Exchange rate theories and

introduction to international accounting

International Economic Relations

EBC1030/EBC1031: Period 5, 2018
School of Business and Economics (SBE)

Karsten Mau

Maastricht University, Department of Econmics (AE2)

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 Exchange rates recap
Questions

What determines exchange rates, why are some volatile and others fixed?
I concept of arbitrage (exchange rates, investment, products)
I long-run versus short-run view

Why do exchange rates matter?

I any international economic transactions, foreign borrowing/lending
I economic stability and political accountability crucial

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 Exchange rates recap
Arbitrage

Arbitrage exploits price differences of a → currency

across locations directly and indirectly

UK = E US E
E$/£ $/£ E$/£ = E $/U
U/£

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 Exchange rates recap
Arbitrage

Arbitrage exploits differences in returns to → investment

covered interest parity (CIP) uncovered interest parity (UIP)

e
E$/£
F$/£
(1 + i$ ) = (1 + i£ ) (1 + i$ ) = (1 + i£ )
| {z } E$/£ | {z } E$/£
domestic return | {z } domestic return | {z }
foreign return expected foreign return

1+i$ e 1+i£
F$/£ = E$/£ 1+i £
E$/£ = E$/£ 1+i $

spot rate and interest rates determine expected rate and interest rates de-
future rate termine spot rate

e
∆E$/£
→ UIP approximation: i$ = i£ + E$/£
see Chapter 13

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 Exchange rates recap
Arbitrage

Arbitrage exploits international price differences of → goods

for single items for basket of goods

g g
PUS = E$/£ PUK PUS = E$/£ PUK
| {z } | {z }
Law of one Price absolute PPP

E$/£ PUK
implies real exchange rate qUS/UK = PUS =1

PUS
... and theory of exchange rate: E$/£ = PUK
(if qUS/UK =1)

e
∆E$/£
→ relative PPP E$/£ = πUS − πUK
considers rate of change
| {z }
inflation differential

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 Exchange rates recap
The long-run theory

Based on relative PPP → monetary approach

I two theories

quantity theory general theory

money market in country c

Mc Mc Mc Mc
Pc = L̄c Yc ⇔ Pc = L̄c Yc Pc = Lc (ic )Yc ⇔ Pc = Lc (ic )Yc

express in rates of change

πc = µc − gc πc = µc − gc

plug into relative PPP for US and UK

e
∆E$/£
E$/£ = πUS − πUK = (µUS − gUS ) − (µUK − gU K )

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 Exchange rates recap
The long-run theory

Difference between quantity theory and general theory only in L

I quantity theory: liquidity preferences constant → L̄
I general theory: liquidity preferences depend negatively on i → L(i)

The general theory determines i through UIP and PPP (in the long run)

e
∆E$/£
UIP → i$ − i£ = E$/£
= πUS − πUK ← relative PPP

→ Fisher effect: i$ − i£ = πUS − πUK

I increase in money supply rate (µ ↑) increases inflation (π ↑) and interest rate (i ↑)

I higher interest rate lowers money demand (L(i) ↓)
I real money balances decline

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 Exchange rates recap
The long-run theory

Analysis of monetary approach using quantity theory (i.e., L ≡ L̄)

e
∆E$/£
E$/£
= πUS − πUK = (µUS − gUS ) − (µUK − gU K )
I Assume: gUS = 0, µUK = 0, gUK = 0, and µUS > 0
e
∆E$/£
I Implies: µUS = πUS = >0
E$/£

I New policy: µ0US = µUS + ∆µ, so that µ0US > µUS

Effects
I inflation adjusts: µ0US = πUS
0
> πUS
I real money balances unchanged: M↑
P↑
= L̄Y
e
∆E$/£ 0 e
∆E$/£
I depreciation rate adjusts: µ0US = >
E$/£ E$/£

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 Exchange rates recap
The long-run theory

Analysis of monetary approach using general theory (i.e., L ≡ L(i))

e
∆E$/£
E$/£
= πUS − πUK = (µUS − gUS ) − (µUK − gU K )
I Assume: gUS = 0, µUK = 0, gUK = 0, and µUS > 0
e
∆E$/£
I Implies: µUS = πUS = >0
E$/£

I New policy: µ0US = µUS + ∆µ, so that µ0US > µUS

Effects
I inflation adjusts: µ0US = πUS
0
> πUS
I Fisher effect: πUS ↑ ⇒ i$ ↑
I real money balances must fall: M
P
↓= L(i) ↓ Y
I price level jumps up and grows at higher rate
I exchange rate jumps up and grows at higher rate

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 Exchange rate recap
Nominal anchors

Besides exchange rate theory, we note that monetary policy can be

important for economic outcomes
I especially through prices and inflation
I high/volatile inflation rates not desirable ⇒ use long-run nominal anchor

1. Exchange rate target

∆E$/£
I based on relative PPP equation: πUS = + πUK
E$/£

2. Money supply target

I based on quantity theory approach: πUS = µUS − gUS

3.Inflation target and interest rate policy

I based on Fisher effect and real interest parity: πUS = iUS − r ∗

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 Exchange rate theory II
A short-run theory

Problem: monetary approach cannot explain short-run x-rate movements

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 Exchange rate theory II
A short-run theory
e
∆E$/£
Asset approach considers currency as an asset ⇒ UIP: i$ = i£ + E$/£
I combines forex market with quantity theory of money
I prices are sticky in short run; interest rates ensure money market equilibrium

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 Exchange rate theory II
A short-run theory
Consider short run adjustments to monetary contraction I
I US is home country, UK is foreign; contraction is temporary

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 Exchange rate theory II
A short-run theory
Consider short run adjustments to monetary contraction II
I US is home country, UK is foreign; contraction is temporary

