Exchange Rates and the Open Economy Chapter 17 (last chapter!)

Chapter 17 Learning Objectives. You should be able to: Distinguish between fixed and flexible exchange rates. Indicate the difference between depreciation and devaluation (and appreciation and revaluation). Discuss the Purchasing Power Parity Theory of exchange rate determination. Use a supply and demand diagram to analyze the effect of monetary policy on the exchange rate. Describe conditions under which a speculative attack can occur. List the advantages and disadvantages of fixed exchange rates.

Foreign Exchange Market Abbreviation: FOREX Over a trillion dollars worth are traded daily. Most trading is to finance the purchase of assets (e.g., bank deposits), not goods and services.

Dollar Drops Against All but Yen DOW JONES NEWSWIRES December 6, 2005 NEW YORK -- The dollar slid broadly yesterday except versus the yen as investors continued to book profits on the U.S. currency's strong performance in recent months. The yen, however, slipped against the dollar and the euro, coming under renewed pressure after a weekend meeting for finance ministers of the Group of Seven industrialized nations suggested there is little official discomfort with a weak yen. The euro's outsize surge to a fresh all-time high of yen also helped the single currency to rise versus the dollar. Overnight, the dollar had touched a fresh 32-month high of yen, though it pared back much of its advance during New York trading. In late trading, the euro was at $1.1787, up from $ late Friday. The dollar was at yen, up from , and at Swiss francs, from The pound rose to $ from $1.7344, while the euro rose to yen from

Two types of exchange rate regime Flexible Exchange rate determined by supply and demand. Characterized by volatility. Creates uncertainty in conducting international business. Changes in value called appreciation and depreciation. Fixed Central bank buys and sells domestic currency at a fixed price. The gold standard was a fixed exchange rate regime. Bretton Woods was another. Provides more certainty in the short run but the system is susceptible to speculative attacks. Changes in value called revaluation and devaluation.

19 th Century Gold Standard 1 oz of gold = $20 = £4  £1 = $5

Bretton Woods Agreement 1944 Established a system of fixed exchange rates. Breakdown

Beginning of the end of fixed exchange rates … Richard Nixon closes the Gold Window in 1971.

Law of One Price If transportation costs are low, the same good will have the same price in different locations.

Purchasing Power Parity Theory (PPPT) The implication of the Law of One Price for exchange rates. It says that when a country has an inflation, its currency depreciates.

Volatility in forex market not explained by PPPT Purchasing power changes slowly. Most FOREX trading is not to finance import/export trade.

Speculative Attack Occurs under a system of fixed exchange rates. When the official price of the currency is set above the true price. For example, if the Argentina peso is valued officially at 1 peso for 1 dollar but in reality is worth only 50 cents. The Argentine central bank and to keep buying peso to keep the price high but it will eventually run out of dollars. Investors predict a revaluation and sell all their pesos now. They will also engage in short-selling: borrow pesos, sell for dollars and buy pesos later.

Summary Flexible Exchange rate determined by supply and demand. Characterized by volatility. Creates uncertainty in conducting international business. Changes in value called appreciation and depreciation. Fixed Central bank buys and sells domestic currency at a fixed price. The gold standard was a fixed exchange rate regime. Bretton Woods was another. Provides more certainty in the short run but the system is susceptible to speculative attacks. Changes in value called revaluation and devaluation.