1. Discuss the international relationships between interest rates, monetary policy and exchange rates in a world of (more or less) free international capital flows. Present at least eight channels of “causal” or mutual (gegenseitige) influence. Exchange rate theories 1) Demand and supply theory: If demand for home currency increases → home currency increases This theory usable for capital account transactions and central bank transactions (China!) 2) Random Walk: E(Et) = Et-1 + ε E(ε)=0 E(ΔEt)= 0 expected change in Exchange Rates is zero So all changes in exchange rates are unexpected changes due to unobservable variables or ideally due to a pure error term ε. Mathematical consequence of the random walk is that every exchange rate value is reached with certainty under the constraint that the average waiting time till it is reached is infinitely long. The Random Walk of Exchange rates couldn’t be disproved yet (no wonder under these “assumptions”) In pure Random Walk Variance rises with the square root of time and goes to infinity In reality over very long periods (20+ years) the variance approaches an upper bound. So Random walk is most suitable for very short time periods and for very long time periods it can be at least integrated with other theories (see ENGEL WEST article) 3) Uncovered Interest Parity Theory, Equillibrium theory (Skriptum page 4f): Best to be explained with an example: RHome = RForeign + ΔEH/F Interest/Rent in home country = Interest/Rent in foreign country +/- aprreciaton/depreciation of Exchange rate from home to foreign country 5% in Europe = 7% in US – 2% depreciation of $ Return If interest rate (all kinds of return on real or financial assets) is higher than in home, I will invest so long into foreign till foreign currency depreciated by difference and equilibrium is reached. • Theory about capital account transactions • “Uncovered” because unvertainty about future Time exchange rates. R is assumed to be certain (short run interest loans etc) • jump appreciation (instant reaction to opportunities) followed by constant depreciation over time. • Assumption that R at home is given (douptful assumption!) 3) Disequillibrium theory (1.3.3 Handout, page 4f) Higher interest rate “should” lead first to appreciation due to capital inflow. It Return should appreciate by just enough that the increase in the rate is just enough to offset the expected future depreciation and equilibrium is reached Here no jump. Takes time to realize investment opportunity, cost of switching investment. Actually, equilibrium for the US$ still not reached (still in upwards movement) Time • Disequilibrium theory can show only the direction of the movement, but not its size • Equilibrium theory (UIP) shows size of movement due to unrealistic assumption that rate of return is known. Covered Interest Parity (Handout 1.3.4) You can cover yourself to avoid possibility of unexpected depreciation- at a cost. This theory practically always fulfils assumption of certainty in contrast to UIP. As tradeoff a forward premium has to be paid. Banks act with this theory together with random walk, where the (fixed) forward rate is expected to equal the future exchange rate. Banks see this business in the long-run, they profit from the fixed charges. 4) Purchasing Power Parity Basic Idea: Price levels, converted at the exchange rate, have to be equal in home and foreign. • Theory used in goods market • UIP is a theory about rates of changes, PPP can as well be a theory about levels → absolute PPP • Relative PPP speaks about exchange rate changes • Over and undervaluation of currency can only be expressed in absolute PPP# Problems: • Trade barriers count and prevent law of one price • Transport costs and sticky prices in goods markets cause no reaction in small disequilibria • Monopolistic practices cause weaker links between prices of similar goods in different markets. • Different commodity baskets and/or consumption habits in different countries 5) Real Growth Differences (Handout 1.3.6, Skriptum page 7) Higher economic growth rates normally lead to higher rate of return on capital (interest rates) So exchange rate appreciates due to higher economic growth, this means better investment opportunities and thus higher real rates of return on capital. (NEUMANN Growth model. KALDOR theory of distribution) So in short Capital inflow appreciates currency. Possible contrary outcome: Higher growth leads to CA deficit and thus to depreciation. Especially in situation of much import and low export. This effect is, if, weaker most of the time. 6) Current account effect theory (Handout 1.3.7 ff, Skriptum page 8) Central bank sterilization: When it looses money via CA deficit it increases money supply by selling bonds. Tries not to permit price level fall (Deflation). USA today. See article “Unnatural causes of dept” CA deficit can become vicious circle, see article “A Topsy-Turvy World” Link of CA to UIP: Because you have to pay imports by buying foreign exchange from central bank, you buy those with home money → reduction in home money → interest rates↑ 7) Risk premium(Handout 1.3.8 ff, Skriptum page 8) small market → variation of exchange rate is higher → this leads to higher risk premium → higher interest rate Example Streissler: Pound in GB → small currency → variation of exchange rate is higher → risk premium → higher interest rate. € and $ are like islands of stability. In Austria before Euro the interest rates where always 0.2% higher than in Germany. In times of political trouble additional 0.5% over German interest rate. If