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 Exchange rate theory II
Combining short-run and long-run theory
Consider short run adjustments to monetary contraction III
I US is home country, UK is foreign; contraction is permanent

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 Exchange rate theory II
Combining short-run and long-run theory
Consider short run adjustments to monetary contraction IV
I US is home country, UK is foreign; contraction is permanent

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 Exchange rate theories: wrap-up
Short- and long-run and the Trilemma

Monetary and asset approach combine to unified theory of exchange rate

I explains short-term volatility and long-run trends
I long-run policy goals (e.g., price stability) require nominal anchors

Additional policy goals

1. constant exchange rate to secure smooth international transactions
e
∆E$/£
→ implies E$/£
=0
2. international capital mobility to promote integration, efficiency, risk-sharing
e
∆E$/£
→ implies i$ = i£ + E$/£

3. monetary policy autonomy to manage domestic business cycle

→ implies i$ 6= i£

⇒ all three goals cannot be (fully) realized at same time

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 break

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 National and international accounts
Introduction

Today’s globally interlinked economies add further items to national

accounts familiar from introductory courses
I international trade of goods or services is balanced by parallel trade in assets
I start with tracking flow of payments in a closed and in an open economy

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 National and international accounts
Closed vs open economy

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 National and international accounts
Measuring economic activity

Three approaches can be used to measure activity:

1. expenditure approach: focus on demand for goods and services (GN E)
2. product approach: focus on production of goods and services (GDP )
3. income approach: focus on income payments to factor owners (GN I and GN DI)

In a closed economy, GN E = GDP = GN I = GN DI

I not necessarily true for open economies

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 National and international accounting
Expenditure approach vs production approach
Gross national expenditure (GNE) Gross domestic product (GDP)

Sum of private consumption, Value of goods/services produced

investment, and government as output, minus
expenditure value of goods/services inputs

GDP equals GNE plus the trade balance:

 
 
GDP
| {z } = |C + {z
I + G} + 
 EX
|{z} − IM
|{z}


gross gross national all exports all imports
domestic expenditure final & intermediate final & intermediate
product GN E | {z }
trade balace
TB

I whenever the trade is not balanced, i.e. EX 6= IM , GDP differs from GN E

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 National and international accounting
Production approach vs income approach

Gross national income (GNI)

Sum of payments to domestic

owners of factors used in the pro-
duction of goods and services

GNI equals GDP plus the net factor income from abroad (NFIA):

GN
| {z I} = C
|
I + G} + (EX − IM ) + (EXF S − IMF S )
+ {z
gross
| {z } | {z }
gross national trade balace net factor income
national expenditure
income TB from abroad
GN E N F IA
| {z }
GDP

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 National and international accounting
Accounting for transfers of income

Gross national disposable income (GNDI)

Income through non-market transactions, such as foreign aid,

remittances, etc.
→ net unilateral transfers: N U T = U TIN − U TOU T

GNDI gives us the full measure of national income:

I + G} + (EX − IM ) + (EXF S − IMF S )−(U TIN − U TOU T )

Y = |C + {z
|{z} | {z } | {z } | {z }
GN DI GN E trade balace net factor income net unilateral
TB from abroad transfers
N F IA NUT
| {z }
GN I

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 National and international accounting
Putting NUT into perspective

Aid and remittances can account

for large portions
I Donor countries also differ
see headlines: Feenstra/Taylor (2017, Ch: 16)

→ US aid 2003: 0.15% of GNI

→ NOR: 0.02%; DNK: 0.84%

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 National and international accounting
Interpretation of the economic aggregates
Last equation shows the division of national and international transactions

I + G}+(EX − IM ) + (EXF S − IMF S ) − (U TIN − U TOU T )

Y = |C + {z
|{z} | {z } | {z } | {z }
GN DI GN E trade balace net factor income net unilateral
TB from abroad transfers
N F IA NUT
| {z }
current account
CA

I only in open economies, the current account can be different from zero
I in closed economies: GN DI = GN I = GDP = GN E

In short
Y = C + I + G + CA

I so-called national income identity: if Y < GN E → CA < 0 (deficit)

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 National and international accounting
National income and current account identity

Based on the the national income identity, obtain national savings

Y = C + I + G + CA
⇔Y
|
− {z
C − G} = I + CA
savings, S

I so-called current account identity:

→ S is greater than I if and only if CA > 0 (in surplus)
→ S is less than I if and only if CA < 0 (in deficit)

I the CA tells us how much a country spends/invests in relation to its available

resources

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 National and international accounting
Global imbalances
Industrialized countries gradually save and invest less over time

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 National and international accounting
Global imbalances
In many cases, private and public savings show different trends
I private savings: Sp ≡ Y − T − C
I public savings: Sg ≡ T − G

Emerging markets show increasing savings and investments

I they also increasingly borrow industrialized countries

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 National and international accounting
The balance of payments
Current account showed positions of income and expenditure
I financial account shows these transactions are financed

→ F A = EXA − IMA
→ any import of goods/services is followed by export of assets
I capital account records additional transactions of non-financial assets

→ KA = KAIN − KAOU T

The financial account differentiates domestic and foreign assets

I domestic asset is a foreign claim on the home country, i.e., an external liablility
I a foreign asset is a domestic claim a foreign country, i.e., an external asset

Together, financial and capital account equal current account

I balance of payments identity

→ CA + F A + KA = 0

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 National and international accounting
The BoP and beyond

Decompositions of the BoP informs on how CA imbalances are financed

I countries can be (net) borrowers or (net) lenders
I implications for evolution of countries’ wealth

International financial positions determine external wealth

I depends on financial/current account and valuation effects

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 explore further details reading the book
and in upcoming tutorial meetings...

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