USING SUPPLY AND DEMAND: FOREIGN

EXCHANGE, TRADE AND BUBBLES

MANAGERIAL ECONOMICS -
SITUATION

 In 2003, a small island nation known primarily for fishing, back to back Ms. World winners, and geothermal heat
suddenly became the fastest-growing economy on the planet.
 It began in the post 9/11 world of cheap money (low interest rates) when all three of Iceland’s recently privatized
banks decided to enter the high risk world of investment banking.
 They borrowed from other banks and bought Beverly Hills condos, British soccer teams, and Danish Airlines.
 Buoyed by their beliefs that asset prices would keep rising, the banks borrowed as much as they could, as quickly
as they could, and bought as much as they could.
SITUATION

 But, by 2006, Icelandic banks were finding it difficult to borrow from other banks, so they started taking deposits
thru the Internet, mainly from UK, Netherlands and Germany.
 They offered the highest interest rates in the developed world, and depositors flocked in.
 In just 2 years, the number of depositors outnumbered the population of Iceland, and the amounts in just those
accounts was much greater than Iceland’s entire national income.
 The rising incomes from the booming economy started a domestic consumption spree.
 Residents bought new houses, cars and appliances, and what they couldn’t pay in cash, they borrowed.
SITUATION

 Icelandic residents borrowed from foreign banks because foreign interest rates (3%) were much lower than
domestic interest rates (15.5%).
 The standard of living tripled and Iceland became the costliest place on earth to live.
 Since every bank borrows short term and lends long term, they are vulnerable to bank runs.
 Banks make long term loans or investments, but they borrow from depositors who can withdraw money at a time.
Consequently, if depositors suspect that the banks cannot pay them back, they rush to withdraw their money. But
since the deposits are lent out, or invested in non-liquid assets designed to earn money over the long-run, they are
not available for withdrawal. And if bank cannot pay back its depositors, it goes out of business.
SITUATION

 Government insures deposits. But, Iceland’s deposit guarantees were several times its entire national income.
Consequently, the government insurance did little to reassure depositors.
 When the bank run came, everything fell apart. The rating agencies downgraded the banks, and foreign depositors
rushed to withdraw their money. Iceland’s currency, the Krona, dropped in value and prices soared.
 The British government went so far as to freeze the assets of one Icelandic bank in a vain attempt to protect
British depositors.
 Iceland is broke, IMF agreed to rescue package for Iceland and now it is essentially is running the country.
 Consumer debt is over eight times the national income. And due to depreciation of krona, Icelanders have little
prospect of paying back their foreign loans.
THE MARKET FOR FOREIGN EXCHANGE: ILLUSTRATION
THE MARKET FOR FOREIGN EXCHANGE

GBP/ISK Exchange Rate

PURCHASING POWER PARITY
 Purchasing power parity (PPP) is an economic metric that compares the standard of living between two countries
by weighing the amount of each currency needed to buy similar goods.
 International trade allows people to shop around for the best price. Given enough time, this comparison shopping
allows everyone's purchasing power to reach "parity," or equalization.
 In economist will use the PPP to compare the economic output of different nations against one another. It might be
used to determine which country has the world's largest economy. Using PPP exchange rates in addition to a
country's gross domestic product (GDP) may help to provide a more detailed picture of a country's economic
health.
PPP (ILLUSTRATION)
PPP

Purchasing power parity is like comparing apples and oranges…

Both of them are fruit, but it’s hard to get a direct comparison because they’re so different. In the same way,
currencies differ widely while serving the same purpose: paying for goods and services. PPP gives people a
way to compare the value of two wildly different currencies.
EFFECTS OF A CURRENCY DEVALUATION
ECONOMIC BUBBLES
QUESTIONS

 Following a peso appreciation relative to the dollar, which of the following results is expected to occur:
a) Prices in the US would rise, and prices in the Philippines would rise
b) Prices in the US would rise, and prices in the Philippines would fall
c) Prices in the US would fall, and prices in the Philippines would rise
d) Prices in the United States would fall, and prices in the Philippines would fall
QUESTIONS

 Following a peso appreciation relative to the dollar, which of the following would most likely occur?

a) US consumers would benefit, and Filipino producers would benefit

b) US consumers would be hurt, and Filipino producers would benefit
c) US consumers would benefit, and Filipino producers would be hurt
d) US consumers would be hurt, and Filipino producers would benefit
QUESTION

 How does decrease in US interest rates affect the EU/US exchange rate? How about the Phil Peso/US exchange
rate?