1. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-1 Chapter 14 Exchange rates and the open economy

2. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-2 Learning objectives 1.What is a nominal exchange rate? 2.What is the different between fixed and floating exchange rates? 3.What is the difference between a nominal and a real exchange rate? 4.What assumptions underlie the purchasing power parity theory of exchange rates? 5.What factors determine the supply of dollars/demand for dollars in the international currency market? 6.How does a flexible exchange rate regime work? 7.How does a fixed exchange rate work? 8.What factors influence a country’s choice of fixed or flexible exchange rates?

3. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-3

4. Nominal exchange rates In international trade, the seller requires the purchase price in their own currency, while the buyer possesses their own country’s currency. –Therefore, in international trade, international currencies also need to be traded for one another. Nominal exchange rate –The relative values at which different currencies can be traded for each other. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-4

5. Tab. 14.1 Nominal exchange rates for the Australian dollar (4 pm, 6 Sept. 2010) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-5

6. Appreciation and depreciation e is used to denote nominal exchange rate = the number of units of the foreign currency that the domestic currency will buy. –An increase in the exchange rate means more foreign currency can be traded for $AUS1, and is called an appreciation. –A decrease in the exchange rate means less foreign currency can be traded for $AUS1, and is called a depreciation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-6

7. Trade weighted index Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-7 Figure 14.1 Australia’s trade weighted nominal exchange rate

8. Flexible versus fixed exchange rates Foreign exchange market –The market on which currencies of various nations are traded for one another Flexible exchange rate –An exchange rate whose value is not officially fixed, but varies according to the supply and demand for the currency in the foreign exchange market. Fixed exchange rate –An exchange rate whose value is set by official government policy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-8

9. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-9

10. The real exchange rate A country’s real exchange rate compares prices of the average domestic good or service relative to the average foreign good or service. Let P = domestic price level, as measured by the consumer price level, which we will use as a measure of the price of an average domestic good or service. Similarly, let P f = the foreign price level, a measure of the price of an average foreign good or service. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-10

11. The real exchange rate (cont.) As these two values are in different currencies, the nominal exchange rate needs to be included. Real exchange rate = price of domestic good price of foreign good, in dollars = P (P f / e) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-11

12. Example: Comparing prices expressed in different currencies Example: An Australian-made computer costs $2400 and a very similar Japanese computer costs ¥242 000. The exchange rate is ¥110 = $1. Real exchange rate = price in dollars price in yen / yen-dollar exchange rate = $2400 = $2400 ¥242 000 / ¥110 $2200 = 1.09 In general, a country’s ability to compete in the international market depends on its prices relative to other countries’ prices. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-12

13. Interpreting the real exchange rate Fluctuations in the real exchange rate reflect changes in the relative price between two countries: –When the real exchange rate is high, domestic goods are more expensive than foreign goods and net exports are likely to be low. –When the real exchange rate is low, domestic goods are less expensive than foreign goods and net exports are likely to be high. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-13

14. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-14

15. The law of one price The law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations. Otherwise, a profit would be made by buying the commodity where it is cheaper and selling it where it is more expensive. If this is true for all goods and services, then it can be used to determine the nominal exchange rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-15

16. Example: Purchasing power parity Example: If the price of a bushel of wheat costs $5 in Sydney and 150 rupees in Mumbai, the exchange rate would be: $AUS5 = 150 rupees $AUS1 = 30 rupees This is the purchasing power parity theory: that nominal exchange rates are determined as necessary for the law of one price to hold. This theory predicts that the currency of a country that experiences significant inflation will tend to depreciate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-16

17. Example: Purchasing power parity (cont.) Example: If India experiences inflation and the price of a bushel of wheat increases to 300 rupees in Mumbai, the exchange rate would be: $AUS5 = 300 rupees $AUS1 = 60 rupees Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-17

18. Inflation and currency depreciation Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-18 Figure 14.2 Inflation and currency depreciation in South America, 1995–2002

19. Shortcomings of the PPP theory PPP is useful for predicting changes in nominal rates over the long run, but works less well in the short run. It relies on the law of one price, which works well for standardised products that are internationally traded, like gold and grain. However, not all goods and services are traded internationally, and many are not standardised. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-19

20. Shortcomings of the PPP theory (cont.) Examples of goods not traded internationally are: –those with large transportation costs, like hairdressing services and heavy construction materials –those that cannot be traded, like agricultural land and buildings –highly perishable food items. Not all goods and services are standardised: –Japanese and Australian cars differ in many respects, and if Japanese cars cost 10% more than Australian, many would still be purchased. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-20

21. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-21

22. Supply and demand analysis Although PPP is useful to explain long-run behaviour of the exchange rate, supply and demand analysis is more useful for the short run. Demand for Australian dollars is from foreigners who seek to purchase Australian goods and assets; supply of Australian dollars is by Australians who seek to purchase foreign goods and assets. The equilibrium exchange rate is the rate that equates the demand and supply of the currency in the foreign exchange market. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-22

23. The supply of dollar The principal suppliers of the Australian dollar to the foreign exchange market are Australian households and firms, so they can: –purchase foreign goods and services –purchase foreign assets. The higher the exchange rate, the more the Australian dollar will be supplied, as foreign currency denominated prices become cheaper and therefore more purchases are made. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-23

24. The demand for dollar The principal demanders of the Australian dollar in the foreign exchange market are foreign households and firms, so they can: –purchase Australian goods and services –purchase Australian assets. The lower the exchange rate, the more the Australian dollar will be demanded, as Australian denominated prices become cheaper to foreign purchasers, so more purchases are made. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-24

