MBMC Exchange Rates and The Open Economy

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 2 Exchange Rates Nominal Exchange Rate The rate at which two currencies can be traded for each other

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 3 Nominal Exchange Rates for the U.S. Dollar CountryForeign currency/dollarDollar/foreign currency United Kingdom (pound) Canada (Canadian dollar) Mexico (peso) Japan (yen) Switzerland (Swiss franc) South Korea (won)1,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 4 Exchange Rates Nominal Exchange Rates The exchange rate between British and Canadian currencies  British pounds = $1 U.S.  Canadian $s = $1 U.S.  British pounds = Canadian $s  / = pounds = 1 Canadian $  British/Canadian exchange pounds per Canadian dollar

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 5 The U.S. Nominal Exchange Rate, More Recent Series:

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 6 Exchange Rates 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 7 Exchange Rates 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 8 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 9 Exchange Rates Foreign Exchange Market The market on which currencies of various nations are traded for one another

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 10 Exchange Rates Fixed Exchange Rate An exchange rate whose value is set by official government policy

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 11 Exchange Rates 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 12 Exchange Rates 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 13 Exchange Rates 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 oPrice in dollars = 242,000 yen/110 = $2,200

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 14 Exchange Rates 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 15 Exchange Rates Real Exchange Rate

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 16 Exchange Rates The Computer Example, revisited E = 110/$1 P = $2,400 P f = 242,000 yen

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 17 Exchange Rates 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 18 Exchange Rates 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 19 Exchange Rates Economic Naturalist Does a strong currency imply a strong economy?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 20 The Determination of the Exchange Rate Law of One Price If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 21 The Determination of the Exchange Rate 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 22 The Determination of the Exchange Rate Purchasing Power Parity (PPP) The theory that nominal exchange rates are determined as necessary for the law of one price to hold

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 23 The Determination of the Exchange Rate Purchasing Power Parity (PPP) In the long run, the currencies of countries that experience significant inflation will tend to depreciate.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 24 The Determination of the Exchange Rate 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 25 The Determination of the Exchange Rate 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 26 Inflation and Currency Depreciation in South America,

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 27 The Determination of the Exchange Rate Example Shortcomings of the PPP Theory  The theory has been successful in the long run but not the short run.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 28 The Determination of the Exchange Rate Example Limits to the PPP Theory  Not all goods and services are traded internationally. oThe greater the share of non-traded goods, the less precise the PPP theory  Not all internationally traded goods and services are perfectly standardized commodities.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 29 The Supply and Demand for Dollars In The Yen-Dollar Market Quantity of dollars traded Yen/dollar exchange rate Demand for dollars Supply of dollars e* The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 30 The Determination of the Exchange Rate 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 31 An Increase In The Supply of Dollars Lowers The Value of The Dollar Quantity of dollars traded Yen/dollar exchange rate D S e* E 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*’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 32 The Determination of the Exchange Rate 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 33 A Tightening of Monetary Policy Strengthens the Dollar Quantity of dollars traded Yen/dollar exchange rate D S e* E Tighter monetary policy raises the domestic real interest rate Foreign demand for U.S. assets increase e*’ F D’ The demand for dollars rises Exchange rate appreciates from e* to e*’

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 34 Monetary Policy and the Exchange Rate Economic Naturalist Why did the dollar appreciate nearly 50 percent in the first half of the 1980s?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 35 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. Conclusion:  Monetary policy is more effective in an open economy with flexible exchange rates.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 36 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 37 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) c.f. “Depreciation,” “Appreciation”

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 38 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 39 An Overvalued Exchange Rate Quantity of pesos traded Dollar/peso exchange rate Demand for pesos Supply of pesos Official value Fundamental value 0.10 dollar/ peso dollar/ peso The peso’s official value is greater than the fundamental value; the peso is overvalued AB To maintain the value, the government must purchase a quantity of pesos (A-B)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 40 Fixed Exchange Rates How to Fix an Exchange Rate Responses to an overvalued currency  Devalue the currency  Impose trade barriers  Purchase the currency

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 41 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 42 Fixed Exchange Rates How to Fix an Exchange Rate To purchase its own currency, a country must hold international reserves. A balance of payments deficit occurs when a country has a net decline in international reserves over a year.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 43 Fixed Exchange Rates How to Fix an Exchange Rate A balance-of-payments surplus occurs when a country has a net increase in international reserves over a year.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 44 Fixed Exchange Rates Example Latinia’s balance-of-payments deficit  Demand = 25, ,000e  Supply = 17, ,000e  Official value of the peso = dollars

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 45 Fixed Exchange Rates Example Latinia’s balance-of-payments deficit  Fundamental value o25, ,000e = 17, ,000e  Solving for e: o7,400 = 74,000e oe = 0.10

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 46 Fixed Exchange Rates Example As the official rate D = 25, ,000(0.125) = 18,750 S = 17, ,000 (0.125) = 20,600 Excess supply = 1,850 pesos Balance of payments deficit = 1,850 pesos

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 47 Fixed Exchange Rates Speculative Attack A massive selling of domestic currency assets by financial investors

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 48 A Speculative Attack on the Peso Quantity of pesos traded Dollar/peso exchange rate AB D S Official value dollar/ peso Peso overvalued at 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

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 49 Fixed Exchange Rates Economic Naturalist Can a speculative attack occur under flexible exchange rates?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 50 A Tightening of Monetary Policy Eliminates An Overvaluation Quantity of pesos traded Dollar/peso exchange rate D S Official value E 0.10 dollar/ peso dollar/ peso Pesos overvalued at F D’ Tightening monetary policy increases D to D’ Official value = fundamental value

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 51 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 52 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 53 Fixed Exchange Rates Economic Naturalist What were the causes and consequences of the East Asian crisis of ?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 54 Fixed Exchange Rates Economic Naturalist How did policy mistakes contribute to the Great Depression?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 55 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 56 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.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 17: Exchange Rates and the Open Economy Slide 57 Economic Naturalist Why have 11 European countries adopted a common currency? Should Exchange Rates Be Fixed or Flexible?

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