Managerial Economics

SEEG5013
Chapter 6
Datuk Prof. Mohd Yusof Kasim

Managing in the
Global Economy
Chapter 6

Import-Export Sales and Exchange Rates

The Market for US Dollars as Foreign Exchange
Foreign Exchange (FX) Risk Management
Determinants of the Long-Run Trends in Exchange Rates
Purchasing Power Parity
International Trade and Trading Blocs (EU & NAFTA)
Comparative Advantage and Trade
Trade Deficits and the Balance of Payments

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The Financial Crisis

and Exports to China
The financial crisis in housing and banking led to a prolonged
recession
US is largest at $14+ trillion; Japan at $5 trillion; China at $4.4 trillion;
Germany at $3.7 trillion; and France at $2.8 trillion.
Though a relatively small portion of US GDP (of 10% exports & 13%
imports), exports and imports have been a driver of growth.
Although both consumers and businesses cut back in expenditures,
exports to China continued.
Solutions to global downturn involves expansionary fiscal and
expansionary monetary policies, although neither has been
especially successful thus far.

The Financial Crisis

and Exports to China

Import-Export Sales and Exchange Rates

More and more firm are becoming multinational

enterprises.
Exports and imports are influenced by changes
in international exchange rates.
Differences in long run inflation rates
(according to the theory of purchasing power
parity), national economic growth rates, and
interest rates help explain long-term exchange
rate movements.

FIGURE 6.1 Foreign Exchange (FX) Rates: The Value of

the U.S. Dollar against Several Major Currencies

Competitiveness and Exchange Rates

The international competitiveness of
products is affected by exchange rates.
If the US exports a Jeep that sells for $30,000, the price of the same car in
Europe is vastly different
In 2000, $/ = $.86/. If a US car costs $30,000, then in Euros that is
$30,000 / $.860/ or 34,884.
When $/ = $.86/, then /$ = 1/ $.86/ = 1.163/$
In 2010, $/ = $1.32/. If that same car costs $30,000, then in Euros
that is $30,000 / $1.32/ or 22,727.
When $/ = $1.32/, then /$ = 1/ $1.32/ = .757/$
Clearly, more Jeeps are likely to be sold in Europe at the lower than
the higher price.

Foreign Exchange Risk Exposure

Transaction Risk Exposure occurs when a change in cash flows
results from contractual commitments to pay or receive a foreign
currency.
When GE sells equipment to Japan in Yen, but they give 60 days before the
payment is due, there is a risk that the Yen will fall in value.

Translation Risk Exposure occurs when the value of foreign assets

or liabilities are affected by exchange rates.
Disney owns a park near Paris. When the Euro rises against the dollar, the
value of the land rises in terms of dollars. This is primarily an accounting
adjustment.

Operating Risk Exposure occurs when cash flows of the firm are
impacted by exchange rates.
When Jeep sells more Grand Cherokees when the value of the dollar is low,
and less when it is high, this is operating risk exposure. This is the most
important risk.

The Market for US Dollars as

Foreign Exchange
Jeep, BMW, and Cummins Engine are buying
and selling foreign exchange in the market.
Governments can also intervene through
buying or selling currencies that they hold.

Spot Price for foreign exchange is current

price(2 day delivery) can appear in different
terms: $/ or /$, which is just the inverse.
Both are given in the Cross Rates.
Forward Price is the price of a foreign
currency for delivery at a future date agreed
by contract today

FIGURE 6.2 Cummins Engine Cash

Flow and Operating Margins

Canadian Dollar
Spot and Forward Rates
August 6, 2010

http://fx.sauder.ubc.ca/CAD/forward.html
Country
Canada (C$) spot
1-month forward
3-months forward
6-months forward

US$ per 1C$

0.9730
0.9727
0.9715
0.9694

What does the market think will happen to the C$

based on the forward rates over the long run?

