Esame International macroeconomics, libro consigliato International Macroeconomics

0 This is a course in international macroeconomics.

Dornbush and Fisher defined macroeconomics as being concerned with the behavior of the economy as a whole booms and recessions, its total output of goods and services and the growth of that output, the rate of inflation unemployment and, then, the balance of payments and exchange rates: so, this course in international macroeconomics is predominantly about the second 2 aspects (the balance of payments and the exchange rates).

John Taylor has given a definition for macroeconomics which is even more precise albeit a little bit more economics, which says open economy macroeconomics is essentially about 6 aggregate: markets, goods, labor, money and, then, foreign exchange domestic bonds, foreign bonds and foreign exchange rates.

About the contents to what's the course is about, it's about the exchange rates and about the balance of payments and a few special topics.

Books: the textbook that the course is based upon is by Feinstein and Taylor (only the second part, the Taylor part).

Exam: 3 open questions: 2 theoretical questions and 1 exercise.

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Exchange rates and course structure

We will talk about exchange rates, which we're going to divide in 3 parts:

1. Exchange rate essentials and the arbitrage conditions that reign on that market;
2. Exchange rate fundamentals: the anchor for exchange rates;
3. The short-run day-to-day possibility to forecast/to predict exchange rates and we will start out by saying that what we're doing when we're talking about exchange rate predictions is that we care about 2 things essentially:
   1. One, we care about the direction our exchange rates appreciate or depreciate and;
   2. Secondly, we're going to be interested in the magnitudes: and that is not necessarily the same thing if you want to just assure yourself that you won’t lose out of it for an exchange… [leggo]

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Exchange rate essentials

So, the first part is going to be about what features of the exchange rates do we need to understand, how these foreign exchange markets operate and what are the arbitrage conditions that matter for exchange rates.

Now, an exchange rate, a nominal exchange rate, - and we use the letter the capital letter E - is the price of some foreign currency expressed in terms of a home or domestic currency.

Now, because it's not clear what's home and what's foreign, we can express exchange rates in 2 ways.

Throughout this lecture, we're going to use the exchange rate as the units of home currency per unit of foreign currency…

Numerical example for the fact that the exchange rate can be 2 things.

The following is the so-called cross tables for exchange rates: so you see those the columns which are in dollars, euros, pounds and you see in in the lines various currencies the Canadian dollar, Danish krona, the euro, the dollar; now, you find the euro-dollar exchange rate in there twice:

1. Once, quoted as how many euros do I get per dollar that would be 0.92 and;
2. Then, once how many dollars do I get per euro and that will be 1.08… [leggo solo tabella]

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Now, if one currency buys more of another currency, we say it has experienced an appreciation and this appreciation will be basically in terms of numbers and you will see a fall in E/in this exchange rate that will be quoted.

We can, by contrast, identify a depreciation the fact that one currency buys less of another currency…

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Exchange rate regimes

The last thing is something about exchange rate regimes:

• We have fixed (or pegged) exchange rates regimes: in this case, a country institution/a central bank would set the exchange rate and say that's it and it's going to be like that forever; and
• We have floating (or flexible) exchange rate regimes: the central bank/the country does not intervene at all.

Obviously, you can have anything in between: something that's sometimes called “dirty floating“ because you let the exchange rate float, but you intervene at certain trigger points.

Now, for us, obviously, this is important because, when you want to predict an exchange rate and there is a fixed exchange rate in place, well, the prediction is very easy: all you really need to be sure is that no exchange rate price has been hit, but otherwise you can be pretty sure that the exchange rate is what it is…

Now, just to give you a few examples, the following is respectively euros against yen, euros against pound, and euros against the Danish krone…

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…and you can basically see:

• The euro yen is fluctuating dramatically;
• The euro pound is fluctuating but not that much (probably because the British Central Bank, the Bank of England might have an interest in holding its currency within a certain range to the euro) and;
• The Euros per Danish krone, which is basically a straight line (in 2001 we see some fluctuation but then onwards it's just a straight line and that is what we consider a fixed exchange rate).

Exchange rates are set on what is called foreign exchange markets (so sometimes called forex markets or even quicker FX markets).

Now, note that these are not organized exchanges: there is not a stock market, there is no building like this the Wall Street stock market. Trade in these exchange market is conducted over the counter: there's be 2 people meeting somewhere not even in real but they meet virtually.

The foreign exchange market is huge: in 2013, over 5 trillion dollars were traded every single day.

And the major foreign exchange centers are the UK, the US, Japan, but there are other important markets in places like Hong Kong, Paris, Singapore, Sydney and Europe… [leggo]

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Spot contracts and derivatives

Now, the simplest transaction for an exchange market is a so-called spot contract: that basically means that I give you my currency and you immediately give me back your currency in the exchange on the spot. When we talk about the exchange rate, this is the exchange rate we mean: the one that is traded on spot markets.

