Monday, November 26 Handout: International Finance

Transcription

1 Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Monday, November 26 Handout: International Finance Another Puzzle Unemp Real Inflation Investment Govt Real Interest Net Year Rate (%) GDP Rate (%) Exp Exp Rate (%) Exports , , , , What happened in 1982? Consumption Component of Aggregate Expenditures President and Congress enacted a 5 percent tax cut The tax cut increased DI at each level of Y. Consumption increased at each level of Y. Consumption component of aggregate demand shifted up Investment Component of Aggregate Expenditures Fed pursued a contractionary monetary policy Real interest rate rose from 4.8% to 7.7% Higher real interest rates reduced the level of investment. Investment component of aggregate demand shifted down Government Component of Aggregate Expenditures Government expenditures rose from 1,371 to 1,395 Government component of aggregate demand shifted up C I G NX C C I I G G NX GDP=Y AE = C + I + G + NX AE = C + I + G + NX In net: The aggregate expenditures curve shifted down. 5,987 Equilibrium GDP decreased. Puzzle: When GDP decreases, net exports should, but net exports.

2 2 Foreign Exchange Rates: Exchange Rate in per Euro = buys $1.30 Exchange Rate in Euros per Dollar =.77 $1.00 buys.77 Exchange Rates and Prices Dollar ( Euro) Price of a Chevy Volt = $30,000 Dollar ( Euro) Exchange Rate.50 per $ per $ per $1.00 Volt $30,000 $30,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. Dollar ( Euro) Price of a BMW 740i = 60,000 Dollar ( Euro) Exchange Rate.50 per $ per $ per $1.00 BMW 60,000 $ 60,000 $ 60,000 $ in Europe in U.S. in Europe in U.S. in Europe in U.S. When the Dollar becomes stronger, the Euro becomes. weaker, the Euro becomes. Question: Who benefits from a weak Dollar Question: Who benefits from a strong Dollar (strong Euro)? (weak Euro)? consumers. consumers. firms. firms. Terms: Appreciation and Depreciation When a currency becomes stronger it is said to. weaker it is said to.

3 3 Foreign Exchange Market for : How is the exchange rate determined? Weak Dollar (Strong Euro) Price of a Chevy Volt = $30,000 Strong Dollar (Weak Euro) Exchange Rate.50 per $ per $ per $1.00 Volt 15,000 $30,000 30,000 $30,000 60,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. Weak Dollar (Strong Euro) Price of a BMW 740i = 60,000 Strong Dollar (Weak Euro) Exchange Rate.50 per $ per $ per $1.00 BMW 60,000 $120,000 60,000 $60,000 60,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. As the exchange rate in terms of Euros per Dollar increases. Does the Dollar become more or less expensive for Europeans?. Do U.S. produced goods and services become more or less expensive for Europeans?. Do Europeans demand more or fewer U. S. produced goods and services?. Do Europeans demand more or fewer?. The demand curve for in the foreign exchange market is sloping. Does the Euro become more or less expensive for Americans?. Do European produced goods and services become more or less expensive for Americans?. Do Americans demand more or fewer European produced goods and services?. Do Americans supply more or fewer?. The supply curve for in the foreign exchange market is sloping.

4 4 Europeans Demand American Goods and Services Europe Demand Foreign Exchange Market Supply United States Americans Demand Europoean Goods and Services Foreign Exchange Market: Demand and Supply Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar S G&S S G&S Equ Exch Rate D G&S D G&S U.S. Imports U.S. Net Exports Demand Curve: How many would Europeans demand, if the exchange rate were Euros per Dollar given that all else relevant to demand remains the same? Question: Why do Europeans demand? Answer: To purchase American and services. European Purchases of American Goods and Services Supply Curve: How many would Americans supply, if the exchange rate were Euros per Dollar given that all else relevant to supply remains the same? Question: Why to Americans supply? Answer: To obtain Euros in order to European goods and services. American Purchases of European Goods and Services U.S. Imports In equilibrium: European Purchases American Purchases of American of European Goods and Services Goods and Services U.S. Imports U.S. Net Exports =

