Globalization and Financial Markets

Exercise solutions 2-10

Exercise 2

1. Thailand had a …xed exchange rate regime with small bands around the parity rate. The exchange
rate was hovering around 25 THB/USD. We could describe it as a soft peg.
2. You should …nd a rate of depreciation of THB/USD around ln(26:1) ln(25:1) 3:9%.
3. However, at the same time, against the basket of currencies the THB appreciated by approximately
2:2% (see calculation in the Table).

Country Export Share Weight exchange rate to USD Bilateral exchange rate (Sj)
j % wj 1st jan 1995 1st May 1997 1st jan 1995 1st May 1997 Change Wj(Sjt/Sjt-1)
US 19 0.25 1.00 1.00 25.11 26.11 3.98% 0.26
Japan 16.5 0.22 100.52 126.57 0.25 0.21 -17.42% 0.18
Eurozone 14 0.19 1.53 1.70 16.41 15.36 -6.40% 0.17
Singapore 12 0.16 1.45 1.45 17.32 18.01 3.98% 0.17
HK 5 0.07 7.74 7.75 3.24 3.37 3.85% 0.07
Malaysia 3.5 0.05 2.55 2.51 9.85 10.40 5.64% 0.05
China 3 0.04 8.46 8.32 2.97 3.14 5.73% 0.04
UK 2.5 0.03 0.64 0.62 39.17 42.30 7.98% 0.04
Total 75.5 1.00 Total 0.9765

4. There is a discrepancy between the trade-weighted index we calculated and the THB/USD rate
changes. The reason is that in the same time, the USD appreciated vis-a-vis many world currencies, and
along with the U.S. dollar so did all the currencies that pegged their currencies to it. This must have hurt
Thai exports and increased imports. Note that if the THB/USD was a hard peg (without any bounds) then
the appreciation relative to the trade weighted index would be more severe.

Exercise 3

1. What is currently the pro…t of XYZ if it sells the product A at 20 Euros? If XYZ cares about pro…t
expressed in Slovos, what exchange rate would it need to have so as to break even? To make a pro…t of 40
Slovos per unit?
A: The cost of a unit is 2 10 = 20 Slovos whereas the pro…t denominated in Slovos is 20 Euros x 2
Slovos/Euro = 40. So a pro…t per unit is 20. The per unit pro…t in Slovos is then 20S 20. XYZ would
break even if S = 1. And for the pro…t to be 40 Slovos per unit 20S 20 = 40, S = 3.
2. Suppose that the technology changes to respect some EU directives and now XYZ needs to use also
input B that they import solely from abroad. You need 1 hour of labor and 1 unit of input B to produce a
unit of product A. One unit of input B costs 5 Euros. What is currently the pro…t of XYZ? If XYZ cares
about pro…t expressed in Slovos, what exchange rate would it need to have so as to break even? To make a
pro…t of 40 Slovos per unit? Do your answers di¤er in comparison to question 1? Comment.
A: The cost per unit is now 10 + 5S = 10 + 5 2 = 20 Slovos per unit. So the per unit pro…t is
20S 10 5S = 15S 10. If S > 32 then XYZ will make pro…t. However, to make a pro…t of 20 Slovos per
unit, 15S 10 = 40 or S = 10 3 . It is easier now for XYZ to break even with a more appreciated exchange
rate than before because a part of their cost is expressed in Euros, so the exchange rate movements have less
of an impact. Now, however, it is also more di¢ cult for XYZ to earn a high pro…t expressed in Slovos: a
depreciated exchange rate will also cause their costs to increase whereas before, when they were expressed in
a local currency, they were not a¤ ected.

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 3. Revert to the situation in question 1. Suppose XYZ has a Euro-denominated loan of 5m Euro that
it has to repay at the end of the year. Is it able to do so given the current exchange rate? If the exchange
rate moves to 2.2 Slovos/EUR then what is the pro…t of XYZ at the end of the year? What if it goes to
3 Slovos/EUR?
A: Suppose that XYZ produces at its maximum capacity of 0.5m units. The operating pro…t is then
0:5m 20 = 10m Slovos, whereas the debt at the current exchange rate would be 10m Slovos. So yes, they
can do so but the debt payments will exactly eat their operating pro…t and they will just break even. How does
this depend on the exchange rate? Operating pro…t is 0:5m (20S 20) = (S 1) 10m. The debt cost is
S 5m. So the overall pro…t will be S 5m 10m. There is no Exercise with XYZ repaying the debt even
if the exchange rate depreciates: the sales are expressed also in Euros.
4. Repeat the analysis in questions 1-3 assuming now that the sales of XYZ would be completely local,
and they would be getting 40 Slovos for each unit of product A.
A: Wrt q1. The cost is still 20, whereas the pro…t is 40 20 = 20 Slovos. The movement of the exchange
rate does not impact pro…tability, and XYZ cannot get a higher or lower pro…t than 20 because of that. Wrt
q2: The cost is now 10 + 5S so the pro…t is 40 10 5S = 30 5S. XYZ is going to break even whenever
30 5S = 0 or S 6. They cannot get a pro…t of 40 per unit. When the involved imported inputs and the
sales are local, the stronger the local currency, the higher the pro…ts. Wrt q3: If the exchange rate depreciates
above 2:2S XYZ cannot repay its debt.
5. The conclusion is that if there is a currency mismatch between your sales and debt you may run into
trouble if the currency in which you are indebted strengthens. Imported intermediate inputs have an impact
on the bottom line in a similar way like debt.

