Exchange Rates and The Open Economy

Chapter 18: Exchange Rates and the Open Economy Nominal Exchange Rate The rate at which two currencies can be traded for each other Chapter 18: Exchange Rates and the Open Economy

Nominal Exchange Rates for the U.S. Dollar Country Foreign currency/dollar Dollar/foreign currency United Kingdom (pound) 0.5442 1.8376 Canada (Canadian dollar) 1.2697 0.7876 Mexico (peso) 11.0096 0.0908 Japan (yen) 106.85 0.009359 Switzerland (Swiss franc) 1.2222 0.8182 South Korea (won) 1,007.46 0.0009926 Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Nominal Exchange Rates The exchange rate between British and Canadian currencies 0.5442 British pounds = $1 U.S. 1.2697 Canadian $s = $1 U.S. 0.5442 British pounds = 1.2697 Canadian $s 0.5442/1.2697 = 0.4286 pounds = 1 Canadian $ British/Canadian exchange 0.4286 pounds per Canadian dollar Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Appreciation An increase in the value of a currency relative to other currencies Depreciation A decrease in the value of a currency relative to other currencies Chapter 18: Exchange Rates and the Open Economy

The U.S. Nominal Exchange Rate, 1973-2004 Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Some Definitions e = nominal exchange rate e = the number of units of foreign currency that the domestic currency will buy If e increases, it is an appreciation of the domestic currency. If e decreases, it is a depreciation of the domestic currency. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy 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 Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Foreign Exchange Market The market on which currencies of various nations are traded for one another Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rate An exchange rate whose value is set by official government policy Chapter 18: Exchange Rates and the Open Economy

The Supply and Demand for Dollars in the Yen-Dollar Market Supply of dollars e* The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded Yen/dollar exchange rate Quantity of dollars traded Chapter 18: Exchange Rates and the Open Economy

The Determination of the Exchange Rate in the Short Run Changes in the Supply of Dollars Factors that increase the supply of dollars An increase in the preference for Japanese goods An increase in U.S. real GDP An increase in the real interest rate on Japanese assets Chapter 18: Exchange Rates and the Open Economy

An Increase in the Supply of Dollars Lowers the Value of the Dollar Increase in demand for Japanese video games e*’ S’ F Supply of dollars increases from S to S’ The value of the dollar in terms of yen falls e* falls to e*’ D S e* E Yen/dollar exchange rate Quantity of dollars traded Chapter 18: Exchange Rates and the Open Economy

The Determination of the Exchange Rate in the Short Run Changes in the Demand for Dollars Factors that increase the demand for dollars Increased preference for U.S. goods Increase in real GDP abroad An increase in the real interest rate on U.S. assets Chapter 18: Exchange Rates and the Open Economy

The Determination of the Exchange Rate in the Short Run Economic Naturalist Does a strong currency imply a strong economy? Chapter 18: Exchange Rates and the Open Economy

A Tightening of Monetary Policy Strengthens the Dollar Tighter monetary policy raises the domestic real interest rate Foreign demand for U.S. assets increase The demand for dollars rises D' e*' F S' The increased demand for U.S. assets by American Savers decreases the supply of dollars Exchange rate appreciates from e* to e*’ S D e* E Yen/dollar exchange rate Quantity of dollars traded Chapter 18: Exchange Rates and the Open Economy

Monetary Policy and the Exchange Rate Economic Naturalist Why did the dollar appreciate nearly 50 percent in the first half of the 1980s? Chapter 18: Exchange Rates and the Open Economy

Monetary Policy and the Exchange Rate Economic Naturalist Why did the dollar depreciate more than 25 percent in 2002 – 2004? Chapter 18: Exchange Rates and the Open Economy

Monetary Policy and the Exchange Rate The Exchange Rate as a Tool of Monetary Policy When the exchange rate is flexible: Tighter monetary policy reduces net exports. Easier monetary policy stimulates net exports. Monetary policy is more effective in an open economy with flexible exchange rates. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates How to Fix an Exchange Rate The government will peg its currency to a major currency or to a “basket” of currencies. The government may have to devalue or revalue its currency. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Devaluation A reduction in the official value of a currency (in a fixed-exchange-rate system) Revaluation An increase in the official value of a currency (in a fixed-exchange-rate system) Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Overvalued Exchange Rate An exchange rate that has an officially fixed value greater than its fundamental value Undervalued Exchange Rate An exchange rate that has an officially fixed value less than its fundamental value Chapter 18: Exchange Rates and the Open Economy