you separate UIP and Disequillibrium theory, we have our “8 channels of causal influence” on E, i and monetary policy. Klausur: Question 1 International relationships between interest rates, monetary policy and exchange rates in a world of „more of less“ free international capital flows. (At least eight channels of “causal” or mutual influence). Monetary policy pursued by central banks is aimed at controlling the interaction between money supply, interest rates and exchange rates in many ways to safeguard internal (and international) monetary and economic stability. These three factors act interdependently, obeying certain “logical” rules when exercising their influence on one another. A few examples are given below: a) Money supply and interest rates: The amount of money supplied to the economy (currency and demand deposits) depends on the currency (reserves). Demand for money rises with an increased demand for an asset, the consequence being rising interest rates accompanied by a loss of the monetary value (inflation). This affects liquidity (the amount of money held by the people increasing with the demand) and the income of the individual (higher personal income) as well as the price level (the higher the prices, the higher is the demand for money). As interest rates go up, demand for money and the price level will start falling. b) Interest rates and exchange rates: When a central bank raises the interest rate, the value of its currency appreciates; if, say, the European Central Bank lowers the interest rate, the Euro will depreciate. c) Interest-rate (and exchange-rate) fluctuations in relation to economic performance (in a situation of full employment): Normally one can differentiate between three stages of development when, for example, the ECB lowers the interest rate: (i) in the short term output and price level will stay constant; the equilibrium in the monetary sector sets in with interest-rate adjustments. (ii) Medium-term influence: When interest rates are lower, the firms’ investment activities accelerate; a higher yield pushes the demand for money outward (interest rates rise). (iii) Long-term influence (example): When the amount of money doubles, the price level is expected to double as well. The price of foreign currency should, therefore, also double. d) Money supply and exchange rates: An increase in the European money supply, for instance, would lower the euro interest rate. It would influence the exchange rate against the US dollar, which would appreciate against the euro. But exchange rates are not only influenced by interest rates, but also by expectations; the latter may change rapidly, making exchange rates volatile and impacting on the money supply. e) Fixed exchange rates and money supply: Under a fixed exchange rate set by the central bank, domestic currency depreciation is zero. To maintain the market equilibrium, the central bank must adjust the money supply in case of an increase in output, which otherwise would lead to a higher interest rate and appreciation of the home currency. f) Fixed exchange rates and monetary policy: Central bank monetary policy tools are ineffective in influencing the economy’s money supply or output. To prevent an increase in the home interest rate and an appreciation of the currency the central bank would have to purchase foreign assets with money, i.e., increase the money supply. g) Exchange rates influenced by devaluation/revaluation: To revalue or devalue its currency the central bank has to express its readiness to trade its domestic currency against foreign currency at a new exchange rate, e.g., to fight unemployment or improve the current account, to raise official reserves or expand the money supply. h) Exchange rate changes under a balance-of-payments crisis: A brisk change in the official foreign exchange reserve, triggered by changed expectations, may dramatically influence the exchange rate, often through far- reaching changes in the interest rate. These and similar “textbook” rules have recently been partially broken by the unexpected results of two phenomena, globalisation and the monetary policy pursued by developing countries and China. According to the surveys “A topsy-turvy world” and “Unnatural causes of debt”, globalisation has been responsible for keeping inflation down to an unusually low level and for longer than at any other time. One reason is that high saving by Asian economies and Middle East oil exporters has caused a global saving surplus, which pushed down interest rates. Most of the surplus money has been put into official reserves (dollar bonds), and foreign central banks have, on the other hand, been intervening in the foreign exchange markets to prop up their currencies. This is a strange phenomenon as, according to the textbooks, usually capital should flow from rich countries (America) to poorer ones, such as China. Asian countries have been pursuing a deliberate policy of currency undervaluation: they buy more and more US Treasury bonds, which reduces interest rates and supports consumer spending in the United States, allowing Americans to buy more Asian exports, and this suits both Asia and America; and interest rates remain low. This may last for as long as China (and other emerging economies) see no way of sustainably catching up with western-style economic “habits”. If the Chinese government implements reforms, forces companies to pay dividends, accepts the liberalisation of financial markets, and spends more money on health and education, then China’s balance of payments will show quite a different