Exercise 4

One could argue that a strong Euro impairs the exports of European products and promotes imports.
Therefore, a weak Euro (vis a vis all the other currencies) would promote GDP growth as exports are a
direct component of GDP. Most Euro zone companies have the privilege of funding themselves in their
home currencies, so needn’t be afraid about paying high interest (and repaying the principal) on foreign-
denominated debt. A weak Euro, furthermore, can operate through the wealth e¤ect: many residents own
foreign assets, and then they’re worth more, enticing them to consume more. We should note, however, that
a weaker Euro can also bring about an increase in in‡ation: both consumer goods but also raw materials and
fuels can cost more. So, given all the above one could indeed claim that there could be short-term bene…ts
from having a weaker Euro. It is not clear, however, how one would wish to "magically" weaken the Euro
(central bank interventions?) given the size of the market and the risks it entails (higher in‡ation if it is
done through faster money creation). Also, similar reasoning applies to many other countries (USA, UK,
Japan, Switzerland...), so trying to "weaken" its exchange rate permanently would eventually bring backlash
(others could do the same); moreover, the PPP forces would start working.

Exercise 5

1. This means that the GDP per capita in France was 43906 USD / 1.39 (USD/EUR) = 31587 EUR
valued at market exchange rates. If this GDP per capita …gure expressed at the PPP exchange rate is 36691
(in international U.S. dollars that is used in comparison in the Penn World Tables), then the PPP exchange
rate is 36691/31587 = 1.162 USD/EUR. Comparing the market rate with the PPP rate we conclude that
the USD that year was undervalued or, in other words, the EUR was overvalued.
2. The USD/EUR exchange rate must have appreciated (indeed, this is what happened, to 1.28 USD/EUR):
the market-rate GDP per capita would indicate a deep fall in French GDP per capita otherwise that did
not occur. We need to be therefore careful while comparing GDP changes across countries using the same
reference currency: we should rather calculate such changes based on their domestic currencies or use the
PPP-implied exchange rate (but, the latter is available only with a lag).
3. For a country with an overvalued exchange rate, the market-based exchange rate overstates the GDP
(global or per capita) in comparison with the PPP-based reading.
4. In such a fantasy world, we would expect the arbitrage in goods to work perfectly; hence there would
be little di¤erence between GDP expressed at market-based and PPP-based rates.

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Exercise 6

There are large changes in the USD/EUR exchange rate within the period. According to the ECB, the
average USD/EUR exchange rate in 2008 was 1.471 while it was 1.083 for the …rst nine months of 2023.1
Therefore, a straight comparison of constant GDPs would indicate immediately an approximately 26%
relative decline in Eurozone GDP measured in dollars. Theoretically, there isn’t a good link between a
growth rate of the economy and the exchange rates: as we have seen it is principally the price levels and
their evolution that matter in the long run.
Moreover, what is compared is the overall GDP. This can increase through time simply with population
growth. US population increased through this time from 304 to 333 million (9.5%) while that of the Eurozone
(some small countries joined as well but let’s skip that) from 334 to 345 million (a 3.2%) decrease. We thus
that a large fraction of the di¤erence in overall GDP in U.S. dollars growth can be attributed to other factors
than actual growth.
A better indicator is GDP per capita in PPP terms to compare the living standards. What does this tell
us? World Bank data in PPP terms (current “international” USD) show that for the Euro area the income
per capita was 35.7k in 2008 and 56.5k in 2022; for the same time period it was 48.6k and 76.4k for the USA
respectively. This means that the respective per capita growth rates in current dollars were 58.2% an 57.2%
respectively. Which means that the per capita discrepancy in GDP per capita between USA and the Euro
area held constant... with living standards being 35% higher in the U.S. in both years!
What has happened with the huge disrepancy that is shown in the article? Apart from the adjustments
mentioned above, what may hide beneath the lack of a di¤erence in PPP terms growth is a slower evolution
of services (nontradables) prices throughout the period in the Euro zone must have been slower (indeed,
in‡ation rates 2008-2023 were much higher in the U.S.).
Two additional words of caution are in order. The PPP statistics, as we have seen in class, can be fraught
with discrepancies which render exercises based on the PPP-implied price levels noisy. Furthermore, what
may matter for …rms when they choose the market to operate is its size, so the comparison of overall GDP,
and also expressed in current dollars, may make sense.

