1. Ch. 9: The Exchange Rate and the Balance of Payments.
Exchange rates
Definition
Determinants
Short run
Long run
Purchasing power parity
Interest rate parity
Balance of payments accounts
Causes of an international deficit
Alternative exchange rate policies and their long-run effects

2. Currencies and Exchange Rates
Supply of $
Created when U.S. Citizens sell dollars in the foreign exchange market in order to purchase foreign currency to
purchase imports
purchase foreign assets (stocks, bonds, real estate, etc.)
Demand for $
Created when Foreign citizens buy dollars in the foreign exchange market with foreign currency to
purchase U.S. exports
purchase U.S. assets.

3. Currencies and Exchange Rates
Foreign Exchange Rates
The price at which one currency exchanges for another.
Currency depreciation
A fall in the value of one currency in terms of another currency
Makes imports more expensive
Makes exports more affordable
Currency appreciation
A rise in value of one currency in terms of another currency.

4. 1/EXUSEU = Euros/$
Current exchange rates at

5. The trade-weighted index is the average exchange rate of the U. S
The trade-weighted index is the average exchange rate of the U.S. dollar against other currencies, with individual currencies weighted by their importance in U.S. international trade. (Higher value implies stronger $)

6. What determines exchange rates? The Foreign Exchange Market
The Demand for One Currency Is the Supply of Another Currency
Foreign citizens demanding U.S. dollars supply their own country’s money.
Factors that influence the demand for U.S. dollars also influence the supply of foreign currencies.
Factors that influence the demand for another country’s currency also influence the supply of U.S. dollars.

7. The Law of Demand for Foreign Exchange
Ceteris paribus, as the P of $ drops, quantity of $ demanded rises
Exports effect
As P of $ drops
foreign citizens wish to purchase more U.S. exports
quantity of $ demanded rises.
Expected profit effect
As P of $ drops,
the larger the expected profit from buying U.S. assets
quantity of $ demanded rises

9. The Law of Supply of Foreign Exchange
Ceteris paribus, as P of $ rises, the greater is the quantity of $ supplied in the foreign exchange market.
Imports effect
As P of $ rises, U.S. citizens increase imports and sell more $ to purchase more imports.
Expected profit effect
As P of $ rises, U.S. citizens see greater potential for profits in foreign assets and sell more $ to purchase more foreign assets.

11. The Foreign Exchange Market
Market Equilibrium
If $ is “too strong”, surplus of $
If $ is “too weak”, shortage of $

12. Exchange Rate Fluctuations
Changes in exchange rate cause movement along the demand curve, NOT a change in demand.
Changes in Demand for $ caused by:
World demand for U.S. exports
U.S. interest rate relative to the foreign interest rate
Expected profits on U.S. assets relative to profits on foreign assets
The expected future exchange rate

13. Exchange Rate Fluctuations
Changes in the exchange rate cause a movement along the supply curve, NOT a change in supply
Changes in the supply of dollar are caused by:
U.S. demand for imports
U.S. interest rates relative to the foreign interest rate
Expected profits on U.S. assets relative to profits on foreign assets
The expected future exchange rate

14. Exchange Rate Fluctuations
Exchange Rate Expectations
The exchange rate changes when it is expected to change.
Expectations about the exchange rate are driven by deeper forces. Two such forces are
Interest rate parity
Purchasing power parity

15. Interest Rate Parity
Expected $ return on investment in foreign currency =
interest rate on foreign currency +
expected change in value of foreign currency
Interest rate parity exists when interest rates are such that expected returns on currencies are equal across countries.
Market forces achieve interest rate parity very quickly.
Example:
U.S. interest rate=5%; German interest rate=8%
What’s required for interest rate parity?

16. Interest Rate Parity
Example: U.S. pays 5% interest; Japan pays 4% interest; Value of $ expected to appreciate by 3% over next year.
Where will U.S. citizens buy bonds?
Japanese buy bonds?
Effect on interest rates in U.S. and Japan

17. Purchasing Power Parity
Exists when the exchange rate is such that a currency has the same “purchasing power” in all countries.
If PPP did not exist, one could take advantage of “arbitrage” opportunities:
buy item at low price and sell at high price
drives up price in low price country and drives down price in high price country.

18. Purchasing Power Parity
Suppose $1 = 2 francs, price of gold=$500 in U.S. and 800 francs in France. What’s the arbitrage opportunity? What will happen to price of gold in U.S. France What will happen to price of $?

