The purpose of these blog posts is to provide commentary for my lecture slides. Lecture slides will only be provided through the university website. If you have any questions or comments, please write them below and I will respond as soon as I can.

Course Logistics

Welcome to International Finance and Banking! Hopefully you are here because you have some interest in understanding foreign exchange rates and the role of central banks in the global economy. As mentioned in the title, this course is exactly about these two topics. In the first half of the course, our objective is to construct a framework or model to understand how foreign exchange rates are determined and linked to the macro-economy. While the first half of the course is applied macroeconomic theory, the second half is finance or applied mathematics. Our focus in the second half of the course is understanding how to apply financial derivatives such as options and futures to manage foreign exchange risk.
Before diving into the course material, I want to make sure you all know what you are getting yourselves into before fully committing to the course. All lecture material will be posted on the university course web portal called Canvas. Due to the size of this class, your TA will hold weekly office hours or review sessions to answer questions. The textbook listed in the syllabus is for reference only and is not necessary to master the course contents.

Course Overview

I want to emphasize that this course is quantitative as we will borrow concepts from both macroeconomics and asset pricing. Some knowledge of Calculus is required, so it could be helpful to dig up your Calculus textbook and keep it handy. The main goal of this course is to help you develop your economic intuition on how and why foreign exchange rates, interest rates, and the macroeconomy are all interdependent. In doing so, we will rely on many financial instruments, namely forward contracts or futures, to develop a coherent theoretical model on exchange rates. The more applied mathematics part of the course deals mainly with risk management. I will spend time later in the semester discussing hedging methods using various financial instruments and the that math is involved.

Deliverables

In order to pass the course, you need to pass both the group assignment part and the final exam part. Both homework assignments and essays are to be completed in groups. Each group should have at least 3 but no more than 5 students. Please inform the TA of your group members. Those who cannot find groups will be randomly formed into groups by the instructor. All homework assignments and case studies should be submitted through the Canvas system. Each group only needs to submit one write-up.
The purpose of homework assignments is to help you familiarize with the concepts taught in class. The case studies provide some real world contexts in which these concepts become relevant.

Etiquette

This is a fairly large class, so attendance will not be taken. Many of you might have part-time jobs or internships. You are all adults and should know how to budget your time appropriately. But if you do plan attend the class, please try to be on time. I will always begin class more or less on time.
Since this is a live lecture, please save your private conversations for the break or after class. Asking questions, on the other hand, is highly encouraged. Asking questions not only makes this class more interesting, but also helps me figure out how to improve the presentation of the course material in the future.

Macroeconomic Perspective

The goal of today’s lecture is to begin building our framework to understand how foreign exchange rates are determined. When we talk about foreign exchange rates, what we are really talking about are relationships between nations and countries. International finance or specifically, foreign exchange rates, are really underpinned by international trade or imports and exports. And when we talk about imports and exports of a country, we are talking about the relationship between macroeconomic variables across countries. Thus, in order to talk about foreign exchange rates, we must first talk about economy-wide factors of a country such as employment, production, and growth. Talking about these variables require us to study a little bit about business cycles (i.e., market boom and busts) and fiscal and monetary policies.
Key macroeconomic variables that you should keep in the back of your heads are the following:

• Unemployment: Unemployment is the proportion of a country’s workers that are looking for work but remain jobless. High unemployment implies low output.
• Consumption and Savings: Consumption is the level goods and services consumed in aggregate by a country. Savings can be interpreted as future consumption or investments.
• Trade and Current Account Balance: The current account balance can be interpreted as net export and import in real terms (or prices that are adjusted for inflation).
• Money, Price level, and Exchange Rate: Money supply, inflation, and exchange rates, therefore, should all be interlinked.

Macroeconomic Accounting

The first step to understanding international trade is to figure out how to measure a country’s income. From a country’s perspective, you make money by selling or exporting goods and you buy goods by importing goods. In your other macroeconomic courses, the typical measure of productivity or economic output of a country is GDP or gross domestic product. However, this is a bad measure of income because GDP measures aggregate output only within borders. What about income that is made abroad by companies and individuals? In order to get a better picture of a country’s national income, what we should be looking at is GNP or gross national product. GNP, which we denote as Y, is the value of all goods and services produced by a country’s factors of production.
Much like balance sheets of corporations, countries have Balance of Payments to keep track of both real and monetary transactions. The Current Account tracks all trade related transactions in real terms. The Financial Account and Capital Account tracks all monetary transactions. The Balance of Payments is a snapshot in a moment in time.

