©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 25: Exchange Rates and the Open Economy

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Define the nominal exchange rate and apply the terms appreciation and depreciation to movements in the nominal exchange rate 2.Use supply and demand to analyze how the nominal exchange rate is determined in the short run 3.Distinguish between flexible exchange rates and fixed exchange rates, and discuss the advantages and disadvantages of each system 4.Define the real exchange rate and show it is related to the prices of goods across pairs of countries 5.Understand the law of one price and apply the purchasing power parity theory of exchange rates to long-run exchange rate determination.

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Exchange Rates Domestic purchases are made with local currency  Purchases of goods abroad requires converting your local currency to their local currency  The exchange rate is the price for that transaction Exchange rates are set in the foreign exchange market, with a small number of exceptions  Rates are determined by supply and demand  Affect the value of imported goods and the costs of foreign investment  Changes in exchange rates can have a significant effect on most economies

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Nominal Exchange Rates The nominal exchange rate is the rate at which two currencies can be traded for each other

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Nominal Exchange Rates  Domestic / foreign currency

©2012 The McGraw-Hill Companies, All Rights Reserved 6 Nominal Exchange Rates  Foreign / domestic currency

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Nominal Exchange Rates Suppose that you need to find the exchange rate between the British pound and the Canadian dollar The table tells us that we can purchase one UAE dirham for Canadian dollars It also tells us that we can buy one UAE dirham for British pound Canadian dollars = British pound 1 Canadian dollar = / = British pounds 1 British pound = / = Canadian dollars

©2012 The McGraw-Hill Companies, All Rights Reserved 8 The Nominal Effective Exchange Rate for Morocco and the UAE, 1975–2010 The Nominal Effective Exchange Rate expresses the value of a currency as an average of its values against other major currencies.

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Changes in Exchange Rates Appreciation is an increase in the value of a currency relative to other currencies  Example: the nominal effective exchange rate (NEER) for the Moroccan dirham was 100 in 2005 (base year) and in  The Moroccan dirham appreciated by 2.5 percent against other currencies between 2005 and Depreciation is a decrease in the value of a currency relative to other currencies  Example: the NEER for the UAE was 100 in 2005 and in  The UAE dirham depreciated by 3.38 percent against other currencies.

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Exchange Rates Definition  e = the number of units of foreign currency that the domestic currency will buy  Example, e is the number of Japanese yen you can buy with 1 UAE dirham  e is the nominal exchange rate Domestic currency appreciates if e increases Domestic currency depreciates if e decreases

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Exchange Rate Strategies Foreign exchange market is the market on which currencies of various nations are traded Flexible exchange rate is a system that sets the exchange rate according to demand and supply of a country's currency Fixed exchange rate is an exchange rate set by official government policy  Can be set independently or by agreement with a number of other governments  Fixed rates can be set relative to the dollar, the euro, or even gold

©2012 The McGraw-Hill Companies, All Rights Reserved 12 Flexible Exchange Rate in the Short Run Exchange rates are set by supply and demand in the foreign exchange market US supplies dollars to buy foreign exchange to buy foreign goods or foreign assets  Not the same as the money supply controlled by the central bank  Supply of dollars in the foreign exchange market is the number of dollars offered for sale for a given foreign currency

©2012 The McGraw-Hill Companies, All Rights Reserved 13 A Supply and Demand Analysis To date, about 60 percent of the world’s foreign currency reserves are in U.S. dollars, followed by about 26 percent in euros This illustrates the importance and influence of the dollar in world markets In this section, we analyze the foreign exchange market and discuss the factors that affect the supply of and demand for dollars, and thus the U.S. dollar exchange rate

©2012 The McGraw-Hill Companies, All Rights Reserved 14 A Supply and Demand Analysis: The Supply of Dollars Anyone who holds dollars is a potential supplier  US households and firms are the most common suppliers In 2010, emerging and developing economies controlled about 66 percent of total foreign exchange holdings and 45 percent of U.S. dollar holdings. Supply curve has a positive slope  The more foreign currency per dollar, the larger the quantity of dollars supplied  This makes foreign goods cheaper When $1 = ¥ 100, a ¥ 5,000 item costs $50  If $1 = ¥ 200, that same ¥ 5,000 item costs $25  When the dollar appreciates, quantity of dollars supplied increases