An Overvalued Exchange Rate Official value Market equilibrium value 0.10 dollar/ peso 0.125 dollar/ The peso’s official value is greater than the fundamental value; the peso is overvalued A B To maintain the value, the government must purchase a quantity of pesos (A-B) Demand for pesos Supply of pesos Dollar/peso exchange rate Quantity of pesos traded Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates How to Fix an Exchange Rate Responses to an overvalued currency Devalue the currency Impose trade barriers Purchase the currency Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates How to Fix an Exchange Rate To purchase its own currency, a country must hold international reserves. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates International Reserves Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Balance-of-Payments Deficit The net decline in a country's stock of international reserves over a year Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Balance-of-Payment Surplus The net increase in a country's stock of international reserves over a year Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Example Latinia’s balance-of-payments deficit Demand = 25,000 - 50,000e Supply = 17,600 - 24,000e Official value of the peso = 0.125 dollars Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Example Latinia’s balance-of-payments deficit Fundamental value 25,000 - 50,000e = 17,600 + 24,000e Solving for e: 7,400 = 74,000e e = 0.10 Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Example As the official rate -- 0.125 D = 25,000 - 50,000(0.125) = 18,750 S = 17,600 - 24,000 (0.125) = 20,600 Excess supply = 1,850 pesos Balance of payments deficit = 1,850 pesos 1,850 x 0.125 = $231.25 Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Economic Naturalist Should China change the way it manages its exchange rate? Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Speculative Attack A massive selling of domestic currency assets by financial investors Chapter 18: Exchange Rates and the Open Economy

A Speculative Attack on the Peso B D S Official value 0.125 dollar/ peso Peso overvalued at 0.125 Central bank buys pesos Investors launch a speculative attack -- sell peso dominated assets 0.10 dollar/ peso S’ C Supply of pesos increases Central bank must purchase more pesos Dollar/peso exchange rate Quantity of pesos traded Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Economic Naturalist Can a speculative attack occur under flexible exchange rates? Chapter 18: Exchange Rates and the Open Economy

A Tightening of Monetary Policy Eliminates an Overvaluation Pesos overvalued at 0.125 D S' Official value 0.125 dollar/ peso F E 0.10 dollar/ peso D' Tightening monetary policy increases D to D’ and the supply will fall S to S'. Official value = fundamental value S Dollar/peso exchange rate Quantity of pesos traded Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Observation If monetary policy is used to set the fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Observation The conflict monetary policymakers face, between stabilizing the exchange rate and stabilizing the domestic economy, is most severe when the exchange rate is under a speculative attack. Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Economic Naturalist What were the causes and consequences of the East Asian crisis of 1997-1998? Chapter 18: Exchange Rates and the Open Economy

Chapter 18: Exchange Rates and the Open Economy Fixed Exchange Rates Economic Naturalist How did policy mistakes contribute to the Great Depression? Chapter 18: Exchange Rates and the Open Economy

Should Exchange Rates Be Fixed or Flexible? Monetary Policy Flexible exchange rates can strengthen the impact of monetary policy. Fixed exchange rates prevent the use of monetary policy to stabilize the economy. Chapter 18: Exchange Rates and the Open Economy

Should Exchange Rates Be Fixed or Flexible? Trade and Economic Integration Fixed exchange rate proponents argue that fixed rates promote international trade. The risk of a speculative attack may make the country less attractive to investors and trade. Chapter 18: Exchange Rates and the Open Economy

Should Exchange Rates Be Fixed or Flexible? Economic Naturalist Why have 11 European countries adopted a common currency? Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run The Real Exchange Rate Nominal exchange rate The price of the domestic currency in terms of a foreign currency Real exchange rate The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example Should you buy a Japanese or American computer for your company? Price of U.S. computer = $2,400 Price of Japanese computer = 242,000 yen Exchange rate = 110 yen/dollar Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example Should you buy a Japanese or American computer for your company? Price in yen = price in dollars x value of dollar in terms of yen Price in dollars = price in yen/yen-dollar exchange rate Price in dollars = 242,000 yen/110 = $2,200 Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example Should you buy a Japanese or American computer for your company? Japanese computer is cheaper. Real exchange rate = $2,400/$2,200 = 1.09 Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Real Exchange Rate Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run The Computer Example, revisited e = 110/$1 P = $2,400 Pf = 242,000 yen Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run The Real Exchange Rate A high real exchange rate implies that domestic producers will have difficulty exporting to other countries. A high real exchange rate will attract imports. Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run The Real Exchange Rate NX will tend to be low when the real exchange rate is high. Real and nominal exchange rates tend to move in the same direction Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Law of One Price If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example How many Indian rupees equal to one Australian dollar? Bushel of grain cost 5 Australian dollars or 150 rupees 5 Australian dollars = 150 rupees Nominal exchange should equal 30 rupees/Australian dollar Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Purchasing Power Parity (PPP) The theory that nominal exchange rates are determined as necessary for the law of one price to hold Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Purchasing Power Parity (PPP) In the long run, the currencies of countries that experience significant inflation will tend to depreciate. Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example How many Indian rupees equal one Australian dollar? Price of grain in India increases from 150 to 300 rupees Price of grain in Australia equals 5 Australian dollars Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example How many Indian rupees equal one Australian dollar? 5 Australian dollars = 300 rupees 1 Australian dollar = 60 rupees Nominal exchange rate increased from 30 to 60 rupees/Australian dollar Indian currency depreciated Australian currency appreciated Chapter 18: Exchange Rates and the Open Economy

Inflation and Currency Depreciation in South America, 1995-2004 Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Shortcomings of the PPP Theory The theory has been successful in the long run but not the short run. Chapter 18: Exchange Rates and the Open Economy

Determination of the Exchange Rate in the Long Run Example Limits to the PPP Theory Not all goods and services are traded internationally. The greater the share of non-traded goods, the less precise the PPP theory Not all internationally traded goods and services are perfectly standardized commodities. Chapter 18: Exchange Rates and the Open Economy

End of Chapter