National Income Accounting

Let us look at the mathematical formulation of GNP. Y is the Gross National Product, C is private consumption, I is private investment, G is government purchases, EX is exports, and IM is imports. C, I, and G are 3 ways to spend income in a closed economy. Closed economy means that there is no trade with other countries. In an open economy, IM is another way to spend income, which is given away to foreigners.
As mentioned before, GNP is simply just GDP plus net transfers, which includes domestic income abroad and excludes foreign income at home. GNP is therefore more closely related to national income. When studying international trade, we need to be clear who owns what is being produced every year.

Robinson Crusoe Example

Let’s go over a simple example to demonstrate the difference GDP and GNP. Robinson Crusoe is a fictional character from a book that lived on an island by himself. Suppose Robinson has a neighbor named Friday living on another Island. Each island has some palm trees and every palm tree yields 1 coconut and then dies. Coconuts can be planted and grown to be palm trees that are ready for harvesting in the next year. For a given year, Robinson havests 100 coconuts and borrow 10 from Friday. Robinson invests 110 coconuts. Next year, Robinson will get 110 coconuts. The GDP of the Robinson economy is 110. GDP counts up domestic value-added in each industry. GDP doesn’t ask who owns the industry. The GNP is only 100 since Robinson has to repay Friday 10 coconuts.
Ireland is a good example where GDP and GNP is vastly different. Ireland’s GDP is 20% larger than its net income, since much of the GDP is produced by foreign factors.

The Current Account

The Current Account is an aggregate number for trade balance, which in mathematically is just defined as exports minus imports in real dollar terms. Rearranging the GNP equation, we can arrive at the current account definition by subtracting C + I + G from GNP. Intuitively, this is just GNP minus the income what is absorbed domestically. Whatever part of the income we don’t absorb is given to net exports.
A positive CA means that domestic residents give up domestic consumption or investments for exports. In return, domestic residents gain the promise of foreign debtors to pay back in the future. So, for every unit of import, domestic residents are borrowing a dollar from a foreigner. For every unit of export, domestic residents are lending a dollar to a foreigner.
Let me give you an example just to make sure you have a strong grasp of these definitions. Suppose you sell a $35 dollar book to a foreigner. The net export is $35. What do you get back? You get money or $35, which you can use to buy valuable products from them in the future. You essentially gave credit to the guy who bought the book.
From these definitions, you should immediately realize that when politicians say that “we need to be a world lender in exports and investment recipient from abroad”, he or she is stating an impossibility. To be a net exporter, you are giving the buyer credit. If you are net importer, or in this case a net recipient of investments, you are a borrower of credit. This statement is a contradiction.

U.S. Gross National Product

Now, let us look at some aggregate data for the U.S., an example of a developed nation. The U.S. is a net importer. So U.S’s Current Account is negative. For instance, U.S. promises China that they will pay China with future goods. China is giving U.S. credit. From 2001 to 2006, we see that GNP has increased by about 13 trillion 2006 dollars, which is mostly driven by consumption. U.S.’s current account is even more negative after those five years. In other words, the U.S. is borrowing more from abroad to fuel their current consumption.

Composition of U.S. Output

In fact, if we look at the decomposition of U.S. GDP, we see that consumption has more or less hovered around 70 percent of GDP. This implies that the U.S. consumption has kept pace with GDP growth. At the same time, the current account has increased to over 5 percent from 1998 to 2007. Note that the sum of government expenditure, consumption and investment can exceed 100% of GDP since current accounts can be negative.

Balance of Payments

So how do people keep track of cross-country transactions? In general, central bankers divide transactions into two accounts: 1) the Current Account and 2) the Financial Account. The Current Account keeps track of cross-border commodity flows and the Financial Account keeps track of purchase and sale of foreign assets, which can include currencies. Balance of Payments is a collective name for these two accounts.

