Ch. 10: 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

Currencies and Exchange Rates U.S. Citizens sell dollars in the foreign exchange market in order to purchase foreign currency to 1. purchase imports 2. purchase foreign assets Foreign citizens buy dollars in the foreign exchange market with foreign currency in order to 1. Purchase U.S. exports 2. Purchase U.S. assets.

Currencies and Exchange Rates Foreign Exchange Rates The price at which one currency exchanges for another is called a foreign exchange rate. Currency depreciation A fall in the value of one currency in terms of another currency Currency appreciation A rise in value of one currency in terms of another currency.

Current exchange rates: http://finance.yahoo.com/currency

Currencies and Exchange Rates Nominal and Real Exchange Rates Nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. The real exchange rate is the relative price of foreign-produced goods and services. It is a measure of the quantity of real GDP of other countries that we get for a unit of U.S. real GDP.

Currencies and Exchange Rates 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.

The Foreign Exchange Market The Demand for One Money Is the Supply of Another Money When people who are holding one money want to exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money. So the factors that influence the demand for U.S. dollars also influence the supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese yen. And the factors that influence the demand for another country’s money also influence the supply of U.S. dollars.

The Foreign Exchange Market Demand for $ in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends on 1. The exchange rate (P of $) 2. World demand for U.S. exports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

The Foreign Exchange Market The Law of Demand for Foreign Exchange The demand for dollars is a derived demand. People buy U.S. dollars so that they can buy U.S.-produced goods and services or U.S. assets. Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market.

The Foreign Exchange Market The exchange rate influences the quantity of U.S. dollars demanded for two reasons: Exports effect As P of $ drops, foreign citizens wish to purchase more U.S. exports and more $. Expected profit effect The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying U.S. assets and the greater is the quantity of $ demanded today

The Foreign Exchange Market Supply in the Foreign Exchange Market The quantity $ supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors but the main ones are 1. The exchange rate 2. U.S. demand for imports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

The Foreign Exchange Market The Law of Supply of Foreign Exchange Other things remaining the same, the higher the exchange rate, 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.

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

Exchange Rate Fluctuations Changes in the Demand for U.S. Dollars 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 The expected future exchange rate

Exchange Rate Fluctuations Changes in the Supply of Dollars 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 The expected future exchange rate

Exchange Rate Fluctuations Analyze effect of each of the following on Supply/Demand for $ and the exchange rate: Increase in U.S. interest rates relative to foreign interest rates. Expectation the U.S. dollar will depreciate in future Increase in U.S. demand for imports Increase in foreign demand for U.S. exports Expectation that U.S. stock market will perform poorly relative to foreign stock markets.

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

Exchange Rate Fluctuations Interest Rate Parity Expected return on a currency = interest rate on that currency + expected rate of appreciation over a given period. interest rate parity exists when return on two currencies is equal. Market forces achieve interest rate parity very quickly. Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.

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 value of $ and interest rates in U.S. and Japan

Interest Rate Parity Example: U.S. pays 5% interest; Japan pays 8% interest; Value of $ expected to depreciate by 5% over next year. Where will U.S. citizens buy bonds? Japanese buy bonds? Effect on value of $ and interest rates in U.S. and Japan

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. Purchasing Power Parity. You can easily get your students to test purchasing power parity. Have them check the prices of some well-known titles at amazon.ca, amazon.com, and at amazon.co.uk, get the latest exchange rate for the U.S. dollar against the U.S. dollar and the U.K. pound, and see whether it is cheaper to buy a given title in Canada, the United States, or the United Kingdom.

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 $?

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

Purchasing Power Parity Amazon.com vs. Amazon.ca Big Mac Index

Financing International Trade Balance of Payments Accounts We record international transactions in the balance of payments accounts. A country’s balance of payments accounts records its international trading, borrowing, and lending. Transactions leading to an inflow of currency into the U.S. create a + in a balance of payments account Transactions leading to an outflow of currency from the U.S. create a – in a balance of payments account. Something new almost every day. This topic is one that is easily kept current. Today, the United States has a very large and persistent deficit. Pay attention to the development of this deficit in the New York Times, Wall Street Journal, and on the news Web sites. Herb Stein’s Dictum. Larry Summers remind me recently of Herb Stein’s dictum: “the unsustainable cannot be sustained and must surely end!” Ask your students what will happen to end the unsustainable current account deficit. They will want to say, a change in the exchange rate. And that is surely part of the answer. But fundamentally, unless Americans save more relative to U.S. investment, the current account will be in deficit no matter what the exchange rate does. Understanding this fundamental fact is a big lesson in this chapter.

Financing International Trade Three balance of payments accounts 1. Current account The current accounts balance equals the sum of exports minus imports, net interest income, and net transfers. 2. Capital account foreign investment in the United States minus U.S. investment abroad. 3. Official settlements account The 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.

Financing International Trade Borrowers and Lenders A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower. A country that is lending more to the rest of the world than it is borrowing from it is called a net lender. The United States is currently a net borrower but during the 1960s and 1970s, the United States was a net lender.

Financing International Trade Debtors and Creditors A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. Since 1986, the United States has been a debtor nation. A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it. The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

Financing International Trade Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

Financing International Trade Current Account Balance The current account balance (CAB) is CAB = NX + Net interest income + Net transfers The main item in the current account balance is net exports (NX). The other two items are much smaller and don’t fluctuate much.

Financing International Trade The government sector surplus or deficit is equal to net taxes, T, minus government expenditures on goods and services G. The private sector surplus or deficit is saving, S, minus investment, I. Net exports is equal to the sum of government sector balance and private sector balance: NX = (T – G) + (S – I)

Financing International Trade For the United States in 2006, Net exports is a deficit of $784 billion, which equals the sum of the government sector deficit of $313 billion and the private sector deficit of $471 billion.

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.

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.

Exchange Rate Policy Fixed Exchange Rate A fixed exchange rate policy is one that 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.

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?

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

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

Exchange Rate Policy People’s Bank of China in the Foreign exchange Market China’s official foreign currency reserves are piling up.

Exchange Rate Policy The People’s bank buy 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?