CROSS RATES 8-6-10

USD $

JPY

EUR

CAD $

GBP

AUD $

CHF

1 USD $

85.435

0.7526

1.0273

0.6264

1.0891

1.0386

1 JPY

0.0117

0.0088

0.012

0.0073

0.0127

0.0122

1 EUR

1.3287 113.5198

1.365

0.8323

1.4471

1.38

1 CAD $

0.9734

0.7326

0.6098

1.0602

1.011

1 GBP

1.5964 136.3905 1.2015

1.64

1.7387

1.658

1 AUD $

0.9182

78.4455

0.691

0.9433

0.5752

0.9536

1 CHF

0.9628

82.2598

0.7246

0.9891

0.6031

1.0486

83.1646

http://finance.yahoo.com/currency-investing#cross-rates
USD $ is the US dollar; JPY is the Japanese yen; EUR is the European Euro; GBP is the
British pound; AUD $ is the Australian dollar; and CHF is the Swiss franc

Outsourcing
Global firms seek lowest cost ways to produce
When firms do one or more steps of their production
outside of their home country, we say that activity
was outsourced
This can help firms survive that face stiff competition
from abroad by holding down their costs. In this
way, some jobs are saved while others leave this
country.
Outsourcing is criticized as exporting jobs.

FIGURE 6.3 Outsourcing Shipping Costs and Component

Sources for HP Personal Computer

China Trade Blossoms

Worldwide trade with China jumped from 4.2%
in 2003 to 8% in 2008, and is growing.
China as joint ventures with global firms (Ford,
McDonnell-Douglas, HP, and many others).
GDP in China grows at phenomenal rates
doubling in 5-7 years, and population growing at
1%, improving their standard of living.
Liberalization of property rights and the creation
of a middle class are hallmarks of moving from a
developing to a developed country.

The Market for Dollars

as Foreign Exchange
Foreign Exchange is used
for trade and
investment. Use a
supply & demand
model to explore FX
rates
Demand for Swiss Francs

(SFr): Demand is associated

with US demand for imports
from Switzerland and
purchase of Swiss financial
securities

$/SFr

1,000 SFr

D
SFr

Supply of SFr
Supply of SFr -- Supply
is associated with
SWISS demand for US
exports and US
financial investments.
Market Clears-- no
$/SFr
excess demand or excess
supply of SF
In Flexible Markets, buying
& selling through
international banks

$.9628

D
SFr

Suppose there is a rise in

US Inflation Rates

S'

Both Supply & Demand of SFr

Shift

SWISS products appear

cheaper, so D shifts to D $2/SFr

US exports appear
more expensive, so
shifts from S to S

$1/SFr

D'

The SFr appreciates, and

the dollar depreciates

SFr

Suppose U.S. interest rates rise

Supply of Swiss francs rises
as Swiss seek to invest in
the US from S to S
Demand for Swiss
investments declines, from
$1/SFr
D to D
Swiss francs fall in value and
the dollar rises in value
$2/SFr
What happens when
Greenspan CUTS interest
rates?

S
S

D
D'

Suppose US Economic Growth rises

Supply of Swiss francs rises
as Swiss seek to invest in
the US from S to S
Demand for Swiss products
and services rise from D to
$1/SFr
D as growth increases
$2/SFr
appetite for everything.
Swiss francs fall in value and
the dollar rises in value
What happens when Swiss
growth rates rise?

S
S

D'

FIGURE 6.4 The Market for U.S. Dollars as

Foreign Exchange (Depreciation of the Dollar,
20012008)

Governmental Intervention in Foreign

Exchange Markets
Governments can and do intervene in markets
Directly by buying and selling foreign currencies
And indirectly by altering interest rates or inflation rates

Sterilized Interventions involve offsetting an

indirect move (like an increase in short term
interest rates) through direct action in the
foreign currency markets
Coordinated Interventions involve several
countries all agreeing to intervene to raise or
lower the exchange rate of some country.

Determinants of Long-Run Trends

in Exchange Rates
1. Countries that have high growth rates in
GDP tend to have rising currency values.
2. Countries that have relatively high real
(inflation-adjusted) interest rates, tend to
have rising currency values .
3. Countries with relatively high inflation
expectations tend to declining currency
values.

