EXCHANGE RATE MECHANISM

SWEDENVeronika, Sean, Léon and Danny

Table of content

1. Introduction

2. Trade balance over time

3. Real exchange rate over time

4. Trade balance and Current account

5. Savings-investments and Current account

6. Trade balance and real exchange rate

7. Savings-investment and real exchange rate

Introduction ERM:

Peg the currency exchange rate to fixed margins, which in turn means that there can be variability within the predefined upper and lower margins.

It’s a preparation for the joining Eurozone1979: ERM I was introduced forcing the countries of

the European Monetary System to keep their currencies changes within an interval of +/- 2.25 percent

1998: ERM II was established including more recent member countries providing them a larger room for manoeuvre for their currency of about 15 percent of a central rate against the euro.

Sweden

1873: Sweden joins the Scandinavian Monetary Union and replaces the riksdaler with the Krona (their current currency).

1995: Sweden joined the EU However, Sweden has never been part

of the ERM 14 September 2003: Referendum in

Sweden (56% against the Euro)

Trade balance

The Trade Balance (TB) is the differences between payments made for imports of goods and services and payments received for exports.

TB= EX-IM

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Sweden Trade Balance bis (%GDP)

Time

Tra

de B

alan

ce

Real exchange rates over time

E increases => depreciation of the home currency

E decreases => appreciation of the home currency

Types of Exchange rate: Fixed, floating, dirty float No arbitrage condition (Equilibrium): E(home) =

E(foreign) UIP approx => i$ = i€ + [(ΔE($/€))/E($/€)] Long run: Relative price level, exchange rate have

similar levels Short run: PPP useless

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1.2

Real Effective Exchange Rate as a function of time

Time

Rea

l Exc

hang

e ra

te

Germany Sweden

Trade balance and current account (%GDP)

The Current Account:

part of a nation’s balance of payments accounts besides the Financial Account (FA) and the Capital Account (KA).

The composition of the current Account: The Current Account (CA) = Trade Balance (TB) + Net

Factor Income from Abroad (NFIA) + Net Unilateral Transfers (NUT).

CA = (EX - IM) + (EXFS – IMFS) + (UTIN – UTOUT) The Current Account to GDP (%) is on average around

10% between countries and its size depends on the balance between the components of the Current Account.

-2 0 2 4 6 8 10

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Trade balance %GDP

Curr

ent a

ccou

nt %

GD

PTrade balance(%GDP) and current account (%GDP)

y = 1,3825x - 3,8036R² = 0,8266

Savings-investments and current account (%GDP)

The national income identity :

Y=C+I+G+CA to (Y-C-G)-I=CA

so, S-I=CA The Saving-Investment Difference in theory

should match the Current Account one-to-one When a country saves too little relative to its

investment needs the Current Account to be negative and therefore in deficit.

High savings high output higher ability to export partly explains high trade balance

-4 -2 0 2 4 6 8 10

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Saving-Investment Dif %GDP

Cu

rre

nt

acc

ou

nt

%G

DP

y = 1109x - 768,33R² = 0,9837

Trade balance and real effective exchange rate

Short run: sticky prices Real exchange rate ↑ -(home currency

depreciates) Domestic prices compared to Foreign prices ↓- Exports ↑ - Foreign prices compared to domestic prices ↑ - Imports↓ : E↑- IM↓= TB↑

Real exchange rate ↓ -(home currency appreciates) Domestic prices compared to Foreign prices ↑- Exports ↓ - Foreign prices compared to domestic prices ↓ - Imports↑ : E↓- IM↑= TB ↓

So: The relation between trade balance and exchange rate should be positive

Trade balance and real effective exchange rate over time

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1.2Sweden SWE Trade Balance (%GDP)

Sweden SWE REal effective ex-change rate index (Home/Foreign)

Saving-investment and real effective exchange rate

We define saving as the sum of private and public saving

As previously mentioned :

Saving > Investment = +current account

Saving < Investment = -Current account

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Saving-Investement Dif (%GDP)

Sweden SWE REal effective exchange rate index (Home/Foreign)

Saving-investment and real exchange rate over time

Conclusion

Savings level is comparatively high high output level

Strong exporting economy Floating exchange rate monetary

autonomy stabilization policy is possible

Sweden managed to achieve economic stability

References: Feenstra, R. C. and Taylor A. M. (2012). International

economics (2nd internat. Ed.), New York: Worth Publishers

Observatory of Economic Complexity, (n.d.). Learn More About Trade in Sweden, retrieved

on seventh of May, 2014 http://atlas.media.mit.edu/profile/country/swe/

Trading Economics, (n.d.). Trade News Events, retrieved on seventh of May 2014,

http://www.tradingeconomics.com/country-list/current-account-to-gdp

http://databank.worldbank.org/data/home.aspx