Exercise 7

a) Some pros:
- Available almost everywhere in the world
- more or less the same in terms of composition and quality.
- It is really simple to calculate and interpret.
Some cons:
- The good is a nontradable; you don’t expect arbitrage of the good between borders.
- The price includes services and nontradable prices like rent that reduce the relevance of the com-
parison. For the two above reasons it may have nothing to do with a serious evaluation of the prices of
tradables which is crucial when one develops such tools as real exchange rates.
- There may be price discrimination between countries.
- In some countries the Big Mac is junk food, in others a fashionable "luxury" product.
- Local tastes and demand di¤er.
- Taxation (for example in some countries you may have no sales tax) may di¤er.
b) For the mentioned countries the long-run movement was in the correct direction implied by the under-
or overvaluation of the exchange rate (you should look in 2002 for this). However the magnitude of the
correction is very di¤erent between the countries so it is a very imprecise tool. In general, this is true for
the Big Mac index: it points well for a potential direction of the adjustment, but is not useful to assess the
size of the change nor the speed of converegence. PPP over such long periods will be much more accurate
in general.
c) You can see the HBS e¤ect (on average) both in level or in the dynamic behavior. For most countries,
as their productivity in tradables is lower, the prices of a Big Mac are lower than in the US. Then, if you
look at the well measured productivity (better than just increases in GDP per capita) you would see the gap
of undervaluation closing for the fast-growing countries. Again, the magnitudes cannot be well predicted.
1 The strong appreciation of the EUR in early 2008 was exceptional by historical standards.

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Exercise 8

No. The reason is that the exchange rate might not have been at the equilibrium value implied by the
absolute PPP two years before. If that is the case, it would not be in such a spot today either, even if the
relative PPP held for some time.

Exercise 9

Throughout, let me assume that I view the Swedish Krona as my home currency –given our convention.

i) = 1% 2% = 1%. The in‡ation di¤erential is 1% in favor of Sweden.

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ii) Let’s calculate the initial RERCP I = 8 1000 = 0:8 < 1. This indicates – given the data in the
exercise –that the Swedish krona is overvalued.

iii) The current gap between the "equilibrium" RER and the current RER is 0.20. There would be an
in‡ation di¤erential in favor of the Krona that would appear of 1%, narrowing somewhat that gap (because
the prices in the Euro zone are increasing faster than in Sweden - so erasing a little bit the extent of Krona
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overvaluation). If the nominal exchange rate would not change then the RER would be 8 1010 = 0:808.
Let’s give an approximate value: we know that 20% of the gap towards the PPP should be corrected (by a
nominal exchange rate change). Starting with the gap at the beginning of the year, we would expect that
the RER depreciates by 0:2 0:2 = 0:04. So we would expect a RER of around 0:84 0:85 one year from
now.

iv) So what could be the nominal rate? Since we expect the RER to be between 0:84 0:85 then this
means we would expect the Krona to be between 1010
102 0:84 = 8: 317 SEK/EUR and 1010
102 0:85 = 8: 416
SEK/EUR at the end of the year.

Observation: you can …rst …gure out the approximative nominal exchange rate one year from now and
then …nd the RER value.

Exercise 10
Nb. Be careful how data on exchange rates is presented on the website. An increase in the nominal or real
exchange rate indices is so de…ned to mean appreciation there. Several commodity-producing countries do so
to underline the movement of their currencies in tandem with the principal commodity price developments.
1. The nominal and real exchange rates for Canada comove strongly for example with the prices of oil.
As oil increases in price, the Canadian dollar appreciates both nominally and in real terms (in the short
run). The reason for this can be traced from the terms of trade e¤ect. As oil exporting companies fetch
higher prices in commodity markets, and they retrieve the additional obtained pro…ts into Canada and the
Canadian dollar, there is a higher demand for Canadian currency. This is the terms-of-trade e¤ect.
2. There is very little di¤erence in the movement of the two quantities. This is because consumer prices
react slowly to any exchange-rate induced movements or excess demand in goods coming from arbitrage.
Real exchange rate di¤erences are driven by nominal exchange rate changes in the short run.