International Transactions: Movies and Bonds

I think the best way to understand how Balance of Payments work is through examples. Suppose the domestic country is the U.S. and we are trading with Japan. In the first example, we are exporting or selling movies to Japan. This is a Current Account credit to the U.S. because we are lending consumption to Japan so that they can consume now, whereas we can consume Japanese products at a later time through future imports. This 10,000 USD export to Japan, however, is accompanied by their payment to us in the form of Japanese Yen, 10,000 USD worth of it. You should think of this as a purchase or import of a foreign assets; that is why it is denoted as a debit on our financial account. This seems counterintuitive, but you should just think this debit and credit system as a way to keep track of exports and imports. Another way to think of this transaction is that Japan lending us Japanese Yen in exchange for the U.S. lending them current consumption. From the U.S. perspective, we gain a Current Account credit and Japan gains a Financial Account credit, which is a Financial Account debit for the U.S.
The second example, which could clarify the potential confusion above, involves the U.S. purchasing Japanese government bonds. This is a Financial Credit for the U.S. because the U.S. is exporting U.S. dollars to Japan. However, this is also a debit on the U.S. Financial Account because the U.S. also imported or purchased Japanese bonds.

International Transactions: Foreign Investment

The third example is the case in which Japan makes an investment in a Californian biotech firm. If Japanese residents buy equity shares on a U.S. biotech firm, the U.S. Financial Account will be credited since this is an asset export of U.S. stock shares. However, these stock shares are purchased with Japanese Yen, which is an import of Japanese financial assets into the U.S. This will show up as a debit on the U.S. Financial Account. Note that these two promises cancel each other out. No real credit extended unless you the U.S. use the imported Japanese to buy Japanese goods.
The final example is the case in which U.S. biotech firms import lab equipment from Japan. This is a commodity import so it will show up as a debit on the U.S. Current Account. However, this purchase is paid with U.S. dollars. This is an export of U.S. dollars to Japan, so it will show up as a credit on the U.S. Financial Account.

Savings in the Open Economy

Hopefully this credit and debit system is not too confusing. There is another of showing this mechanism through a country’s aggregate savings. In a closed economy in which a country is not trading with any other countries, all domestic savings is equal to total domestic investments. In an open economy, savings is now decomposed into domestic investments and net lending to the rest of the world. In other words, part of savings includes current investments abroad.

The CA Flipside: Savings Invested Abroad

Rearranging the savings equation, we can now write the Current Account equation as the difference between aggregate savings and total domestic investments. Setting this new definition of the Current Account and setting it equal to net exports minus imports, we should gain some new insights: Net lending to foreigners is income from production not consumed or invested. Therefore, goods must be shipped abroad. The first definition of the Current Account stresses the physical side of the current account. The second definition using aggregate savings at the country level stresses that financial side of the current account.

Savings in the Open Economy: The Derivation

Deriving the savings equation is a matter of simple Algebra using the definitions we have already seen before. Define S^P as private savings, which is equal to GNP minus taxes paid minus consumption. Government savings S^G is equal to tax revenue minus government spending. The Economy wide savings is therefore S^P plus S^G, which is equal to GNP minus consumption minus government savings. Using our definition of GNP, economy-wide savings is therefore equal to aggregate consumption plus domestic investments plus government spending plus exports minus exports minus aggregate consumption and minus government spending, which we then arrive at domestic investments plus exports and minus imports.

Current Account Value and Trade Volumes

There is one other interpretation of the Current Account that we will revisit in the future but I will introduce here. The Current Account can also be interpreted as trade volumes or the value of domestic gross exports in dollar of gross imports. You should think of the Current Account here as quantities. In order to do this, we need to define a new variable called the real exchange rate. The real exchange rate is the relative price of home goods in terms of foreign goods, averaged over all good types. A low real exchange rate implies that the domestic country is exporting lots of goods compared to the rest of the world. Conversely, a high real exchange rate implies that the domestic country is exporting only little amounts of goods. Using the real exchange rate, we can rewrite the Current Account equation in terms of foreign exports. This will come in handy later on in the course.

