Study Unit 4
Import restrictions for purposes of creating domestic employment may lead to
retaliation by other countries.
In the short run, Import quotas help to improve
the balance of payments
Trade barriers
If foreign govt. places restrictions on importation of goods from consumer's home country, trade between 2 countries slows & demand for foreign currency falls, shifting demand curve to left. As foreign currency is unwanted, its prices falls.
Effect of rise in foreign interest rate on domestic rates
If foreign interest rates exceed domestic rates, the domestic currency falls in value as investors seek the higher rates available in the foreign country.
Forward Discount
If the domestic currency fetches fewer units of a foreign currency in the forward market than in the spot market, the domestic currency is said to be trading at a forward discount with respect to the foreign currency.
Forward Premium
If the domestic currency fetches more units of a foreign currency in the forward market than in the spot market, the domestic currency is said to be trading at a forward premium with respect to the foreign currency.
Advantage of freely floating exchange rate system is that
it tends to automatically correct any disequillibrium in the balance of payments.
The summary of three theory
- IRP deals with forward rate & its explanatory variable is interest rates - PPP deals with spot rate & its explanatory variable is inflation rates - IFE deals with spot rate & its explanatory variable is interest rates
Effect of exchange rate set too low is
- It tends to create a surplus in the balance of payments.
The economic effects of Voluntary Export Restrictions
- Raise prices in the importing countries - Used to create artificially low supply - Counterproductive as higher prices can be charged to earn extra profit
Forms of Protectionism
- Tariffs - Import Quotas - Direct Subsidies - Export subsidies - Anti dumping legislation - Exchange Rate Manipulation - Administrative barriers - International Patent system
Purchasing Power Parity Theory is presented in two forms:
- The absolute form of the Purchasing Power Parity Theory - The Relative form of the Purchasing Power Parity Theory
In a managed float exchange rate system
- The governement allows market forces to determine exchange rates until they move too far in one directions or another. - The government then intervene to maintain the currency within the broad range considered appropriate.
Reasons of imposing tariffs are
- To increase the cost to importers, - To discourage consumption of foreign goods, and - To Raise revenue
Relative Inflation Rate and currency fluctuation
- When one currency is experiencing higher inflation than another,the holder of inflating currency will seek means to preserve their eroding purchasing power. - They will begin buying up units of the less inflated currency, thereby raising the demand for that currency and driving up its price in terms of other currencies.
Difference between Tariffs and Quotas
-Tariffs are taxes on imported goods, quotas are limit on quantity of goods that can be imported. -Tariff earn revenue & increase GDP,quota neutralizes GDP. - Tariff revenue brings gains, quotas are beneficial for traders in foreign countries
Currency Appreciation & Depreciation
-When one currency can be exchanged for more units of another currency, the first currency is said to have appreciated with respect to the second currency. - By the same token, the second currency is said to have depreciated against the first.
Disadvantage of a fixed exchange rate system is
A government can manipulate the value of its currency.
Domestic Content Rule
Domestic content rule require that at least a portion of any imported product be constructed from parts manufactured in the importing nation.
Protectionism is
Economic policy of restraining trade between states through methods such as tariffs, restrictive quotas, and a variety of other government regulations designed to allow "fair competition" between imports and goods & services produced domestically.
The forward premium or discount un-annualized on a currency with respect to another currency can be calculated as
Forward discount minus spot rate divided by Spot rate = days in year divided by days in forward period
Calculation for Forward premium & discount
Forward premium & discount = 1 + domestic interest rate divided by 1 + domestic interest rate minus 1
Political and psychological factors and currency value
Political / psychological factors are believed to have influence on exchange rates. Many currencies have tradition of behaving in particular way for e.g.Swiss franc as refuge. US Dollar as safer haven whenever there's political crisis in world.
Antidumping rule is meant for
Preventing foreign producers from "dumping" excess goods on the domestic market at less than cost to squeeze out competitors and gain control of the market.