picture, and its present- day tactics would not produce the result it is currently enjoying. Frage 2: Sketch briefly the main assumptions and conclusions of the RICARDO Model of comparative advantage and the HECKSCHER-OHLIN model of trade due to factor proportions. Give 6 reasons why the one or the other of these models leads to more realistic evaluations of trade. (You might use arguments HARRIGAN or ROMALIS etc.) David Ricardo’s theory of Comparative Advantage (CA) Assumptions of the model: A1) Derivation had zero transport cost. A2) Generalized constant full employment assumption: Workers can be costlessly switched from one production to the other. A3) Wages are fully flexible with the decisively less productive country having a lower wage level. A4) Labour requirement is scale independent, i.e. constant returns of scale A5) Pricing is cost pricing, i.e. • Homogeneous goods with • Perfect information and • Perfect competition A6) There are no policy barriers, i.e. free trade A7) Certainty economics without supply or demand shifts A8) Production functions differ but are static Conclusions of the model: Ricardo’s model posits that, if Country A can produce Good A at a lower opportunity cost than Country B, and Country B can produce Good B at lower opportunity cost than Country A, then both countries should trade Good A for Good B. Opportunity cost is the unit of measurement for comparative advantage. Opportunity cost is the amount of Good B a country must forego producing in order to produce Good A. CA also assumes one factor, labour, the productivity of which varies amongst countries because of technological advantages. Each country should specialize in the good it is most-best at producing. In other words, a country should export the goods produced with a relatively high productivity so that the value balances imports of relatively low productivity goods. According to Ricardo’s model: There is always a gain to (fixed income) consumers. A loss to consumers can only result if a) exchange is not voluntary, b) ex post contracts are not realised. The smaller the relative demand of foreign products the less home gains can be realized. Due to Ricardo’s constant returns of scale production, the small country (relative to the world demand) tends to gain most from trade. Developing countries can compete with technologically more advanced countries, and industries paying higher wages can compete with lower wage earning countries, because CA produces greater efficiencies in production and consumption than protection. The Heckscher-Olin Model Assumptions of the model: A1) The production functions are the same across countries and differ in usage of the factors, capital and labour. Specifically, good A is labour-intensive and good B is capital-intensive. A2) Total supply of the two factors is fixed. Input factors are homogenous and completely mobile across industries. However, capital and labour are perfectly immobile across countries. A2) There are no market distortions such as imperfect competition, labour unions or taxes. Full employment prevails. A3) Countries differ in their relative factor endowments (this is the only difference between countries). Conclusions of the model: In the Heckscher-Ohlin model, comparative advantages and trade are determined by international differences in factor endowments. Given the assumptions of the model (stated above), a country will export the commodity that intensively uses its relatively abundant factor. The capital-abundant country A will export the capital-intensive good, while the labour-abundant country B will export the labour-intensive good, because the relative abundance in capital will cause the capital-abundant country to produce the capital-intensive good cheaper than the labour-abundant country and vice versa. 6 reasons why the one or the other of these models leads to more realistic evaluations of trade Pro Ricardo: 1. The Leontief paradox (Wassily Leontief, 1954) found that the U.S. (the most capital-abundant country in the world) exported labour-intensive commodities and imported capital-intensive commodities, in apparent contradiction with Heckscher- Ohlin theorem but not in contradiction with Ricardo’s CA. 2. The (original) Heckscher-Ohlin model is a two factor model (labour, capital) with a labour market specified by one single class of worker’s productivity. Therefore, the theorem can not make any predictions about the different effects of skilled and unskilled labour. Ricardo’s model can do such predictions if skilled labour is seen as a different technology. Pro Heckscher-Ohlin: 1. The Ricardo model is best applicable for developed countries and badly applicable to developing countries. The Ricardo model due to its assumptions stands for free trade and full specialization as far as possible. In contrast the Heckscher-Ohlin model posits that the scarce factor in each country will clamour for protection. Besides, complete specialization in production rarely happens in reality and less developed countries have higher risks of specialization and more severe booms and busts (Harrigan). 2. The Ricardo model assumes, in contrast to the Heckscher-Ohlin model, that wages are fully flexible. But this is, in the short run, not realistic because it takes at least 5 years to adjust (Streissler, 21.11.2006). 3. Another point, which argues against the Ricardo model, is that the absolute disadvantage determines the relative wage. A country that wants to trade has to have a lower real wage. This is a conclusion which can not be fulfilled in practice. 