central bank can credibly promise to raise the money supply permanently, the expected exchange rate Ee would increase.

AA-DD and Fixed Exchange Rates

Reminder: Fixed ER

• Crucial feature:
  • The central bank defends a selected preferred level of exchange rate.
• Defense – interventions
  • Oral interventions, speeches, etc.
  • Actual operations in forex markets
  • Non-sterilized interventions – purchases/sales of foreign currency
  • Sterilized interventions – purchases/sales of foreign currency while attempting to keep the monetary base stable
• And of course: they can respond by changing other parameters of the monetary policy (minimum reserve requirements, convertibility) – but we will leave this aside for a moment.

CEB: Balance Sheet (1)

• Non-sterilized intervention: interventions influences monetary base!

CEB: Balance Sheet (2)

• Sterilized intervention: compensation of effects on the monetary base!

Monetary Expansion: Explanation

• The central bank attempts to increase the money supply; the AA curve should move to the right.
• This will reduce interest rates, and it will lead to a pressure towards the depreciation of the domestic currency.
• The central bank will defend the original exchange rate by intervening (selling foreign currency and buying the domestic currency).
• An unsterilized intervention will reduce the central bank’s FOREX reserves and the monetary base.
• The AA curve will be returning back to the original position.
• Monetary policy becomes impotent….

Fiscal Expansion: Explanation

• Government increases G or reduces T; the DD curve will shift to the right.
• This will increase interest rates, and it will lead to a pressure towards the appreciation of the domestic currency.
• The central bank will defend the original exchange rate by intervening (buying foreign currency and selling the domestic currency).
• An unsterilized intervention will therefore increase the central bank’s FOREX reserves and the monetary base.
• The AA curve will therefore move to the right.
• The Central Bank is forced to support the fiscal stimulus; the effect of fiscal policy is enhanced.