Macroeconomic Policy Concerns

In the last part of this lecture, we are going to talk a little bit about monetary policy and the history of central banking. There are two objectives that most central banks have to support their respective economies. The Internal Balance objective is something you must have all learned in your introduction to Macroeconomics courses. Whenever central banks such as the Hong Kong Monetary Authority or the Federal Reserve, it is usually about two things: 1) whether there is sufficient amount of employment in the general economy or 2) are prices stable so that the economy is steadily growing. The central bank wants to make sure that people don’t take too long to find a job after economic downturns and they want to make sure there isn’t severe inflation or deflation. Inflation can be controlled by the central bank through essentially printing or retiring money. However, money can take many forms such as cash and bonds.
The External Balance objective is what we are more concerned with for now. Various countries have different approaches in dealing with their Current Accounts. It is important to note that taking the Current Account to the extremes may not always be a good idea. Excessive Current Account Deficits can mean low domestic savings, high consumption, and loss of foreign investor confidence. Conversely, Excessive Current Account surpluses can mean low domestic investment in equipment and plants and excessive foreign lending at high risk. So, central banks need to figure out how to balance their current accounts to suit their countries’ needs.

International Money

While our ultimate goal is to understand how foreign exchange rates are determined, we first have to ask ourselves what exactly is money. Money is a medium of exchange, unit of account, and a store of value. A unit of account just means a unit of measure (you can compare two goods or services) and a store of value means that the currency can be saved and retrieved later on to be used for transactions. However, note that money’s value will inherently fluctuate based on supply. If there is inflation, it will lose value. If there is deflation, it will gain value.
Given these properties of money and assuming money works well within each country, what are the “rules of the game” so that each country’s central bank can adjust their internal and external balances in different ways to suit their needs, which may not be the same as in other countries?

Currencies, Gold, and the Price Level

So far in the history of monetary systems, there has been two sets of rules that has been attempted at an international level: 1) the Gold Standard, which was used from 1914 to 1970, and 2) Fiat money, which has been used until today. Under the gold standard, higher gold supply depresses the gold price and raises the price level of goods. Similarly, high money supply of Fiat money bids up the price level of goods. Under the gold standard, central banks pledge to exchange money for gold. Many countries in the past pegged their currencies to gold (e.g., 21 dollars for 1 ounce of gold). Pegs, however, were changed over time. These peg applies to everyone across all countries, and so foreign exchange rates are fixed. Under Fiat money, currencies have intrinsic value and the foreign exchange markets clear based on demand and supply across countries.
Why does Fiat money still have value? In general, people believe Fiat money is convenient (decentralized, almost anonymous), is useful for accounting purposes, and it stores value so long as we trust it or use it for future transactions. When people lose trust in Fiat money, you will usually get hyperinflation.

Monetary Systems

The history of international monetary systems can be broken into 4 periods. During the International Gold Standard between 1880 and 1914, currencies were convertible into gold and there were essentially no foreign exchange restrictions. During the Interwar period from 1918 to 1939, convertibility of currencies into gold was still managed, but some restrictions on foreign exchange hampered trade and economic growth. During the Bretton Woods Order, from 1945 to 1973, global currencies were convertible to the U.S. dollar, while the U.S. dollar was pegged to gold. The International Monetary Fund played a large role in foreign exchange rate determination. Lastly, today’s international monetary system allows for fixed, managed, and freely floating currencies.

Gold Standard: External Balance

Under the gold standard, central banks’ duties are fairly simple. Their task is to 1) preserve a fixed parity between domestic currency and gold. This means that they have to permit the free conversion of paper money into gold in unlimited amounts. 2) Preserve full international capital mobility. Therefore, during this time period, foreign exchange rates were fixed since all currencies were pegged to gold. We arrive at fixed exchange rates through a mechanism called Price-Specie-Flow.

Price-Specie-Flow Mechanism

Let’s start with an example. Suppose a country has a Current Account surplus and therefore accumulates gold. This raises price of all other commodities in the home country relative to gold since there is more supply of gold. This higher domestic price level makes domestic goods more costly both for domestic and foreign residents, while making foreign goods less expensive. This ultimately ends the trade imbalance since more foreign goods will be imported.
We can also look at this in the other way. Suppose a country has a Current Account deficit. This means that they are net importers and will be paying with gold. So there is a net gold outflow. Gold is now scarce and gold price will increase relative to other goods. Domestic goods are therefore cheaper.
As you can see, Current Account imbalances will cause gold shipments and subsequent price adjustments. These price adjustments will undo the Current Account imbalances.