FIGURE 6.5 The Market for U.S. Dollars as

Foreign Exchange (Depreciation against the Yen,
20072009, and the Euro, 20012008)

Purchasing Power Parity (PPP)

Purchasing power parity says that the price of
traded goods tends to be equal around the world.
This is: the law of one price.
if exchange rates are flexible and there are no
significant costs or barriers to trade, then:
Relative PPP [6.1]:

S1 = ( 1 + h )
S0 ( 1 + f )

S1/S0 shows the expected change in the direct quote of a

currency. The right side of the equation is the ratio of home and
foreign inflation rates. If the foreign inflation rises (f), then the
domestic expected future spot rates S1 declines.

PPP Example
Suppose inflation in the US is 3%
Suppose that inflation in Canada is 4%
The currency price of the Canadian dollar is
$.973/C$.
What is the expected price of the Canadian dollar
in one year?
Answer:
S1 = ( 1 + h ) = 1.03 = .9903 = S1
S0 ( 1 + f ) 1.04
.973
Hence, S1 = .973*.9903 = $ 0.9636/C$, a slight
decline from $.973.

PPP As Yardstick Of Comparative Growth

PPP can be used to compare growth rates
An implied FX rate is the ratio of prices of like items in
two countries, say iPods sold in US and UK.
A $225 iPod in US and the same one in the UK for 167, for an
implied exchange rate of $1.347/ = $225/167.
The law of one price says identical items priced the same
PriceUS = PriceUK x Implied FX
$225 = 167 x ($1.347/), which says iPods in both countries
cost the same.

Even though Chinese currency (Yuan) is managed, we

can uncover an implied exchange rate using PPP. It is
more like 3.8Yuan/$ than the official rate of 6.8Yuan/$.

Qualifications of PPP
1. PPP is sensitive to the starting point, S0. The base time
period may not in equilibrium.
2. Differences in the traded goods, or cross-cultural
differences, may prevent the law of one price to
equilibrate price differences.

If a product like Italian Dixan is unknown in the US to

wash dishes, it is not viewed a substitute for Joy or Dawn
dishwashing liquid.

3. The inflation rate used may include some non-traded

goods.
4. PPP tends to work better in the long run than in short
run changes in inflationary expectations.

Big Mac Index

Although prepared food is not a traded good, we
can investigate what is the dollar price of
McDonalds Big Mac is in various countries.
In the US, the Big Mac sells for $2.99
In Japan, the Big Mac sells for 600, but a dollar
buy 90. So, in dollar terms, the Big Mac sells for
600/(90/$) = $6.67
They are not equal. It shows that a Big Mac does cost
more in Japan.
However, we tend to find that products become
somewhat more equivalent in cost over time.

Trade-Weighted Exchange Rate Index

With many countries and many exchange rates, whether a
currency rose or fell is complex. We tend to combine the cost of
foreign currency into an index based on the amount of trade to
each country.
The trade-weighted exchange rate index is a measure of the
value of the dollar.
The index, EER, is weighted by the amount of trade with other
countries, wit. An index of the change in value of pairs of
currencies since a base year, eI$it.
If .40/$ is the exchange rate in the base year and is now .50/$,
then the index is (.50/$) /(.40/$) 100 = 125.
This means that the dollar is 25% more expensive to the British.
The index is:
$
$
t
it
it
t

EER eI w

International Trade
and Regional Trading Blocs
US trade has been growing over the past 25 years, and
a growing proportion of all world trade now
comprising 31% of world trade (exports + imports).
Exports have contributed to US GDP growth.
Part of the growth is within regional trading blocs
NAFTA, the North American Free Trade Agreement
expanded trade among US, Canada, and Mexico.
EU, the European Union, and the creation of the Euro
expanded trade within Europe
MERCOSUR, expanded trade among Argentina, Brazil,
Paraguay, Uruguay, Bolivia, and Chile
Less dramatic, but similar patterns in ASEAN (Association of
Southeast Asian Nations) and APEC (Asian-Pacific Economic
Cooperation).

Real Terms of Trade

Example: Table 6.3
Real Terms of Trade involves a comparison of costs across
Countries.
Absolute Cost US Absolute Cost Japan

Carburetors

$120

10,000

Memory Chips

$300

8,000

The question is: Which country should make

carburetors and which should make chips?

