FOREX Practice

Graph both currencies.

Label them as either “appreciating” or “depreciating” in value.

Tell what happens to US Exports after the change.

US $ and the Mexican Peso (M$):

Drug wars in Mexico cause US tourists to stay away from Mexico.

US $ and the Euro (€):

US goes into deep recession, Europe does not.

US $ and the Japanese Yen (¥):

Japanese game companies bring out hugely popular new game systems.

US $ and the Chinese Yuan (C¥ or ):

China decides to reduce sales of rare earth minerals to the US.

(Assume that the Yuan trades on S and D markets.)

US $ and the Canadian Dollar (C$)

After the Calgary Winter Olympic Games, Canada becomes a favorite US tourist destination.

US $ and the Chilean Peso (CLP$):

The two countries sign a trade agreement that dramatically increases the food Chile will export to the US during the winter in the northern hemisphere.

US $ and the Euro (€):

Gasoline prices spike to $10.00 a gallon worldwide and German car companies introduce several models of cars that get 75 miles per gallon in efficiency.

US $ and the Australian Dollar (A$):

After massive flooding in Australia, the US decides to send billions in aid money to Australia.

US $ and the Russian Ruble ( R ):

Russians decide that US cars are extremely fashionable to own.

US $ and the Nigerian Naira ( N ):

The US increases investments in newly discovered oil fields in Nigeria.

Protectionism vs. Trade

Arguments for protectionism

Military Self-Sufficiency

• not economic, political and military
• need to preserve industries that are essential for national defense 
• point: when you do this, you will incurs economic costs 
• what counts as "essential?"

Diversification for Stability

• common in economies dependent on one or two products (Saudi Arabia)
• need to diversify at home because changes to the dependent product markets can be devastating
• not relevant to the US

Infant Industry 

• need to shelter young industries temporarily until they compete globally 
• which industries will be capable of competing in the future? 
• protection may not be temporary

Protection Against Dumping 

• dumping: the sale of a product in a foreign country at prices either below cost or below the prices commonly charged at home.
• tactic for driving competitors in other countries out of business. 
• US imposes antidumping duties where it find it
• hard to differentiate between dumping and competition

Increased Domestic Employment

• tariff to "save our jobs"
• common during recessions 
• idea is to protect certain jobs by blocking foreign imports
• jobs are also created, only some gone 
• maintaining status quo by making neighbors poorer 
• trade wars likely 

Cheap Foreign Labor

• domestic workers must be shielded from counties where wages are low 
• ignores the fact that trade benefits both parties
• ignores comparative advantage
• ignores differences in labor productivity

Big Picture: Protectionist actions will benefit some part of the economy at the expense of the rest of the economy, and in some cases, the rest of the world. 

Let's talk about labor in the third world 
 

Trade and Growth

We already know

• people and nations trade to improve their standard of living
• trade is voluntary 
• trade will only occur if both sides expect to gain something
• a nation will import if world price < domestic price
• a nation will export is world price > domestic price  
• allows nations to specialize in what they do best

recall: law of comparative advantage: through specialization and trade, nations are able to go beyond their PPF

short and sweet: free trade makes everyone better off

but....

Barriers to trade

tariff: excise taxes on imported goods

• revenue tariff: taxes on imported goods not produced domestically in order to raise revenue for the federal government.
• protective tariff: tax designed to shield domestic producers from foreign competition

nontariff barrier: licensing requirements imposed on domestic importers of foreign goods.
quotas. By restricting licensing, governments can restrict imports.

voluntary export restriction: voluntary limitations agreed to in the hopes of avoiding more stringent trade barriers.

Quota: legal limit placed on the amount of a good that can be imported in a given year.

Effects: 

• quotas generate revenue for foreign producers by keeping prices high. 
• tariffs generate revenue for the domestic government.
• in both cases, the prices for domestic consumers are higher. 
• limit potential gains from trade
• protect domestic sellers and the expense of domestic buyers

they also

• reduce efficiency in the allocation of scarce resources
• (slows economic growth!)

BoP and FOREX

(Balance of Payments and Foreign Exchange)
 
First, some differentiation

• Balance of Trade: looks only at a nation's exports and imports of goods.
• Balance of Payments: considers all economic transfers.