4. Another problem of only the Ricardo model is that transport costs are taken as zero. This is unrealistic. If transport costs are high and if a certain commodity A is only slightly lower in price than commodity B, then when you add the transport costs to the price of commodity A the price advantage is gone and the commodity will not be exported. So when you take transport cost as higher than zero the Ricardo model may fail. Other problems: Problems of H-O: Countries differ not only in the resource endowments (E.g. different preferences) Problems of Ricardo: • No economies of scale; the unit labour costs are taken as given • Relative factors and price must not change, because relative factor costs are taken as constant Ricardo Model David Ricardo’s model of Comparative Advantage explains how differences in productivity of labour between countries cause productive differences and therefore lead to gains from trade. In his model he assumes a perfect market thus • a world with homogenous products • full employment • fully flexible wages • perfect information • perfect competition • free trading possibilities (no policy barriers) • no transportation costs! • no supply or demand shifts and • labour can be switched between different commodities without any costs. Due to Ricardo, gains from trade do not occur because of absolute costs of productivity but the ratio of relative costs of the produced goods. A country should specialize in producing a good which it can produce comparatively cheaper than the other country. Therefore trade and international division of work are even beneficial for countries which can produce all goods to a higher price than its counterparts. In reality this concept is not as simple, basically because there is no perfect market. In addition there is hardly a complete specialization in production and normally developed countries do have higher risks of specialization. Model of Heckscher / Ohlin (factor endowment model) Factors of production: • labour • land • and capital Factor endowments = quantity of these factors.. "A capital-abundant country will export the capital-intensive good, while the labor- abundant country will export the labour-intensive good." This model developed of two Swedish economists builds on Ricardo’s theory of comparative advantage. Basically this model assumes that countries will export products that realize their abundant factors of production and will import goods that utilize the countries’ spare factors. Since the countries’ economies do have a relative different environment, i.e. wealth economies with specialize in capital intensive goods and countries with lots of working force will specialize in labour intensive goods. Therefore a country should export goods having the abundant factor used. A problematic issue is the assumption of two homogeneous markets and a world with constant supply of labour and land. Six reasons why the one or the other of these models leads to more realistic evaluations of trade 1. Heckscher / Ohlin assumed away technology differences and concentrate on differences in relative supplies of capital and labour as causes of trade. The H- O model has identical production technology everywhere. However Ricardo does not ignore this fact, in his model of comparative advantage a country can specialize for example in a product which is highly technological developed and therefore can create a gain of this specialization. James Harrigan is the first who introduces a model focusing on technology and factor supply differences and therefore combines the Ricardo and Heckscher Ohlin model. 2. Leontief paradox: the most capital-abundant country in the world by (any criteria) exported labor-intensive commodities and imported capital-intensive commodities, in apparent contradiction with Heckscher-Ohlin theorem. In 1953 Vasily Leontief explored the external trade sector of the U.S. which was, at this time, best endowed with capital. He found out that U.S.’ exports were more labour-intensive than the imports and on the other side the imports were more capital-intensive than the exports. Therefore he argues that quantity and quality are facts that matters. 3. Ricardo only considered a single factor of production (which was labour; in contrast to H-O which considered 3 factors namely: capital, land and labour) and there therefore would not be able to produce a comparative advantage without technological differences between countries. On the other hand H-O removed variations in technology but introduced variable capital endowments. 4. H-O only consider capital, land and labour but they do not care of the education of the works, so whether they are skilled or unskilled. In Ricardo’s model only specialization is important and therefore i.e. high skilled workers would produce a better product than the unskilled of the other country do and hence would have a gain because of specialization. 5. Ricardo basically argues that specialization lead to gains in trade. To do so, countries need to import and export the products and have therefore a need of transportation. However Ricardo assumes a perfect world without any transportation costs which can lead to a false result, i.e. Japan and Austria could have a comparative advantage but there will be high costs of transporting these goods. 6. Another problem in the H-O model is that they think of two homogenous countries which is not quite realistic. To differ, in Ricardo’s model the two considered countries can trade because of their differences and therefore gain.
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