Professional Documents
Culture Documents
First Class:
1) Review basic tools of finance - PV, EV, NPV, internal rate of return, CAPM, MM
PV = sum(Ct/(1+r)t ), example:$100 for 3 years at 10%, $100 in perpetuity at 10%
EV = sum({prob of s}*Cs)
expected NPV = -500 now, 30% prob of 1000 in 4 years, 40% prob of 500 in 4 years, 30% prob of
200 in 4 years.
Internal rate of return - the interest rate such that returns equal costs of project:
arbitrage- buying and selling the same good in different places to make money. More generally,
trading of equivalent securities to make money.
market efficiency - a market takes all available information and uses it to set prices. (There are no
$500 bills lying on the street)
CAPM: more risky projects require a higher rate of return; projects whose risk is more highly
correlated with overall market risk require a higher rate of return (undiversifiable risk).
Modigliani-Miller: debt/equity policy doesnt matter because they are all contingent claims on the
firms revenues. However, this requires many stringent assumptions, and other capital structure
theories trade-off and pecking order are more realistic.
Important points: comparative, not absolute advantage is what matters. Both countries benefit
through trade, But notice, if only one country has tariffs, it can be better off while the other is worse
off.
Side issue: in only 1 country, having a monopolist decreases welfare. But, if you have a monopoly
(or monopsony) in your country on an international scale, you may be better off. Examples:
Microsoft or Dole banana in the early 20th century.
Other problems with the classical model of trade (include hysteresis - once you start selling
somewhere the equilibrium may not shift back -- A supply shift out leads to a change in preferences
(D shift out) and may not shift back as much as we would expect if its all driven by exchange rates
cross-product trade (cars and car parts);
inputs are becoming mobile as well as outputs -- particularly capital and raw materials, and to some
degree labor;
countries export what they consume in quantity
Note that capital goes from the low interest rate to the high interest rate country until r= r* (riskless
interest rates equal).
Also note that this does not explain 2-way flows in capital (very very common) called crosshauling.
And also note that U.S. has the most capital, but is currently importing capital.
So, MacDougall is a nice simple model that fits our intuition but not the facts.
See film:
http://digital.films.com/PortalPlaylists.aspx?aid=2478&xtid=34993&loid=37128
Evolution of the Global Capital Market
Historical Exchange Rate policies:
1) The gold standard 1834-1933 the US maintained a price standard of $20.67 per ounce, although
the US had floating exchange rates (and seignorage) during 1861-78, Gold Standard works by:
a country has an increase in productivity => a relative decrease in the price of that good =>
increase in exports => more gold flows in to US => higher US prices => lower prices in the rest
of the world. In the long-run, prices for all other goods are slightly lower than before the
productivity increase. In reality, deflations dont happen without massive unemployment
2) The Gold Exchange Standard: 1925-31 was an attempt to return to the gold standard between
the wars. Problem was, they tried to return at the pre-war price levels, and this was highly out
of equilibrium. Thus some countries had to go through massive deflations. Whoever stayed in
the system longest was hurt the worst (Germany in particular). (similar to the big American
depression around 1880)
3) Bretton Woods System: 1946-71 was an attempt at fixed exchange rates where lots of countries
devalued anyway.
Problem: this amounts to continuous deflation every time we have an increase in productivity in a
good and inflation when we find gold deposits. Examples: when gold was brought from Mexico by
the Conquistadors this was a highly inflationary shock (although it was partly cured by making gold
and silver utensils).
3) Unofficial pegging
Target-Zone arrangement Countries formally agree to peg their interest rates to some band of
exchange rates. for example in the EMS (European Monetary System - i.e. pre-Euro) exchange
rates were fixed with a 2.25% leeway (6% for Britain and Spain).
Fixed exchange rates the government guarantees the price of a particular currency (and may make
some types of transactions illegal.
How do fixed exchange rates work? Well, say the $ becomes overvalued in the $/euro relationship.
The Fed can easily reverse this trend by selling $s and buying euros. This is unsterilized
intervention because it changes the money supply. Increasing the money supply will reduce interest
rates (more dollars need to be invested overnight) and possibly increase inflation (more dollars
chasing the same amount of goods). Sterilized intervention occurs when the government also buys
or sells bonds to put the money supply back where it was (so, sell $s, buy euros and also sell
bonds to take the additional $s out of circulation). Note that the net effect is a substitution of one
type of reserve (euro bonds) for another ($ bonds).
Mundell came up with the idea of optimal currency area (and won the Nobel prize). Optimal
Currency Area: theres an advantage in having separate currencies it allows monetary policy to
work in each country and offset real shocks. But there are drawbacks to too many currencies with
risk and transaction costs. So Optimum may exist.
Advantages of the Euro: no costs to convert from one currency to another. No hedging required in
international transactions between Euro countries less risk and less hedging costs. Also, now free
trade within Euro zone.
Disadvantages: Euro countries now have same monetary policy. This also ties their fiscal policies
together (if the Euro is going to continue).