For the current and capital accounts:

• if foreign currency is used to complete the transaction, it is a debt (negative)
• if foreign currency is earned in a transaction, it is a credit (positive)

Trade requires nations to exchange currencies 

• exchange rate: the price of one currency in terms of another. Generally set by supply and demand.

Appreciation:

• increase in the value of a nation's currency in foreign exchange markets
• tends to reduce exports and increase imports

Depreciation:

• decrease in the value of a nation's currency in foreign exchange markets
• tends to increase exports and decrease imports

Monetary and Fiscal policies can affect exchange rates, and therefore the international balance of trade and balance of payments. 

Recall: Three rules for S/D of currency graphs

• Always change the D line on one currency graph, the S line on the other currency’s graph. 
• Move the lines of the two currency graphs the same direction. (demand moves out, supply moves out, etc.)
• One currency will appreciate, the other will depreciate. 

Recall: Shifters of currency supply and demand 

• taste and preferences  
• demand for products increases
• so will demand for currency  
• cell phones, other electronics, etc.   
• price level (inflation
• consumers will seek cheaper goods if domestic prices rise 
• income 
• imports vary directly with its income level 
• income rises, people buy more domestic good and more foreign goods.  
• real interest rates
• higher real interest rates will attract investment as foreigners seek higher returns 

Balance of Payments

Balance of payments (BoP) accounts: an accounting record of all monetary transactions between a country and the rest of the world

These include: 
Current Accounts
    Goods: Consumer, Capital, Agricultural
    Services:  Receipts versus Payments
        (includes Travel, Royalties, License Fees)

Capital / Financial Accounts
    “Net Capital Account Payments”
    Assets:  Purchases of Securities, Direct Investment Payments

Official Reserve Assets

Why keep track of this?

• To establish the ability to balance accounts and trade in the future
• Fixed vs. floating exchange rates 

Individuals and Businesses record stuff like...

• Job income, interest income, consumption payments, investment payments

So nations are expected to keep track of this responsibly

• Why? helps stabilize currencies and trade expectations for future investments

International BOP can be summarized as a ledger sheet for each trading nation.

• Current Account keeps track of the difference between a country's total exports and total imports. (physical stuff, services, investment income, transfers) 
• trade deficit = importing more than you export (Xn is a negative number) 
• trade surplus = exporting more than you import (Xn is a positive number) 
• Capital Account (sometimes called the Financial Account) keeps track of ownership of assets. (foreigners who own US assets and US citizens who own foreign assets)
• Net Capital Outflow 

Terms:
Current Account (CA): An immediate and final transaction
CA Net Exports                                 Export values minus Import                                                                 values
CA Balance of Trade                        (Goods and Services)
CA Balance on Goods & Services   Tourism Expenditures
CA Trade Balance

• CA Net Investments: Payments on prior stock and bond investments like dividend payments 
• CA Net Transfers: Aid, Transfers and Remittances, Royalty Payments

Capital and Financial Account (KA): Purchases and payments are made that hope to create future revenues and obligations (people buy stuff as an investment)

• KA Real and Financial Assets: Stocks, Bonds, Land, Companies, Franchises, ….

Reserves: Used to balance out accounts if Current Accounts don’t equal Capital and Financial Accounts  

• Official Reserves: Gold and Currency Holdings 
• Official Settlements: Also Gold and Currency Holdings 
• Special Drawing Rights at the IMF: Funds held by the International Monetary Fund

BOP Assets or Credits: A positive number for a nation

• Currency Inflows: Wealth amounts coming into a country as a result of the transaction 
• Currency Demand: Wealth amounts are therefore demand for the currency of the country

BOP Liabilities or Debits: A negative number for a nation

• Currency Outflows: Wealth amounts leaving a country as a result of the transaction 
• Currency Supply: Wealth amounts are therefore supply of the currency moving out of the country

A Final Word on Balances

• There is constant news and discussion about the USA’s massive and increasing Trade Deficit.  
• This is most obvious in the imbalance of imports versus exports, 
• the US imports hundreds of billions more annually that it exports.  

The two major culprits are usually:  

• oil imports 
• trade with China.  

We do export lots of items, 

• mostly heavy equipment and services
• but those amounts do not equal the oil imported and the lack of ability to sell goods to China. (right now) 

what really occurs 

• oil producing nations and China turn around and use lots of the extra dollars they receive and invest in US stocks and bonds (Capital and Financial Account Asset for the US).