25. Demand and supply of the Australian dollar Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-25 Figure 14.3 The supply and demand for dollars in the yen–dollar market

26. Shifts in supply of the Australian dollar Factors that increase the supply of the Australian dollar, and therefore shift the supply curve to the right: –An increased preference for the foreign country’s goods or services –An increase in Australian real GDP, which will increase consumption in Australia, part of which will be on foreign goods and services –An increase in the real interest rate on foreign assets, which would make them more attractive to Australians Conversely, the supply curve shifts to the left if there is a reduction in these factors. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-26

27. An increase in the supply of dollars Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-27 Figure 14.4 An increase in the supply of dollars lowers the value of the dollar

28. Shifts in demand for the Australian dollar Factors that increase the demand for the Australian dollar, and therefore shift the demand curve to the right: –An increased preference for Australian goods or services –An increase in real GDP abroad, which will increase incomes, part of which will be spent on Australian goods and services –An increase in the real interest rate on Australian assets, which would make them more attractive to foreigners Conversely, the demand curve shifts to the left if there is a reduction in these factors. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-28

29. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-29

30. Monetary policy and the exchange rate The monetary policy of the country’s central bank is one of the most important factors that influences the exchange rate. A tightening of monetary policy will increase the interest rate. This makes Australian assets more attractive to foreigners. The increased demand for Australian dollars will shift the demand curve to the right and increase the equilibrium exchange rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-30

31. Effects of tight monetary policy Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-31 Figure 14.5 A tightening of monetary policy strengthens the dollar

32. Example: The rise of the Australian dollar over 2009–2010 Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-32 Figure 14.6 Official interest rates in Australia and the United States

33. Monetary policy and aggregate demand We saw previously that in a closed economy, tightening of monetary policy reduces aggregate demand (AD) through reducing C and I. In an open economy with a flexible exchange rate, tightening monetary policy will also increase the exchange rate. The higher exchange rate reduces exports and increases imports. Net exports reduces AD further, and reinforces the monetary policy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-33

34. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-34

35. Fixed exchange rates Fixed exchange rates are determined by the government of a nation. They are usually set in terms of a major currency, such as the $US or a basket of currencies. We will assume that once the exchange rate has been fixed, the government usually tries to keep it unchanged for some time (although the crawling peg and target zone systems are possible, too). Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-35

36. Example: A fixed exchange rate regime Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-36 Figure 14.7 An overvalued exchange rate

37. Example: A fixed exchange rate regime (cont.) This means the peso is overvalued. There are three ways Latinia can deal with this: 1.Latinia can devalue its currency and allow it to trade at 10 pesos to the dollar. However, doing this frequently would be like having a flexible exchange rate. 2.Latinia could impose restrictions on international transactions to manipulate the fundamental value. This would reduce the benefits from trade and capital flows to their households. 3.Latinia’s government could become a demander of its own currency, buying an amount of pesos equivalent to AB, to add to private demand so as to match to private supply. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-37

38. An overvalued exchange rate: Balance-of-payments deficit To be able to buy enough currency to match demand with supply, the government needs to hold foreign currency assets called international reserves. A country with an overvalued exchange rate needs to use part of its reserves to support the value of the currency, and its international reserves will decline. The net decline (increase) in a country’s stock of international reserves over a year is called its balance- of-payments deficit (surplus). Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-38

39. Speculative attacks on currency A government can maintain an overvalued exchange rate for some time, but there is a limit as their international reserves are finite. A speculative attack can end the overvaluation quickly and unexpectedly. This occurs because of a fear that an overvalued currency will soon be devalued. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-39

40. A speculative attack Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-40 Figure 14.8 A speculative attack on the peso

41. Monetary policy and fixed exchange rates There is no really satisfactory way to maintaining a fixed exchange rate above its fundamental value, as we have seen. An alternative to trying to maintain an overvalued exchange rate is to take actions that increase the fundamental value, to the point of the official value. The most effective way is through monetary policy. Tightening monetary policy will increase the demand for the currency, eliminating the overvaluation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-41

42. A tightening of monetary policy eliminates an overvaluation Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-42 Figure 14.9 A tightening of monetary policy eliminates an overvaluation

43. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-43

44. Fixed versus flexible exchange rates There are two major issues to consider between a fixed and a flexible exchange rate system. 1.The first is that the type of exchange rate a country has impacts on their ability to use monetary policy to stabilise the economy. A flexible exchange rate strengthens the impact of monetary policy on AD, but a fixed exchange rate prevents policy-makers from using it to stabilise the economy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-44

45. Fixed versus flexible exchange rates (cont.) 2.The second important issue is the effect of the exchange rate on trade and economic integration. Fixed exchange rates can be argued to provide a level of certainty about an important factor in the profitability of trade and cross- border economic co-operation, where flexible exchange rates do not. However, fixed exchange rates are not guaranteed to remain fixed forever, and may lead suddenly and unpredictably to a large devaluation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-45

46. Chapter organisation 14.1Nominal exchange rates 14.2The real exchange rate 14.3The determination of the exchange rate 14.4The determination of the exchange rate: A supply and demand analysis 14.5Monetary policy and the exchange rate 14.6Fixed exchange rates 14.7Should exchange rates be fixed or flexible? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-46

47. Summary The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. The PPP theory predicts that the currencies of countries that experience significant inflation will tend to depreciate in the long run. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-47

48. Summary (cont.) Supply and demand analysis is useful in determining the fundamental value of the exchange rate. In a flexible exchange rate regime, a tight monetary policy increases the demand for the currency and causes it to appreciate. In a fixed exchange rate regime, an overvalued currency may be prone to speculative attacks. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 14-48