And this is the biggest market: 90% of all forex transactions are spot market… [leggo]

There are others and these are what is called derivatives and, in particular,:

• Forwards;
• Swaps;
• Futures;
• Options.

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The forward is the simplest and most used derivative actually and you see on the graph on the right hand panel that this forward rate 3 months ahead is pretty much identical to the current spot rate when we talk about the euro dollar exchange rate… [leggo]

[studio]…

So, with the swap, you might sell dollars today with the obligation to buy them back in 3 months from now: so, basically, a swap is nothing else but a spot contract + a forward contract.

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So, a future is standardized and that makes it rather different in the sense that there are regular dates (end of trimester, for instance) where these futures would be happening.

So, as opposed to a forward where I’m obliged to buy, with an option I’m not obliged to buy.

For example: suppose you think that the dollar is going to increase in three months from now and, so, you sign a forward contract today to buy dollars at extreme specified price today in three months from now and, if the dollar really increases, you're going to make a gain out of that.

Now, it could of course be that the dollar falls and, in that case, you're going to lose because you still have promised to buy the dollars at the current price, but the value of the dollars in 3 months from now is less and you make a loss.

An option gives you the possibility to renege on that [rinnegarlo] and you say “well, I bought these dollar options because I thought the dollar price would go up, but it turns out it didn't so I don't want those dollars anymore” and you renege on that option contract by, basically, not pulling your option.

So that's a very easy way to do it: obviously, there is a cost to substitute it because somebody would sell the option to you today if and only if that is more favorable to him or her as opposed to selling you a forward right away.

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Hedging and speculation

You engage in derivative trading for 2 reasons:

1. Because of hedging and hatching: in order to have risk avoidance and, so, we basically try to eliminate risk by hedging against a currency.
2. The other reason is speculation: so, there will be no real money coming in, but I think I have an idea/I have a model which tells me that, in the future, I am going to see an increase in the dollars and, therefore, I'm going to buy all the forwards and all the options on dollars that I can get hand off right.

Therefore, the idea is behind hedging is I might have a future revenue, I might be a firm in Germany and I know that in 3 months from now I’m going to get money from the US, okay.

And, so, what will I do is: I know that I get money then, but I don't know how much are the dollars that I’ll get in 3 months from now are worth and, therefore, I buy a forward contract which guarantees me the price of a new day and, so, I have no risk associated with this future payment of dollars that I receive;

And that would be speculation because it's taking a risk because, in case the dollar moves the other way, I’m going to lose…

Now, it's important to know that both of these things exist on the exchange markets.

Now, we want those derivative markets because we want to have an instrument for firms to avoid risk.

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Speculation is something that happens on top of that and is unavoidable, but very very often it is the speculators that are important because, if there wouldn't be speculators, it might not be that somebody is going to cover the position of that German firm who wants to hedge away its risks.

So, these speculators are, in a way, needed to guarantee the functioning of the foreign exchange market.

Arbitrage in exchange markets

Now this brings us to arbitrage.

Arbitrage is the way how prices equalize on markets.

There are 3 forms of arbitrage:

1. The simplest one so simple that people don't realize it is a way of arbitrage is arbitrage on the spot exchange rate.
2. As opposed to that, you could also transfer your money to London: you can exchange your dollars in London for British pounds and you can then use those pounds in London for whatever: in particular, transferring back to your New York bank account.

So, in the following slide, there are 2 markets: New York, on the top, and London, in the bottom; maybe, someone wants to transfer dollars in New York to pounds in New York: therefore, he goes to a foreign exchange market in New York, calls up Citibank or whoever and says “I want British pounds” and they'd quote you an exchange rate and you'd transfer your dollars into British pounds on the New York exchange market;

You might have done that as well you might have gone on holidays abroad and, instead of already exchanging money at home, you will wait until you arrive at destination because you think the exchange rates are better there.

In liquid markets, like the dollar pound market, that shouldn't be the case because it is more profitable for a trader in New York to move the money to London to exchange in London and, then, to move the money back to New York and, by doing that, there is less of the pound demand in New York (so the price for the pound in New York will fall), there is more demand for pounds in London and, so, the price would increase and, in the end, these 2 markets would find an equilibrium price or the exchange rate whether you transfer it to New York or whether you're transferring in London should be the very same (!).

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I might say that's not perfectly correct because there's all these transaction fees: so, the market guarantees that, wherever you are in the globe, these prices are identical.

Arbitrage in three currencies

Now, the following is a little bit more tricky and this is arbitrage in 3 currencies: therefore, if you do this only in New York and in London, we've just showed it that doesn't matter and, so, let's ignore the place of trade; here, instead, we will be doing something slightly different and we're going to be looking at direct or indirect exchange of currencies.