People in the US worry when 

• China tries to buy stuff like US car companies
• US ports (blocked by the government)
• China tries to buy the panama canal
• resource rich areas in Africa  

Exchange Rates, Supply and Demand of Currencies

Currencies as part of Supply and Demand

• All major currencies of the world “float” on supply and demand markets. 
• Some minor currencies are “pegged” to other major currencies like the 
• US dollar and the Euro, 
• but rise and fall in value with those major currencies.
• The only major currency that is “fixed” in exchange rates by governmental decree is the People’s Republic of China’s Yuan.  
• The Chinese government does adjust the “fixed” rate occasionally, 
• most recently as a response to US pressure to balance trade issue flaws.
• Currencies either “appreciate” or “depreciate” in EP.

When changes occur between two countries’ economies, the currencies will reflect those changes:

• When other countries want something from us they are demanding dollars.

• When we want something from other countries we are supplying dollars.  

three rules of currency demand graphs 

• Always change the D line on one currency graph, the S line on the other currency’s graph.
• One currency will appreciate, the other will depreciate.
• Move the lines of the two currency graphs the same direction and you will end up with the correct answer.

How do currencies move?

1. Fads, tastes, and political actions like boycotts, occur in a country as it deals with another country.
2. The country with less inflation has the more attractive economy compared to a trading partner.
3. The country with better investment opportunities (higher real interest rates for investments) has the more attractive economy.
4. The country “expected” to improve its economic standing more quickly than trading partners will have the more attractive economy.
5. If the overall real wealth of one country improves, compared to the wealth of a trading partner, the improving country will have the more attractive economy.

Economic Growth

Economic growth
(A percentage rate of growth per quarter)

• increase in real GDP
• (or)
• increase in real GDP per capita
• real GDP / population, compared to previous quarters 

growth lessens the burden on scarcity 

Rule of 70: provides a mathematical grasp of the effect of economic growth rate changes.

• Number of years for variable to double = 70 / Annual Growth Rate of the Variable

Why do we see growth in some areas and not in others?

 

Institutions that promote growth

• strong property rights
• patents and copyrights
• efficient financial institutions
• widespread education
• free trade
• competitive market system 

Non-institutional factors

(supply) increase in:

• quantity and quality of natural resources 
• quantity and quality of human resources 
• stock of capital goods 
• advances in technology     

(demand) increases in:

• total spending

(efficiency) increase in:

• allocative efficiency 
• productive efficiency

Discussion: is growth desirable?        

The Laffer Curve

Major points:

• high tax rates 

• reduce incentives to work, save, and invest.
• impede the long run growth of aggregate supply 
• (rewards of working vs. leisure / saving vs. consuming are reduced)

• There's a range were the tax rate will discourage people from doing things with their money.

Things to consider:

• value of work 
• value of leisure
• after-tax revenue

The curve suggests:

• High tax rates will lead to less overall tax revenue
• lower tax rates will increase overall tax revenue

• lower rates encourage saving and investing
• people have an incentive to substitute work for leisure  
• firms have better equipment (improves productivity) 
• rise in labor productivity expands LRAS 
• unemployment and inflation rates low   

Internationally...

• firms are doing more "tax shopping". 
• People and businesses headquarter in places with low tax rates. 
• the government in the home country is loosing all of their tax revenue from that business or person.

The Phillips Curve

The Original Short Run Phillips Curve
Basic Assumptions:

• inverse relationship between inflation and unemployment. 
• When one increases, the other decreases.
• If an economy has inflation, 
• usually due to demand pull growth
• more workers are being hired to produce the greater number of goods being produced.
• If an economy is in a recession, 
  
• more resources are being left idle
• fewer workers are needed and less pressure is put on the resource base.  
• This results in less inflation.

Movement along the Phillips Curve represents year to year

changes in the business cycle.

• The original data collected in the 1940’s and 1950’s showed this general connection with the business cycle. This also held during the 1960’s in the US (see most texts).

The Problem of Stagflation
(Phillips Curves under attack:)

• Starting in the mid-1970’s the economy started to suffer from increasing amounts of inflation and unemployment
• The data points on the Phillips Curve no longer fit into any immediately recognizable pattern.
• Did the model seem to present the relationship between inflation and unemployment too simplistically?

