Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Exchange Rates and the Open Economy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Dealing with Foreign Currency  Translating the value of foreign money into dollars is a problem every international traveler faces  Exchanges rates  The rates at which one country’s money trades for another  They may change unpredictably

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Importance of Exchange Rates  Exchange rates make a difference in the following  Competitiveness of U.S. exports  Prices Americans pay for imported goods  Value of financial investments made across borders

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Trade Involves Currency  Trade in goods, services, and assets within a nation normally involves a single currency  Trade between nations usually involves dealing in different currencies  American manufacturers want to be paid in dollars  South Korean manufacturers want to be paid in won

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Nominal Exchange Rates  Nominal exchange rate  The rate at which one national currency trades for another  Suppose one U.S. dollar can be exchanged for 110 Japanese yen  The exchange rate is 110 yen/dollar  e = 110 yen/dollar  Can be equivalently expressed either as  The amount of foreign currency needed to purchase one dollar  The number of dollars needed to purchase one unit of the foreign currency  They are simply reciprocal

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Changes in Value  Exchange rates can also be expressed as an average of its values against other major currencies  Appreciation  An increase in the value of a currency relative to other currencies  An increase in e  Depreciation  A decrease in the value of a currency relative to other currencies  A decrease in e

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The U.S. Nominal Exchange Rate,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Flexible Exchange Rates  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  AKA Floating exchange rate  Varies according to the supply and demand for the currency  Foreign exchange market  The market on which currencies of various nations are traded for one another

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fixed Exchange Rates  Fixed exchange rate  An exchange rate whose value is set by official government policy  Argentina fixes their currency to the U.S. dollar  Under the gold standard, currency values were fixed in terms of ounces of gold

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Comparing Prices  U.S made computer costs $2,400  Similar Japanese computer costs 242,000 yen  e = 110 yen/dollar  Measure prices of both computers in terms of the same currency  Convert the Japanese computer’s price into dollars

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Comparing Prices  The Japanese computer is a better deal  U.S. computer costs $2,400  The value of a dollar in terms of yen is just the yen-dollar exchange rate:

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Competitiveness  The price of the U.S. good relative to the price of the foreign good is  $2,400/$2,200 = 1.09  U.S. computer is 9% more expensive than the Japanese computer

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real Exchange Rates  Real exchange rate  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  There are important implications for the ability to sell its exports abroad

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Defining the Real Interest Rate  e equals the nominal exchange rate  The number of units of foreign currency per dollar  P equals the domestic price level  P f equals the foreign price level  We can compare P and P f if we convert one into a common currency  To convert foreign prices into dollars:  Divide the foreign price by the exchange rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Formula for the Real Interest Rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Checking the Real Price of Computers  Confirms the earlier result

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Net Exports and Real Exchange Rates  High real exchange rate implies  Domestic producers will have difficulty exporting to to other countries  Foreign goods will sell well in the home country  Net exports will tend to be low when the real exchange rate is high  Net exports will tend to be high when the real exchange rate is low

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Real and Nominal Exchange Rates  Real exchange rate tends to move in the same direction as the nominal exchange rate e  Net exports will be  Hurt with a high nominal exchange rate  Helped by a low nominal exchange rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Determination of Flexible Exchange Rates  Law of one price  If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations  The price of a bushel of wheat should be the same in Bombay, India and Sydney, Australia

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Purchasing Power Parity  Purchasing power parity PPP  The theory nominal exchange rates are determined as necessary for the law of one price to hold  The currencies of countries that experience significant inflation tend to depreciate  Inflation implies a nation’s currency is losing purchasing power in domestic and international markets

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig Inflation and Currency Depreciation in South America,

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Shortcomings of PPP  PPP works  Well long-run movements in exchange rates  Explains why countries with high inflation tend to have exchange rate depreciation  Law of one price works well for standardized commodities traded widely  Less well in short-run movements in exchange rates  Not all goods and services are traded internationally  High transportation costs  Not all goods and services are standardized commodities

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Supply and Demand and Exchange Rates  Supply and demand analysis is  More useful than PPP when studying short-run behavior of exchange rates  Dollars are demanded in the foreign exchange market by  Foreigners wanting to purchase U.S. goods and assets  Dollars are supplied in the foreign exchange market by  U.S. residents wanting foreign currencies to buy foreign products