• So, what do we have: once again, you want to exchange 1 dollar in the British pound and there is an exchange rate for that. And this is the direct exchange rate: it says you know for 1 dollar, you get a 1,10 pounds;
• But, instead of going directly to trade dollars for pounds, you could also go the indirect way: you could first exchange your dollars for euros and, then, exchange your euros for British pounds. And you could say why would I do that and the reason could be that that is the cheaper alternative that, by going the indirect way, you get more pounds for your dollars.

Now, if that is the case, then, immediately you would see traders flowing into that possibility. And how would they do that? Very simply: they will, basically, sell dollars and buy euros and that will increase the price of those euros, it will reduce the price of the British pound and exactly these 2 price movements are going to move once again those markets into equilibrium.

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So, you're going to be ending up that the direct exchange rate is going to be the same as the indirect exchange rate or the exchange of dollars to count dollars is going to be equal to exchange of pounds to euros multiplied by the exchange rate of euros to dollars: so, it's basically going to be the same (!)…

Now, this is important for 2 reasons:

1. First, it doesn't make any sense at all to go directly;
2. Second, it makes a lot of sense to go indirectly because, basically, instead of having an exchange rate quoted between any 2 countries of the world, this arbitrage condition guarantees us that we can actually always go the indirect way and, therefore, we do not need all these cross traits of the table and all we need is the direct exchange rates to the dollar and we can always go indirectly and we can be assured that exchange markets will give us the same price.

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Arbitrage on the future and interest rates

The last of the arbitrage conditions is an arbitrage condition on the future: so, here, we're starting talking about interest rates. And that is a 3rd form of arbitrage of these markets… [leggo]

Now, the idea behind it is that you don't really care for foreign exchange, but you care for keeping your money safe: so, you might have money today and you might want to keep that for up to the next year; now, if you do that, you can deposit your dollars in your US bank account and you get i dollar interest rates on that and, so, for 1 dollar is going to give you 1+i dollars in a year from now.

Instead, you could transfer your dollars into euros and that would give you the euro-dollar exchange rate euros today and, then, you deposit those euros in Europe and you get E euro interests on that: so, that would give you 1/E dollar euro multiplied by (1+i) euros in a year from now; and, then, you take those euros in a year from now and you transfer them back into dollars, but, important, when you do that, you don’t know what the future price of dollars is in euros (!)…

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However, there is a market for that, the forward market: so, you just go to the forward market today and you say “I want to buy dollars in a year from now” and, so, you multiply your euros for the foreign rate F dollar-euro and that's going to give you your return.

Once again: if one or the other yields a higher return, traders would immediately abandon where they are and move to the trader and that would drive the prices up and the returns down so that because of arbitrage the direct way to keep money for the future must be identical to the indirect way.

We call this relationship the covered interest parity: “covered”, in the sense that your risk is completely covered: there is no risk associated with it because:

• You know what dollar deposits earn;
• You know what your deposits earn and;
• You know what the forward exchange rate is because there is a market for that: therefore, nothing is uncertain in that (which is why this relation holds so tightly)… [solo relazione]

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The following is a graph…

… and you see that, from 1981 onwards and both with the fact that UK and Germany have abolished capital controls, there is basically no profits to be made from deviation from covered interest parity: so, basically, there is no difference in these exchange rates (except for really minor fluctuations).

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Uncovered interest parity

Now, there is a 2nd way to do that called the Uncovered Interest Parity.

It looks really the same, but with one single difference: instead of using the forward rate to transfer our future euros into dollars, what we're going to be do is we are going to be using our expectation of the exchange rate and, so, we do not close that position, we keep it open, we risk.

That is of course no longer a risk-free way to look at it because now we have a risk, but our Uncovered Interest Parity gives us a fundamental relation in exchange rate economics (!)…

Now, the following is, once again, the UIP: dollar returns equal to expected dollar returns when using euro deposits… [leggo]

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And we can reformulate that and it gives us an idea of the current exchange rate and, basically, it says that the current exchange rate is equal to the interest rate differential (so, how much more or less interest rates do I get in Europe with respect to the US) multiplied by the expected exchange rate…

And you're going to say: “I know what the interest rates are, but I don't really know what the expected exchange rate is”. There are 2 ways to find out:

1. Just look at forward rates because forward rates are nothing else than the consolidated belief of the market about the future exchange rate;
2. The other way is basically look at well what are the fundamentals of the exchange rate.

Just to give you an idea about how good the uncovered interest period is (and you'd see well actually it's not).

So, what do we have in the following are 2 things:

1. The expected rate of depreciation: so, the Uncovered Interest Parity and;
2. The forward premium.

And every green dot is just 1 country's bilateral exchange rate.

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And you'd see a huge cloud and you say “but there is noise in it and not all countries have perfectly open capital markets”: ok, but deviations can happen, and what's important is that these deviations