A New “Phillips” Approach
Stagflation, and its removal, explained:

• If the fundamental efficiencies and demographics of an economy change, then the relationship between inflation and unemployment is still valid, just in a new range.
• One key change is the type of inflation. 
• If inflation now becomes “cost push” inflation, the resource
  
  base has now changed.  
• The aggregate supply is reduced due to resources being used up or lost, disasters, boycotts, etc. 
• More costs and job losses occur.
• The result of cost push inflation will be higher prices due to
  
  fewer and more expensive resources, plus more unemployment due to business production cuts.  
• This is also known as a supply shock.

The Short Run Phillips Curve still has a relationship between the two factors, but the curve moves outward.  

• Year to year business cycles still occur, just at higher levels than before.

• When the economy is able to adjust with improved technologies, or the resource supply is re-established, the inflation pressures level off and businesses are able to lower costs and produce more.  The SRPC moves back inward (to the left). 

This approach appears to answer the late 1970’s changes.  

• As energy resources were cut and significant demographic changes like women moving into the workforce changed, the economy suffered from stagflation.  
• This was “cured” by the restoration of cheaper energy and new technologies in the 1980’s and 1990’s.
• The logic of the Phillips Curve was intact, just in new ranges.

The Long Run Phillips Curve
Inflation has less importance in the Long Run.

Two new factors emerge in Long Run analysis. 

• the economy can adjust for inflation in the long run through wage and real-wage changes. 
• Rational Expectations School theories that expected inflation rates are controllable and predictable by the market, therefore no longer a random factor. 

The Long Run Phillips Curve is therefore vertical at some natural rate of unemployment. 

• now presumed to be around 4 to 5 % for the US and 6% for Canada.  
• This vertical LRPC is also known as the NAIRU line, or “non accelerating inflation rate of unemployment”. 

The analysis of the LRPC 

• based on arguments of how a country can change the natural rate of unemployment.  
• connected to long run productivity of the workforce and the willingness of a country to help those who are unemployed.   
• The theory is that financial assistance given to those who lose jobs will lengthen their “willingness” to wait, or settle, for new jobs.  
• This will increase the natural rate of unemployment (move it to greater levels of unemployment). 

The Phillips Curve and the AD/AS Model
Phillips Curves and AD/AS Graphs:  Mirror Images

• When you move points along the SRPC you are showing changes in the year to year business cycle.  
• This is exactly what you are illustrating when you move the AD line on the AD/AS model.
• When you move the entire SRPC outward to show supply shocks or cost push inflation problems, it is exactly the same at moving the SRAS curve inward. 
• The AD/AS model will also show the simultaneous creation of greater inflation and more unemployment. 
• This will also be true of movements in the opposite directions, like the SRPC moving back inward is the same as the SRAS curve moving outward to better levels of inflation and production.

Crowding Out

What is it?

• A critique and flaw of Keynesian  policies that are applied to fight a recession. (An expansionary policy!)

Why does it happen?

• The policy of cutting Taxes and raising Spending will create a budget deficit.
• The budget deficit must be funded and to do this Congress orders the sale of US bonds.
• (This is NOT a Monetary Policy tool used by the Fed)

Where does the money come from?

• US citizens and companies, investment firms, foreign countries

therefore?

• Money that could be spent on Consumption or used for Private Savings is now being used to buy bonds.

On the money market graph

• This will cause the Money Demand curve to shift outward.  Remember this is a Fiscal event!

On the Loanable Funds Market

• This will cause the Supply  curve to shift inward  because we are not Saving money privately any more.
• This can cause the Demand  curve to shift outward because the private and public demand for $ increases_.

on both graphs

• The nominal and real interest rate will increase.

Therefore, on the Investment D graph

• The increase in nominal and real interest   rates will cause Ig to decrease.

Isn't this counterproductive?

• Fiscal Policy supporters (Keynesians) insist that gains in
• C and G will outweigh any loss in future Ig.

Why?

• C and G are greater than Ig and they are Short Run improvements.  
• Ig is longer run and Keynesians don’t worry about that.  
• In the long run we are all dead.

this is summarized on the Aggregate Model.  

• The AD will move outward due to the increases in C and G 
• then “maybe” move inward due to a loss of Ig, 
• but not as much as the increase.  
• Therefore the economy improves.