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Supply of Dollars  U.S. households supply dollars in the foreign exchange market  To purchase foreign goods and services  To buy a Japanese car  To purchase foreign assets  To buy a Japanese government bond  Upward-sloping supply of dollars  The more yen each dollar can buy, the cheaper those goods, services, and assets  Americans buying more Japanese products need to trade more dollars for yen

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Demand for Dollars  Demanders of dollars in the yen-dollar market mainly Japanese households and firms wanting to buy  U.S. goods and services  U.S. assets  Downward sloping  The more yen a Japanese citizen must pay to get one dollar, the more expensive U.S. goods, services, and assets  Japanese buying less American products need to trade fewer yen for dollars

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig The Supply and Demand for Dollars in the yen-dollar Market

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Equilibrium Value of the Dollar  Fundamental value of the exchange rate  Fundamental value of the exchange rate [Equilibrium exchange rate]  The exchange rate that equates the quantities of the currency supplied and demanded in the foreign exchange market  Flexible or floating exchange rates  Exchange rates that are determined by the forces of supply and demand in the foreign exchange market

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Changing Supply of Dollars  The supply of dollars increases when  There’s increased preference for Japanese goods  U.S. real GDP increases  Real interest rate on Japanese assets increases  The supply of dollars decreases when  There’s lower demand for Japanese goods  U.S. real GDP decreases  Real interest rate on Japanese assets falls

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig An Increase in the Supply of Dollars Lowers the Value of the Dollar

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Monetary Policy and Exchange Rates  Monetary policy affects the exchange rate mainly through  Its effect on the real interest rate r  Tighter monetary policy  Raises domestic U.S. real interest rate r  U.S. assets are more attractive  Increases the demand for dollars  Increases the exchange rate (i.e., the dollar has appreciated)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Tightening of Monetary Policy Strengthens the Dollar

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Another Fed Tool  Open economies with flexible exchange rates provide  Another tool for monetary policy  Monetary policy is more effective in an open economy with a flexible exchange rate  Suppose the Fed is worried about inflation and imposes a tighter monetary policy. It  Increases the value of a dollar  Reduces the cost of imported goods  Imports increase  Increases the cost of domestic goods  Exports decrease  Causes aggregate demand (AD) to fall

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fixed Exchange Rates  Important for small or developing nations  Ability to use monetary policy as a stabilization tool is greatly reduced  A fixed exchange rate is determined by the government  Usually set in terms of a major currency  One-to-one with the dollar  Relative to a “basket” of currencies

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Revaluation and Devaluation  Revaluation  An increase in the official value of a currency in a fixed-exchange-rate system  Devaluation  A reduction in the official value of a currency in a fixed-exchange-rate system

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Overvalued and Undervalued  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  International reserves  Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig An Overvalued Exchange Rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Balance-of-Payments  Balance-of-payments deficit  The net decline in a country’s stock of international reserves over a year  Balance-of-payments surplus  The net increase in country’s stock of international reserves over a year

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Speculative Attacks  Speculative attacks  A massive selling of domestic currency assets by financial investors  Investors fear an overvalued currency will soon be devalued  Often turn out to be the cause of devaluation  Ends a government’s attempts to maintain an overvalued exchange rate

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Speculative Attack on the Peso

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Monetary Policy and Fixed Exchange Rates  No way to maintain a fixed exchange rate above its fundamental value for extended periods  Changing the fundamental value will eliminate the overvaluation problem  Most effective way to change the fundamental value is through monetary policy  Tighter monetary policy increases real interest rate  Increasing demand for domestic currency raises the fundamental value

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fig A Tightening of Monetary Policy Eliminates an Overvaluation

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Use of Stabilization Monetary Policy  Monetary policy can be used to keep the fundamental value of the exchange rate equal to the official value  However, then monetary policy is no longer available for stabilizing the domestic economy

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide One or the Other  During a recession due to insufficient demand, at the same time the exchange rate is overvalued  To solve the recession  Central bank could lower real interest rate to increase spending and output  To solve the overvaluation  Central bank could raise the real interest rate  Monetary policy cannot solve both problems at once

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide Fixed or Flexible?  Flexible exchange rate  Strengthens the impact of monetary policy  Large economies should nearly always employ flexible exchange rates  Fixed exchange rate  Prevents stabilization policy  Small economies don’t lose much when fixing their exchange rates  If all countries had fixed rates  Less uncertainty about the future is reduced  Fixed exchange rates are not guaranteed forever