Relative Inflation Rate means
Relative inflation rates, affect the economy's international competitiveness, so if the economy is experiencing higher inflation rate than its trading partners, its purchasing power is eroded and thus the demand for that particular currency.
Purchasing Power Parity Theory can be used to determine
The percentage that the value of a foreign currency should change to compensate for the difference in inflation between the two countries.
If the forward currency is trading at a forward premium
Then it is expected to gain purchasing power.
Interest Rate Parity Theory can be used to determine
the forward premium or discount at which a given foreign currency should be trading.
Economic effect of Exchange rate manipulation
- Raises the cost of imports - Lowers the cost of exports, - Improvement in trade balance - May lead to inflation
Relative Income Levels
- Citizens with higher incomes look for new consumption opportunities in other countries,driving up demand for those currencies & shifting demand curve to right. - Thus, as income rise in one country,price of foreign currencies rise as well.
An embargo is
- Complete or total ban on some kind of imports - It is an extreme form of the import quota
Purchasing Power Parity Theory and Interest Rate Parity Theory
- IRP deals with the forward rate, PPP is concerned with the spot rate. - IRP focuses on interest rates,PPP holds that relative inflation is more appropriate tool for explaining exchange rate differentials.
Exchange Rate between two currencies
- Is the rate at which one currency will be exchanged for another - It is also regarded as the value of one country's currency in terms of another currency
In a pegged exchange rate system
A government fixes the rate of exchange for its currency with respect to another country's currency or to a "basket" of several currencies.
Countervailing duties in reference to export subsidy
A government may impose countervailing duties on imported goods if those goods were produced in a foreign country with the aid of a governmental subsidy.
Exchange rate manipulation:
A government may intervene in the foreign exchange market to lower the value of its currency by selling its currency in the foreign exchange market.
Voluntary Export Restrictions are
Agreements entered into by exporters to reduce number of products made available in foreign country in an attempt to avoid official sanctions. OR Govt. imposed limit on quantity that can be exported out of country during specified period of time
International trade & currency value: International trade affects value of currency through
Amount of export/imports nation may have, countries selling many goods, tend to appreciate Forex standards & those importing highly have currency fall in value since they are spending more to their trading partners than they gain from them.
Government participation and currency value
Govt participate to influence currency value either by flooding market with domestic currency to lower price,or buying in order to raise price. This is known as Central Bank intervention. However,size / volume of Forex market makes it impossible.
Ease of Capital Flow
If a country with high real interest rates loosens restrictions against the cross border movement of capital, the demand for the currency will rise as investors seek higher returns.
Effect of rise in domestic inflation on foreign inflation
If the domestic inflation exceeds foreign inflation, the domestic currency will loose purchasing power.
Advantage of managed float exchange rate system is that
It has the market-response nature of a freely floating system while still allowing for government intervention when necessary.
Advantage of a fixed exchange rate system is
It makes for a high degree of predictability in international trade because the element of uncertainty about gains and losses on exchange rate fluctuations is eliminated.
International Fisher Effect Theory states that
Spot rate is expected to change equally in opposite direction of int rate differential;thus,currency of country with higher int rate is expected to depreciate against currency with lower rate,as higher interest rates reflect expectation of inflation.
Meaning of Tariffs
Tariffs are taxes imposed on imported goods.
An exemption from U.S. antitrust law is provided by
The Export Trading Company Act of 1982
The absolute form of the Purchasing Power Parity Theory
The absolute form of the theory asserts that the price of a given good in various countries must necessarily converge since consumers will seek out the lowest price.
The Relative form of the Purchasing Power Parity Theory
The absolute form of the theory asserts that, because of transportation costs and government intervention in form of price supports, tariffs, quotas, etc, prices worldwide can never truly be the same on a given food.
Currency fluctuation and position in market
The foreign company will have advantage in the U.S. market, when a foreign competitor's currency becomes weaker compared to the U.S. dollar.
With regards to high-inflation currencies, IRP suggests that
They usually trade at large forward discounts.
With regards to high-inflation currencies, PPP & IFE suggests that
They will weaken over time.