5 5 Question: What are we missing? Sources of Demand and Supply in Foreign Exchange Markets Purchase of Goods and Services (Imports and Exports) Purchase of Assets: Stocks, Bonds, Europeans Demand American Assets Europeans Demand American Goods and Services Europe Demand Foreign Exchange Market Supply United States Americans Demand Europoean Goods and Services Americans Demand European Assets In equilibrium: U.S. Purchases U.S. Purchases European Purchases European Purchases of European + of European = of American + of American Assets Goods and Services Goods and Services Assets U.S. Imports

6 6 Benchmark Case: European Purchase of American Assets Equals U.S. Purchases of European Assets Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar S G&S U.S. Assets Equ Exch Rate Eur Assets D G&S U.S. Imports U.S. Net Exports = 0 Net Exports and the Real Interest Rate Question: What would occur if real interest rates rose in the U.S.? Europeans find Americans find American Assets European Assets attractive attractive The demand curve for The supply curve for Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar S G&S+A Euros per Dollar S G&S+A S G&S Equ Exch Rate D G&S+A D G&S+A D G&S U.S. Imports U.S. Net Exports Summary Real Interest Rate Increases Exchange Rate Net Exports

7 7 Resolving the Puzzle Unemp Real Inflation Investment Govt Real Interest Net Year Rate (%) GDP Rate (%) Exp Exp Rate (%) Exports , , , , What happened in 1982? Consumption Component President and Congress enacted a 5 percent tax cut The tax cut increased DI at each level of Y. Consumption increased at each level of Y. Consumption component of aggregate demand shifted up Investment Component Fed pursued a contractionary monetary policy Real interest rate rose from 4.8% to 7.7% Higher real interest rates reduced the level of investment. Investment component of aggregate demand shifted down C I G NX C C I I G G NX Government Component Government expenditures rose from 1,371 to 1,395 Government component of aggregate demand shifted up Net Export Component Real interest rate rose from 4.8% to 7.7% Exchange rates Net Export component of aggregate demand 5,987 GDP=Y AE = C + I + G + NX AE = C + I + G + NX British Pound German Mark French Franc per Dollar per Dollar per Dollar June June In net: The aggregate expenditures curve shifted down. Equilibrium GDP decreased from 5,987 to 5,871.

8 8 Greek Debt Crisis Greek Treasury promises to pay the owner Greek Treasury promises to pay the owner y,yyy Euros on January 15, 2011 y,yyy Euros on February 15, 2011 Greek Treasury promises to pay the owner y,yyy Euros on March 15, Greek Government Finances Tax Revenue Euros Euros Greek Treasury January 2011 September 2011: Specter of Greek Default Emerges Moody's cuts Greece's credit rating to B1 from Ba1. Moody's cuts Greece's credit rating to Caa1. Moody's cuts Greece's credit rating to Ca. Questions: What is the basic problem? Bondholders Euros Purchases of Goods and Services Transfer Payments How might the problem be solved? November 2011 January 2012: Austerity, Political Turmoil, and Negotiations for a Bailout Greek Prime Minister George Papandreou s government presents 2012 budget to Parliament calling for sharp increases in taxes and spending cuts. Violent protests erupt amid a 48-hour general strike. Greek Prime Minister George Papandreou loses his majority in Parliament. The country s major political parties (Socialist and Conservative) agree to form a national unity government and Socialist Prime Minister George Papandreou agrees to resign. After days of wrangling Greek political leaders name Lucas Papademos as interim prime minister. Nationwide strike by civil servants and private-sector workers to protest new cutbacks. Greek Prime Minister Papademos heads to Brussels to negotiate a bailout after weekend talks with private creditors over a debt restructuring deal.