Comparative Advantage
Countries or firms should produce more of those goods for which
they have lower relative cost.
Relative Cost in US Relative Cost in Japan
Carburetors .4 Chips = $120/$300
1.25 Chips =
10,000/8,000

Computer
Chips

2.5 Carb.= $300/$120

8 Carb. =

8,000/10,000
It costs $120 in the US to make a carburetor and $300 to make chips, the
cost of a carburetor is the .4 chips foregone (take the ratio $120/$300 to find
.4 chips).
The US relative cost of carburetors is much lower than that of the Japanese
(1.25 Chips), whereas the Japanese relative cost of chips (.8 Carburetors) is
much lower than that of the US.
Japan should make chips and US should make carburetors and the US
should make carburetors. Both are cheapest!

Gains from Comparative Advantage

In this example, suppose that both countries currently make 1
carburetor and 1 chip.
World production is 2 carburetors and 2 memory chips before
trade.
Now, let the US make all of the carburetors. Since each chip
given up is 2.5 carburetors, the US now makes 3.5 carburetors
(the one they were making and the 2.5 extra ones made).
Let Japan also specialize in memory chips. They stop making
the carburetor and make instead 1.25 chips. Along with the
original chip, they make 2.25 chips.
World production rose to 3.5 carburetors and 2.25 chips
through comparative advantage.
Both countries will be richer by this trade.

Import Controls and Protective Tariffs

Tariffs taxes on foreign-produced goods designed to
raise revenues and assist local over foreign producers.
Expands domestic production
But raises the price for consumers
May lead to foreign retaliation imposing tariffs on your own
exports

Import quotas limits on goods imported

Sometimes voluntary quotas, as when Japan restricted the
number of cars exported to the US.
This also raises the price for consumers

Exchange rate controls limits on FX permitted

Reduces trade by restricting access to foreign currencies

FIGURE 6.12 Trade-Weighted

Tariffs, 2008

The Case For and Against a Strategic Trade Policy

I. The case for helping
particular industries:

II. The case against helping particular

industries:

1. Help industries related 1.

to national defense
2. Help infant industries 2.
3. Offset subsidies given
by foreign competitors 3.
4. Anti-dumping
sanctions
4.
5. Increasing returns
5.
6. Network externalities

National income is typically

reduced by trade restrictions
Violation of the WTO, the
World Trade Organization
Every industry thinks it needs
special help
Free Trade avoids trade wars
Unclear if governments knows
which industry is likely to be
desirable in the future.

Optimal Currency Areas

The Optimal Currency Area involves the question of how
many different currencies are best.
If all of Europe has only one currency, trade is quite easy.

But when Greece needed assistance, reducing the value

of the Euro for the whole group of countries doesn't
target the single ailing region.
It is expected that the Euro helps the participating countries,
but it makes helping the poorest countries harder.

Labor mobility is still restricted in Europe.

Although each country has its language and culture, they
all have been subject to correlated shocks: higher oil
prices, trade collapse, leading to a growing dispersion of
unemployment rates.

What about One Currency

for NATFA?
Should the US, Canada, and Mexico consider having
one united currency, the Peso-Dollar?
The US has the same currency in all 50 states, and this
has helped the US. All states have open borders, so
Ohio workers can move to Missouri if they want to find
work.
But one currency makes helping poorer states harder.
If problems arise in Mexico, they would not
able to depreciate the peso to help.
Also, open borders within North America does
exactly exist.

be
not

What is US Largest Trading Partner?

Canada is the USs largest trading partner, due in part to its
location and NAFTA
Prior to NAFTA, the region called maquiladora in Northern
Mexico permitted US firms to assemble US parts and ship
finished goods back to the US without tariff. Now, all of Mexico
is essentially maquiladora through NAFTA.
Trade restrictions are side-stepped by:
Parallel imports arbitrage of tariffs across countries (the
low tariff buyers sell to higher tariff buyers)
Gray markets and Knockoffs selling possibly counterfeit
versions of branded goods

The Persistent US Trade Deficit

The US has often had a trade deficit
A trade deficit must be offset by capital
inflows (foreigners buying US securities,
bonds, or other lending)
What are reasons for a large trade deficit?
Outsourcing of production outside the US
Oil imports
Exchange rates that make foreign goods look
cheap (as with an under-priced Chinese Yuan)
And the willingness of other nations to use the
dollar as a form of safe-haven.