International topics june 2010

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Macroeconomics:The Global Context

Robert A. Gough, Jr., Ph.D.


Macroeconomics

Is about the overall economic environment

…How it works as a whole …How:

(1) Output GDP = C + I + G + (Ex – M)

(2) Role of Money

(3) Expectations

…impact and determine Macroeconomic conditions


Macroeconomics

The Global Context is about…

• Trade flows• Income flows

• People flows

Tariffs…Quotas…Terms of trade…Dumping…Protectionism…Trade zones…Exchange rates…Balance of payments…

IMF…World Bank…World currency…Purchasing powerparity…Current account…Capital account…


International Finance



Balance of Payments……a close cousin to GDP accounting

• GDP Account = reports a nation’s output and its component parts

• BOP Statement = records a nation’s cross-border transactions



As in a GDP account…all numbers in aBalance of Payments Statement are flows…

…indicating the value of:

• Exports and Imports• Income Receipts and Payments• New Foreign Borrowing or Lending

…over a particular period oftime…like a year.



A Balance of Payments Statement

Current Account

• Balance on Trade of Goods & Services

• Balance on Merchandise Trade (Goods)• Balance on Trade in Services

• Net Income (Net Factor Receipts)

• Net Unilateral Transfers




Capital and Financial Account

• Net Capital Account

• Financial Account

• Net Foreign Direct Investment• Net Portfolio Flows• Other Capital Flows, Net• Change in Official Reserves

• Errors and Omissions (Statistical Discrepancy)




…is very revealing…offers a unique window on a country’s cross border transactions…summarizes a country’s relationship to the global economy

• It tells a story……just like your personal checkbook…and your library
















Some explanations…Capital & Financial Account

“Financial Account”…

“Changes in official reserves” = reflect increases/decreasesin the government’s stockpile of gold and foreign currencies.

“Errors & Omissions” = residual category reflecting statisticaldiscrepancies in compiling BOP data.





Exchange Rates……strongly affected by:

(1) A country’s current account balance…trade balance

Logic:

• If consumer demand for foreign products rises…• A country’s current account balance deteriorates…• …and its currency depreciates• Because higher demand for foreign products bids up

price of foreign currencies needed to buy them



Exchange Rates…

“Sustained current account deficits are moretypically associated with long-term currencydepreciation than with long-term appreciation.”




(2) A country’s inflation…purchasing power parity

Logic:

• If a country experiences consistently higher inflation…• A country’s current account balance deteriorates…• …and its currency depreciates• Because…rising prices for a country’s products

reduces demand for those products.



Exchange Rates…

Relationship between inflation and exchange ratesviewed through “purchasing power parity”….

• The Law of One Price• The “Big Mac Index” criteria

…A unit of currency ($) should always have the samepurchasing power in one country as another.

…Inflation undermines this parity.




(3) A country’s interest rates…regarded by currency traders as the single most

powerful driver of exchange rates…in short run.

Logic:

• Higher interest rates attract foreign capital…• …driving up the value of a country’s currency



Exchange Rates…

Regardless of other models and observations…Law of One Price – “uncovered interest rate parity”

A country’s currency tends to appreciate after arise in its interest rates…and to depreciate after a fall.



Making Sense of Exchange Rates…

• It’s difficult…!

• Most important lesson: currency markets are unpredictable…

• …and irrational

“Ask 10 traders…likely get 10 different explanations!”




But…

…exchange rates are still subject to basicpressures of supply and demand.

• Exchange rate is the price of one currency in terms of another…like products!

• What raises the demand for a currency creates pressure for appreciation…and vice versa




Examples:

• Surge in American demand for foreign goods or financial assets…will weaken the dollar.

• Burst of European inflation…will weaken the euro…and strengthen the dollar.

• Unexpected increase in British interest rates…would strengthen the pound.




Reason why exchange rates are difficult to predict…

• Currencies are subject to a myriad of pressuresat the same time.

Ups and downs in aggregate demand…currencyinterventions by governments…interest rate

movements…inflation…financial panics…politicalcrises…oil shocks…new technologies…abrupt changes

in expectations…etc.




Upshot…Rules of Thumb…Best Predictors:

(1) Interest rates – for short-term movements…interest rate increases ► rapid

appreciation

(2) Inflation – for medium-term movements…high inflation ► depreciation

(3) Current account imbalances – for longer-termmovements

…deficits ► depreciation


Macroeconomics

Is about the overall economic environment

…How it works as a whole …How:

(1) Output GDP = C + I + G + (Ex – M)

(2) Role of Money

(3) Expectations

…impact and determine Macroeconomic conditions


Macroeconomics – The Global Context

Is about the global economic environment:

...How various forces

...Summarized by:

(1) Balance of Payments

(2) Exchange Rates

…impact and determine global economic conditions

Economy & Finance

International topics june 2010