9 9 Benchmark Case: Net Exports = 0 Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar S G&S U.S. Assets Equ Exch Rate Eur Assets D G&S U.S. Imports U.S. Net Exports = 0 Question: What effect did the crisis have on the attractiveness of European and American assets? Europeans find American Assets attractive The demand curve for Americans find European Assets attractive The supply curve for Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar S G&S+A Euros per Dollar S G&S+A S G&S Equ Exch Rate D G&S+A D G&S+A D G&S U.S. Imports U.S. Net Exports Prediction: The equilibrium exchange rate in terms of Euros per Dollar.

10 10 Speculation Question: What would occur if individuals expected the Dollar to become dramatically stronger and hence the Euro dramatically weaker in the near future? For example suppose that you have 7,700 deposited in a Paris bank that you plan to use in January when you will be vacationing in France. Furthermore, as a consequence of the European debt crisis you expect the dollar to strengthen with the exchange rate rising from.77 per $1.00 today to 1.00 per $1.00 in January: 7,700 Today: Exchange Euros for Exchange Rate.77 per $1.00 $ January: Exchange for Euros Exchange Rate 1.00 per $1.00 If others share your view become Euros become attractive today attractive today Demand curve for Supply curve for shifts shifts Equilibrium exchage rate today Foreign Exchange Market for Euros per Dollar Equ Exch Rate A vicuous circle could ensue. Question: How did the crisis affected the U.S. economy? Exchange rate rises Net exports Net Export (NX) component of aggregate expenditures (AE) shifts Aggregate expenditures (AE) curve shifts Real GDP Unemployment

11 11 January 2012 February 2012: Austerity and a Bailout (Bond Swap) Greece's leaders agree on austerity moves needed for a new bailout, but euro-zone finance ministers demand a vote in the Greek Parliament, setting the stage for further uncertainty. Parliament passes new austerity measures demanded by bailout creditors. A massive bond swap that would wipe 107 billion off the country's privately-held debt, a day before Greece is expected to launch a formal offering to private bondholders. Euro-zone countries sign off on a 130 billion bailout for Greece, ending a negotiating process that started in July The hope is that the package will be enough to keep Greece funded until March 2012 April 2012: Relative Calm Relative calm emerges before May 6 elections to form a new government. May 2012 July 2012: Greek Elections and the Return of Political Turmoil Greek voters Sunday delivered a stinging rejection of Greece's incumbent Socialist and Conservative parties and the austerity program they support. At least seven parties, most of which reject austerity policies, were poised to clear the 3% threshold needed to enter parliament, meaning that the next Greek government will have difficulty implementing the reform program demanded by the country's European and international creditors in exchange for funding a continued bailout for Greece. Greece's first efforts to negotiate a cross-party coalition government following inconclusive weekend elections stumbled Monday, after conservative leader Antonis Samaras failed to reach a deal with rival lawmakers. At stake is Greece's ability to implement the agreed reforms it must take in order to secure continued financing. After Greece's May 6 elections left pro-bailout parties (Socialist and Conservative) too weakened to govern the country, more elections are scheduled for June. The lack of a stable government has thrown Greece s austerity measures off course.

12 12 July 2012 August 2012: New Government Formed and More Austerity The June elections allow the Conservatives to form a government along with a few small Democratic Left parties. Greece's newly elected government is seeking billions of euros of additional budget cuts and looks poised to announce the first steps toward streamlining the country's bloated public sector. Details of Greece's 11.5 billion ($14.2 billion) austerity plan are emerging as Conservative Prime Minister Antonis Samaras moves to demonstrate his government is serious about cost-cutting efforts ahead of meetings with European leaders later this week. Greece successfully staved off a default on debts owed to the European Central Bank. September 2012 November 2012: Some Warning Signs Nonperforming loans, measured as loans that are more than 90 days overdue, now account for more than 20% of the total 240 billion in loans to Greek households and companies. Greek unemployment rate rises to 25 percent. Spain and Italy also experiencing problems.