Gold Standard and No Arbitrage

Given this Price-Specie-Flow mechanism, speculation can have a stabilizing effect. Speculation are trades that are meant to find arbitrage profits. The principle of arbitrage is a simple way to price things. If you believe things should only have 1 price, then no speculative profits can exist.
Take for example if you observe upward pressure on exchange rates. Exchange rates should be set so that no speculative profits can be made. Suppose you observe exchange rates deviate from the no-arbitrage level and appreciates. In this case, you should observe that domestic price levels increase relative to foreign price levels, and therefore domestic money will buy more foreign goods and currencies as well. You can take the following steps to make arbitrage profits.

Arbitrage Opportunity Steps

1. Buy foreign currency with domestic currency on foreign exchange market
2. Send foreign currency to foreign central bank and exchange it for gold
3. Ship gold back home
4. get more of domestic currency than you started

Gold Standard: A Double-Standard?

Therefore, the Rules of the Game under the gold standard is to expedite the restoration of the Current Account balance by preempting the Price-Specie-Flow Mechanism. The central bank can prevent gold outflows by selling assets to expedite deflation. This is monetary contraction. The central bank can also prevent gold inflows by buying assets to expedite inflation. This is called monetary expansion. Therefore, if central banks commit to the Gold Standard, actual flows are unnecessary. However, the burden of supporting this system falls on countries with Current Account deficits. Countries with Current Account surpluses would welcome gold inflows and inflation, leaving the adjustment to countries with incipient Current Account deficits.

Gold Convertibility of the USD, 1800-1971

This chart shows gold convertibility of the USD from 1800 to 1971. The U.S. abandoned gold convertibility briefly during the Civil War. In 1879, the U.S. again readopted the gold standard. It’s convertibility was repegged shortly after the Great Depression.

Interwar Period

The monetary policy during the Interwar Period, from 1918 to 1939, was a return back to the gold standard. However, after the Great Depression, many of these developed nations went off the gold standard. Current account surpluses can be achieved through devaluations.

Bretton Woods System

The Bretton Woods System, which was in place from 1945 to 1973, is an interesting monetary system that made the U.S. the key currency regime. All countries but the U.S. preserved a fixed exchange rate with the U.S. dollar. The U.S. would preserve a fixed parity between dollar and gold. Under this system, the IMF could now lend to countries with current account deficits. This system addressed the system in place during the Interwar period because it allowed countries to attain external balance without sacrificing internal balance.
However, one major flaw with the Bretton Woods System is that if world trade grows faster than world production of gold, then the world would run out of liquidity to finance trade. Trade requires legal currency, and if legal currency is pegged to gold, trade can’t grow faster than gold reserves.

Bretton Woods: Success and Failure

So while external balance was achieved for most countries and the dollar and gold shortage was overcome, we nevertheless arrive at something called the Triffin Dilemma: as long as U.S. gold reserves are sufficient, dollar holdings are attractive central banks. However, if the volume of international transactions grow faster than U.S. gold reserves, then the U.S. Federal Reserve would no longer be able to convert dollars for gold if holders tried to convert simultaneous. Thus, central banks would ultimately be unwilling to accumulate dollars. So, in this circumstance, the U.S. can either go off the gold standard, or slow down world trade.

International Monetary System since 1973

In the end, the international monetary system decided that trade was most important and so the Bretton Woods System was abandoned. We get a world with multiple types of exchange rate regimes, which we will briefly cover later in this course, that coexist with each other. However, because of this more complex and dynamic system, we also have more frequent financial crises, as shown by gold prices since 1973.

Gold Price in USD, 1971-2008

Gold now serves primarily as a safe haven asset, something that is negatively correlated with the performance of the global economy. In the late 1970s and early 1980s, the U.S. experienced several oil shocks that impacted economic growth. And not surprisingly, we observe a growing spike since 2000 to 2008 resulting from 9/11 and the financial crisis.