# and exchange rates in a world of (more or by ikn20172

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```									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.
transactions
• “Uncovered” because

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
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.

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
factor proportions. Give 6 reasons why the one or the other of these models
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:
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

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
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
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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