Repatriation of currency
When foreign currency is converted back to the currency of the home country it is referred to as repatriation.
Relation between currency fluctuations and import & export price fluctuations
When the U.S. dollar depreciates, the import prices will increase and the export prices will decrease.
Speculation and currency value
When there's belief that economy is 'over heating' & soon there will be devaluation, then chances are high that, speculators will pull out monies, causing there to be more supply than demand on Forex for that currency, hence its depreciation.
A trigger price mechanism is
a tariff barrier against unfairly cheap imports by levying a duty or tariff on all imports below a particular reference price, it means the price that "triggers" the tariff.
Special tax benefits to exporters are
an indirect form of export subsidy
Calculation of change in value of foreign currency with Purchasing Power Parity Theory
change in value of foreign currency = 1 + Domestic inflation rate divided by 1 + foreign inflation rate minus 1
Tariffs are
import restrictions.
The most likely response to foreign export subsidies is
imposing contervailling duties.
Disadvantage of freely floating exchange rate system is that
it makes a country vulnerable to economic conditions in other countries.
Disadvanatge of managed float exchange rate system is that
it makes exporting countries vulnerable to sudden changes in exchange rates and lacks the self correcting mechanism on a freely floating system.
Export subsidies are
payments by the governement to producers in certain industries in an attempt to increase exports.
Relative Interest Rates
- If interest rate in given country rises, other currencies will pour in as investors seek higher returns from fixed income securities. - As demand for that country's currency rises, its price will rise in terms of other country's currencies.
Import Quotas
- It is a type of protectionist trade restriction - It sets a physical limit on the quantity of a good that can be imported into a country in a given period of time.
Effect of exchange rate set too high is
- It makes a country's exports less affordable to consumers in other countries. - This tends to create a deficit in the balance of payments.
The economic effects of an import quota is
- Protection to domestic industries from foreign comp. - Protection to workers who otherwise might be laid off. - Rising prices for the consumer by reducing the amount of cheaper, foreign-made goods - Reducing competition for domestic industries
Calculation of change in foreign currency with International Fisher Effect Theory
1 + domestic interest rate divided by 1 + domestic interest rate minus 1
In case of balance of payment deficit, a company can take following actions.
1) Attempt to increase exports 2) Devalue its currency 3) Draw down its reserves of the trading partners' currencies.
Types of Exchange Rate Systems
1) Fixed exchange rate system 2) Freely floating exchange rate system 3) Managed float exchange rate system 4) Pegged exchange rate system
Three basic arguments in favor of Protectionism
1) Reducing imports protects domestic jobs 2) Certain industries are essential to national security 3) Infant industries need protection in the early stages of development.
The five factors that affect currency exchange rates can be classified as
1) Trade related factors are - Relative inflation rates - Relative income levels - Trade barriers 2) Financial factors are - Relative interest rates - Ease of capital flow
Economic effect of Tariffs and Quotas
1) Workers are shifted from relatively efficient export industries into less efficient protected industries. 2) Real wages decline as a result, as does total world output.
A direct effect of imposing a protactive tariff on an imported product is
Lower domestic consumption of the item.
In a freely floating exchange rate system
The government steps aside and allows exchange rates to be determined entirely by the market forces of supply and demand.
The Forward rate is
The number of units of a foreign currency that can be received at some definite date in future in exchange for a single unit of the domestic currency today.
Spot Rate
The number of units of foreign currency that can be received today in exchange for a single unit of the domestic currency.
In A Fixed exchange rate system
The value of a country's currency in relation to another country's currency is either fixed or allowed to fluctuate only within a very narrow range.
With regards to high-inflation currencies, IRP suggests that
Their economies will have high interest rates.
If the forward currency is trading at a forward discount
Then it is expected to lose purchasing power.
Interest Rate Parity Theory
Theory holds that exchange rates will settle at an equilibrium point where difference between forward rate and spot rate i.e. forward premium or discount equals exact amount necessary to offset difference in interest rates between two countries.
When the demand for a country's merchandise, capital assets, and financial instruments rises
demand for its country's currency rises.
