8.2 FOREX and trade

Question 1

What is the market for foreign currency exchange?

Answer 1

• Demand for pound is equal to NX, since paid in pounds
• Supply of pounds = NCO, since people wanting to purchase foreign assets must sell pounds at the FX market to buy them

Real exchange rate E equilibrates the supply an demand for pounds in the forex market

Supply NCO is fixed given the interest rate (supply curve vertical)
- We saw that the NCO is determined in the market for loanable funds in 8.1 And thus depends on this

Demand NX decreasing in real exchange rate - higher exchange rate decrease exports, increaase imports (SPICED)

Axis:
y = real exchange rate
x = quantity of pounds exchange into foreign currency

Question 2

How do market for loanable funds and forex market relate to eachother?

Answer 2

Page 29

• Market for loanable funds determines equilibrium real rate of intersest
• This determines the net capital outflow, which determines the real exchange rate together with the forex demand NX

Loanable funds - S and D determine interest

Interest determines NCO, provides supply of pounds in FOREX market

Forex market - S and D in $ in the market for foreign currency exchange determine the real exchange rate

In short:
E and r, adjust to equilibrate market for loanable funds (r) and FOREX market (e)

These in turn determine:
National saving
DOmestic investment
Net capital outflow
Net exports

Question 3

What is the relationship with PPP with FOREX?

Answer 3

PPP in long run where intenrational trade fully responds to changes in P/P* i.e. to changes in relative price levels

• Implies FOREX demand curve in third graph is horizontal at E = 1

Current model allows for real exchange rates different from what PPP would have - consistent with reality and facts

Question 4

What are examples and impacts of trade policy

Answer 4

Examples:
- Tariffs
Import quotas
-Voluntary export restrictions

Macro impact:
- Directly lowers imports, leads to increase in net exports
- Effect offset by increase in real exchange rate - lower net exports back to level it started at (namely the NCO determined by the real exchange rate)

Question 5

What are import quotas?

Answer 5

• Increases net exports for any given real exchange rate, demand for pounds in FOREX market prices, demand shifts outwards

NOTE only affects FX market
- Import quota increased demand for pounds so shifts up
- Causes real exchange rate E to appreciate

There is a rise in net exports for any given real exchange rate. As a result, demand rises for pounds in the market for foreign currency exchange rises. This appreciation tends to reduce net export, thus offsetting the direct effect of the import quota on the trade balance

Micro effects:
- Can affect specific firms and industries e.g. UK car manufacturers may benefit from quota on Japanese cars, but exporters lose out due to pound appreciating

Conclusion:
- Import quotas surprisingly do not affect UK trade balance

Less suprisingly when we recall:

NX = NCO = S - I
- Trade policies do not alter S and I, and real exchange rate must adjust to keep trade balance the same, regardless of any trade policies imposed by he government

Question 6

What is capital flight?

Answer 6

Political/economimc instability leads to capital flight

This is a large and usdden reduction in demand for assets location in a country

examples:
Mexico 1990s
Thailand banking crisis 1997
Greece after financial crisis
Brexit (not nearly as bad)
Russia 2022

Effect illustrated page 29:

1. Decide risky place to saving, so moves capital to safer place - increases NCO for country so NCO shifts right
2. Conseqeuently, demand for loanable funds shifts right too, driving up interest rates
3. Since NCO higher for any interest rate, the curve shifts the NCO to the right
4. At the same time, in the FX market, supply of country 1 currency shifts right, causing the value to depreciate - making less valuable compared to other currencies

Question 7

Impact of capital flight

Answer 7

Affects both markets:
Real interest rate rises
- Less domestic investment
- Less capital accumulation
- SLows economic growth

Currency depreciates
- Increases net exports, improves trade balance ceteris paribus

Question 8

What happened in Mexico

Answer 8

1994-5 interest rate on short term Mexican government bonds rose from 14% to 70%

Peso also depreciated from 29 to 15 US cents per peso

Note: to stem capital flight, central banks often raise interest rate directly

Question 9

What happened in Russia?

Answer 9

Capital flight and direct sanctions on portfolio investments - as we have seen this increases the real interest rate and thus reduces growth
- Depreciation of the ruble
- To counter this, CB increased interest rate sharply