© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 33 The World of International Finance

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin What Are Exchange Rates? The exchange rate is the rate at which we can exchange one currency for another. It is a crucial determinant of the trade in goods and assets.The exchange rate is the rate at which we can exchange one currency for another. It is a crucial determinant of the trade in goods and assets. An increase in the value of a currency is called appreciation, and a reduction in value is called depreciation.An increase in the value of a currency is called appreciation, and a reduction in value is called depreciation. We measure the exchange rate in units of foreign currency. The exchange rate of the dollar is the price of the dollar in terms of foreign currency.We measure the exchange rate in units of foreign currency. The exchange rate of the dollar is the price of the dollar in terms of foreign currency.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin What are Exchange Rates If the dollar appreciates against a particular foreign currency, that currency must depreciate against the dollar.If the dollar appreciates against a particular foreign currency, that currency must depreciate against the dollar. The exchange rate enables us to convert prices in one country to values in another country.The exchange rate enables us to convert prices in one country to values in another country.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Dollars If e increases from 2.0 to 2.5 marks/dollar, then 1 dollar buys more marks, and the price of dollars in terms of marks has increased. Therefore, the dollar has appreciated and the mark has depreciated.If e increases from 2.0 to 2.5 marks/dollar, then 1 dollar buys more marks, and the price of dollars in terms of marks has increased. Therefore, the dollar has appreciated and the mark has depreciated.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Demand for and Supply of Dollars If e decreases to 1.5 marks/dollar, the dollar has depreciated in value against the mark.If e decreases to 1.5 marks/dollar, the dollar has depreciated in value against the mark.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand for Dollars Two factors will increase the demand for dollars:Two factors will increase the demand for dollars: Higher U.S. interest ratesHigher U.S. interest rates Lower U.S. pricesLower U.S. prices

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Shifts in Demand for Dollars An increase in the demand for dollars will also increase, or appreciate, the exchange rate.An increase in the demand for dollars will also increase, or appreciate, the exchange rate.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Exchange Rates and Purchasing Power Parity Changes in market exchange rates can affect the demand for a country’s goods and services. As prices change, we need to adjust the exchange rate to take into account those price changes.Changes in market exchange rates can affect the demand for a country’s goods and services. As prices change, we need to adjust the exchange rate to take into account those price changes. Reality PRINCIPLE What matters to people is the real value of money or income–its purchasing power–not the face value of money or income.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Exchange Rates and Purchasing Power Parity Economists have developed a concept that adjusts market exchange rates for changes in prices, called the real exchange rate.Economists have developed a concept that adjusts market exchange rates for changes in prices, called the real exchange rate. The real exchange rate adjusts for price changes by expressing U.S. prices in foreign currency and comparing them to foreign prices.The real exchange rate adjusts for price changes by expressing U.S. prices in foreign currency and comparing them to foreign prices.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Exchange Rate and Net Exports as Share of GDP, The index of the real exchange rate is based on an average of real exchange rates with all U.S. trading partners, called the multilateral real exchange rate.The index of the real exchange rate is based on an average of real exchange rates with all U.S. trading partners, called the multilateral real exchange rate. Notice that when the multilateral real exchange rate rises, U.S. net exports fall.Notice that when the multilateral real exchange rate rises, U.S. net exports fall.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Exchange Rate and Net Exports as Share of GDP,

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Real Exchange Rates and Purchasing Power Parity The tendency for easily tradable goods to sell at the same price when expressed in a common currency is known as the law of one price.The tendency for easily tradable goods to sell at the same price when expressed in a common currency is known as the law of one price. The theory of purchasing power parity states that the exchange rate between two currencies is determined by the price levels in those two countries.The theory of purchasing power parity states that the exchange rate between two currencies is determined by the price levels in those two countries.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Big Mac Around the World Country Price of a Big Mac in Local Currency Price of a Big Mac in Dollars Predicted Purchasing Power Exchange Rate (Foreign Currency per Dollar) United States 2.54 dollars $2.54 United Kingdom 1.99 pounds $ Hong Kong 10.7 HK dollars $ Switzerland 6.30 Swiss francs $ Mexico 21.9 pesos $ Singapore 3.30 Singapore dollars $ Japan 294 yen $

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Fixing the Exchange Rate An increase in the value of the U.S. dollar has two effects:An increase in the value of the U.S. dollar has two effects: Imports are less expensive for the residents of the U.S.Imports are less expensive for the residents of the U.S. U.S. exports are more expensive in world markets.U.S. exports are more expensive in world markets. Since exports decrease and imports increase, net exports (exports minus imports) decline.Since exports decrease and imports increase, net exports (exports minus imports) decline.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Fixing the Exchange Rate To avoid a reduction in net exports from an exchange rate appreciation, or a sharp increase in the cost of living from an exchange rate depreciation, the U.S. government could enter the foreign exchange market to try to influence the price of foreign exchange. These efforts are called foreign exchange market intervention.To avoid a reduction in net exports from an exchange rate appreciation, or a sharp increase in the cost of living from an exchange rate depreciation, the U.S. government could enter the foreign exchange market to try to influence the price of foreign exchange. These efforts are called foreign exchange market intervention.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Fixed Exchange Rates Currency systems in which governments try to keep constant the values of their currencies against one another are called fixed exchange rate systems.Currency systems in which governments try to keep constant the values of their currencies against one another are called fixed exchange rate systems. Government intervention is required if, at the fixed exchange rate, the private demand and supply for its currency are not equal.Government intervention is required if, at the fixed exchange rate, the private demand and supply for its currency are not equal.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Fixed Exchange Rates Under a fixed exchange rate system, the balance of payments deficit is a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate.Under a fixed exchange rate system, the balance of payments deficit is a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate. Under a fixed exchange rate system, the balance of payments surplus is a situation in which the demand for a country’s currency exceeds the supply of its currency at the current exchange rate.Under a fixed exchange rate system, the balance of payments surplus is a situation in which the demand for a country’s currency exceeds the supply of its currency at the current exchange rate.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Fixed Exchange Rates Under a fixed exchange rate system, countries that run persistent balance of payments deficits or balance of payments surpluses must take corrective actions:Under a fixed exchange rate system, countries that run persistent balance of payments deficits or balance of payments surpluses must take corrective actions: Devaluation is a decrease in the exchange rate in a fixed exchange rate system.Devaluation is a decrease in the exchange rate in a fixed exchange rate system. Revaluation is an increase in the exchange rate in a fixed exchange rate system.Revaluation is an increase in the exchange rate in a fixed exchange rate system.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The U.S. Experience with Fixed and Flexible Exchange Rates A flexible exchange rate is a currency system in which exchange rates are determined by free markets.A flexible exchange rate is a currency system in which exchange rates are determined by free markets. The exchange rate of a currency is determined by the supply and demand for it.The exchange rate of a currency is determined by the supply and demand for it. After World War II, the countries of the world operated under a fixed exchange rate system known as Bretton Woods, whereby all countries fixed or pegged their currencies against the U.S. dollar.After World War II, the countries of the world operated under a fixed exchange rate system known as Bretton Woods, whereby all countries fixed or pegged their currencies against the U.S. dollar.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Exchange Rate Systems Today One way to avoid the difficulties of fixing exchange rates between countries is to establish a single currency.One way to avoid the difficulties of fixing exchange rates between countries is to establish a single currency. A group of European countries decided to establish the common currency in Europe called the Euro.A group of European countries decided to establish the common currency in Europe called the Euro. Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.Some economists believe that the world will eventually settle into three large currency blocs: the euro, the dollar, and the yen.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The End Have a fun and safe Holiday Break!