19. Purchasing Power Parity
In the long run, because of PPP: Exchange rate between foreign currency and dollar = price in foreign country / price in U.S. % ch in price of $ (exchange rate)= % ch in foreign price - % ch in U.S. prices

20. Financing International Trade
Balance of Payments Accounts
Record a country’s international trading, borrowing, and lending.
Transactions leading to an inflow of currency into the U.S. create a + (credit) in a balance of payments account
Transactions leading to an outflow of currency from the U.S. create a – (debit) in a balance of payments account.

21. Financing International Trade
Three balance of payments accounts
Current account
= NX + Net interest income + Net transfers
Capital account
=Foreign invest. in the U.S. - U.S. invest. abroad.
Official settlements account
records the change in U.S. official reserves.
U.S. official reserves are the government’s holdings of foreign currency
If U.S. official reserves increase, the official settlements account is negative.
The sum of the three account balances is zero.

22. Financing International Trade
Borrowers and Lenders
A net borrower has a current account deficit
A net lender has a current account surplus
The U.S. is currently a net borrower but during the 1960s and 1970s, the U.S. was a net lender.

24. Financing International Trade
Debtors and Creditors
A debtor nation
country that owes more than other countries owe to it.
A creditor nation
a country that owes less than other coutnries owe to it.
Since 1986, the United States has been a debtor nation.
Borrower/lender status based upon one year
Debtor/creditor status based upon entire history of borrowing/lending.

25. Financing International Trade
Is being a net borrower “bad”?
does not reduce long term economic growth if funds are used to finance capital accumulation
can reduce economic growth if the borrowed funds are used to finance consumption.
difficult to determine whether U.S. is borrowing for consumption or capital accumulation.
Low savings rates in U.S. may be a concern.

26. Financing International Trade
Determinants of U.S. borrowing/lending from rest of world
C+S+T=C+I+G+NX (T=net taxes)
NX=(S-I) + (T-G)
(S-I) = private sector balance
(T-G) = public sector balance
if balance>0, surplus
if balance<0, deficit
Ceteris paribus, U.S. borrowing from rest of world rises as public or private sector balance decreases

27. Financing International Trade
For the United States in 2010,
Net exports were -$536 billion.
Government sector balance was -$1,295 billion
Private sector balance was $759 billion

28. Financing International Trade
The Three Sector Balances
The private sector balance and the government sector balance tend to move in opposite directions.
Net exports is the sum of the private sector and government sector balances.

29. Exchange Rate Policy Three possible exchange rate policies are
Flexible exchange rate
Fixed exchange rate
Crawling peg
Flexible Exchange Rate
A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.

30. Exchange Rate Policy
Fixed Exchange Rate pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market. A fixed exchange rate requires active intervention in the foreign exchange market.

31. Exchange Rate Policy
Suppose that the target is 100 yen per U.S. dollar.
If demand increases, the central bank sells U.S. dollars to increase supply.
Effect of “undervalued dollar” and subsequent intervention on 1. U.S. money supply? 2. U.S. Inflation?

32. Exchange Rate Policy
If demand decreases, the central bank buys U.S. dollars (with foreign reserves) to decrease supply.
Effect of “over-valued” dollar and subsequent intervention on:
U.S. money supply and reserves of foreign currency
U.S. inflation

33. Exchange Rate Policy Crawling Peg
selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path.
China is a country that operates a crawling peg.
Crawling peg works like a fixed exchange rate except that the target value changes.
Avoids wild swings in the exchange rate

35. Exchange Rate Policy
The People’s bank buys U.S. dollars to maintain the target exchange rate. China’s official foreign reserves increase. Based on diagram, is $ over- or under-valued relative to Chinese Yuan?

36. Exchange Rate Policy
People’s Bank of China in the Foreign exchange Market China’s official foreign currency reserves were rising until Stable and falling since. China will buy $ to drive up price of $; sell $ to drive down price of $.

37. Maintaining fixed exchange rates
If China wishes to maintain its exchange rate relative to the dollar, how will each of the following affect Chinese build-up of dollar reserves?
An increase in inflation in China relative to U.S. inflation
An increase in U.S. interest rates relative to China
An increase in U.S. demand for Chinese exports.
An increase in Chinese demand for U.S. exports