Macroeconomics in an Open Economy Part II: Exchange rates, PPP, monetary policy, Europe’s Crazy Challenges

The market for euros. Just like any other market. How many dollars for one unit of euros? $/bbl in the oil market

$/€ in the euro market

The price is dollars per unit of oil. The quantity is units of oil. The price is dollars per unit of euro. The quantity is units of euro. And, of course, we have downward sloping demand!

The surge in oil prices, 1972 to 1980 led to a sharp demand reduction. The plunge in the price of European currencies, 1980 to 1984, drove the price of European products sharply lower in the USA. This led to a surge in the buying of euros, to facilitate the buying, U.S. citizens, of European goods.

Supply: upward sloping. Oil leaps to $100/bbl, fracking is invented, output soars. The price of the euro soars, this means you get many more $ per euro. The purchasing power of the euro jumps, you swap your euros for dollars to buy cheap USA goods

What is the long term equilibrium for a currency? In theory, PPP? • Purchasing Power Parity USA HAIRCUT CAR HOUSE WINE CHEESE MOVIES

$20 $25,000 $100,000 $20 $5 $12 $125,057

FRANCE ε28 ε27,000 ε73,400 ε17 ε3 ε9 ε100,457

HOW DO WE CALCULATE PPP

let’s think about it for wealthy folk: • USA $125,000 TO LIVE • FRANCE: € 100,000 TO LIVE • PPP exchange rate is 125/100 = 1.25 $ per €

• Where is euro? 1.06$ = 1€ • So the euro area, today, has an undervalued exchange rate. • It’s a good time to visit Paris!

The Economist Magazine Offers us the Big Mac Index (as of 11/16) USA:

($5.00)/(1 burger)

China: (18.6 rm)/(1 burger)

We calculate what the rm/$ exchange rate need s to be, so as to equalize the cost of the

burger: $5.00 ?? rm 18.6 rm X = 1 burger 1 burger 1$ ?? rm 18.6 rm 1 burger = X 1 burger $ 5.00 1$ 1$ = 3.72 rm

The current rm/$ exchange rate tells us it requires 6.9 rm to get 1$. The Big Mac index says it should only take 3.7 rm to buy 1$. 3.72 rm 6.9 rm , so 1 rm = 27 cents versus s , so 1 rm = 14.5 cents 1$ 1$ 14 cents 27 cents = 53% Thus the Big Mac index says the rm is 47% undervalued.

The Big Mac index: We compare hamburger prices, and infer the currency value that makes them equal: (July 2016 values for burgers, November 2016 exchange rates)

burger

price (local)

local

dollar

implied

currency price of value for overvalued (-) per $

burger currency undervalued (+)

USA

5.00

China

18.6

6.9

2.70

3.72

46%

euro area

3.82

0.94

4.06

0.76

19%

Japan

370

112

3.30

74

34%

Russia

130

65.4

1.99

26

60%

How has PPP fared over the past two years.

China euro area Japan Russia

2014

2016

Δ, percentage pts

43%

46%

3%

-4%

19%

23%

24%

34%

10%

60%

60%

0%

Central banks can use monetary policy to guide their exchange rate: (China kept the renminbi at 8.3 per $ for 10 years)

When thinking about ‘Open Economies’ we must return to thinking about monetary policy:

• What do central banks do? • They usually buy and sell treasury bills. • Why? We said, from a closed economy perspective, to drive one of two targets: They can use the quantity equation and target money: MV = PY They can think of a loanable funds model and target interest rates: ff = π + 0.5 X(π – π*) + (U* - U) +r*

How did the renminbi stay steady vs the dollar as the U.S. trade deficit with China soared?

• China pegged their currency: • We bought a gazillion TVs

• The Chinese central bank bought T bonds

We can use our supply and demand model: • U.S. demand for China made goods soared. • U.S. deficit with China climbs from $20 billion to $200 billion, 1995 to 2005. • U.S. demand for Chinese renminbi, needed to buy Chinese goods soared.

U.S. Demand for RM soars: the RM should soar vs $ A dime for a RM in 1995, a Quarter for a RM in 2005 (0.12$/RM = 8.3RM/$)

U.S. Demands RM. But P.B.o.C. Supplies Needed RM. They do so to keep RM/$ STEADY

Cumulative purchases? China bought over $4 trillion of U.S. treasury securities.

A central bank can print money, increase supply, and drive its currency lower.

Zero interest rates in Japan 2005-2007, invited a lower yen.

Bank of Japan tired of 20 year deflation. Their answer, drive their currency down! • If my currency falls, it requires more yen to buy other currencies. • The cost of imports will rise. • This should help lift overall prices, and help end deflation. • It also will increase foreign demand for your exports. • This will strengthen your economy, also a good idea to end deflation.

From 2005 to mid-2008, during the period of yen normalization, import prices from Japan slide by 11% versus import prices from Germany.

In 2008-2009 the world plunged into a deep recession… • Some argued that the USA needed to use super easy monetary policy to get the dollar to fall. • They were arguing the USA should pursue, 2008-2009, the strategy Japan pursued in 2005-2007 • Why was that a nutty suggestion? • (Hint: can everyone pursue that strategy?)

The Euro Area: France wants a Geo-Political role. Rest-of-Europe want German interest rates. • France wanted to return to relevance, convinced Germany that: ‘in unity there is strength’ Rest of Europe envied low borrowing costs that Germany had secured via its tough stance on inflation.

• Germany, paranoid about inflation, insisted ECB must operate on Bundesbank principles

Why did Italy, before the euro, have much higher interest rates relative to Germany? Before the euro, Italy had its own monetary policy. Italian laborers, consistently demanded bigger wage increases than in Germany , despite failing to keep up with their German competitors productivity. Italian products would become uncompetitive. Italy’s trade deficit would swell and its economy would struggle.

The Bank of Italy, as it rescued the Italian economy, explains, higher Italian interest rates

• Periodically, the Italian central bank would drive the Italian Lira sharply lower, versus the German D-mark. • This would reduce the global cost of Italian labor. It would restart the economy. • But anyone who owned Italian bonds would see their value plunge, in $ of D-mark terms. • So Italy paid a premium interest rate, to compensate for the risk of a big plunge in the lira.

The Problem? Germany, as always, delivered super competitiveness

Italy found itself to be uncompetitive, but without the ability to devalue! • Italy had a large trade imbalance. • It’s workers were uncompetitive. • But it could not lower the value of the lira

And Germany refused to be a team player! • Two problems: Italy wages are 20% higher than Germany’s.

The ECB is legally mandated to deliver 2% inflation.

It is arithmetic. To meet both goals Germany needed to accept higher inflation

Germany Italy

100 120

104 120

108 120

112 120

116 120

120 120

Germany Italy

100 120

102 118

104 116

106 114

108 112

110 110