©2012 The McGraw-Hill Companies, All Rights Reserved 15 A Supply and Demand Analysis: The Demand of Dollars Anyone who holds yen can demand dollars  Japanese households and firms are the most common demanders Demand curve has a negative slope  The more foreign currency per dollar, the smaller the quantity of dollars demanded  This makes US goods more expensive When $1 = ¥ 100, a $30 item costs ¥ 3,000  If $1 = ¥ 200, that same $30 item costs ¥ 6,000  When the dollar appreciates, quantity of dollars demanded decreases

©2012 The McGraw-Hill Companies, All Rights Reserved 16 The Dollar – Yen Market  Market equilibrium equates the number of dollars supplied and the number demanded at an exchange rate, e*  Dollar appreciates if the exchange rate exceeds e*  Dollar depreciates if the exchange rate is less than e* Market for Dollars Quantity of dollars Yen/dollar exchange rate Demand for dollars Supply of dollars e* Q* Dollar appreciates

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Changes in the Supply of Dollars Supply of dollars for Japanese yen is determined by  The preference for Japanese goods  The stronger the preference, the greater the supply of dollars  US real GDP  The higher GDP, the greater the supply of dollars  Real interest rate on Japanese assets and the real interest rate on US assets  Supply of dollars will be greater if Real interest rate on Japanese assets are higher Real interest rate on US assets is lower

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Changes in the Demand of Dollars Demand for dollars by holders of yen is determined by  The preference for goods denominated in dollars  The stronger the preference, the greater the demand for dollars  Real GDP in Japan  The higher GDP, the greater the demand for dollars  Real interest rate on Japanese assets and real interest rate on US assets  Supply of dollars will be greater if Real interest rate on Japanese assets are lower Real interest rate on US assets is higher

©2012 The McGraw-Hill Companies, All Rights Reserved 19 An Increase in the Supply of Dollars  Initial equilibrium at E  Suppose consumers prefer the new video game system made in Japan  Shift in preferences  Increase in the supply of dollars shifts dollar supply curve to the right  New equilibrium at F  Dollar depreciates to e*'  Quantity of dollars traded increases to Q*' Quantity of dollars Yen / dollar exchange rate D S e* E F S' Q* e*' Q*'

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Does a Strong Currency Imply a Strong Economy? A strong currency means its value is high in terms of other countries A strong currency is unrelated to a strong economy Strong currencies reduce net exports  UAE Dirham strengthens against Euro  European goods are cheaper and UAE goods are more expensive, so European NX increases and UAE NX declines  NX affects spending and aggregate demand

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Monetary Policy and The Exchange Rate Monetary policy affects interest rates which affect the exchange rate  Tighter Turkish monetary policy, leading to a higher real interest rate  Higher interest rates make Turkish assets more attractive than foreign assets  Demand for the Lira increases by foreigners Demand curve shifts to the right  Supply of Lira by Turkey decreases Supply curve shifts to the left  Lira appreciates

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Tighter Monetary Policy  Higher real interest rates in Turkey increase demand for Lira and decrease supply  Lira appreciates  Change in quantity of Lira traded depends on  Size of shifts in demand and supply  Slopes of supply and demand Quantity of Lira Yen / Lira exchange rate e *' F S D e*e* E S' D'

©2012 The McGraw-Hill Companies, All Rights Reserved 23 The Exchange Rate As A Tool of Monetary Policy Flexible exchange rates make monetary policy more effective  When the central bank tightens money, it sets off a chain of domestic events  And a chain of international events Monetary policy is more effective in an open economy with flexible exchange rates r  C, I P  PAE  Y  r  e*  NX  PAE  Y 

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Fixed Exchange Rates Most large industrial countries use a flexible exchange rate  Small and developing countries may use fixed exchange rate Fixed exchange rates greatly reduce the effectiveness of monetary policy as a stabilization tool

©2012 The McGraw-Hill Companies, All Rights Reserved 25 How to Fix An Exchange Rate To establish a fixed exchange rate system, the government states the value of its currency in terms of a major currency  May use an average of the currencies of its major trading partners Government attempts to maintain fixed exchange rate at its existing level The government may change the value of its currency in response to market events  Devaluation is a reduction in the official value  Revaluation is an increase in the official value  Analogous to depreciation and appreciation

©2012 The McGraw-Hill Companies, All Rights Reserved 26 Selected Countries with a Fixed Exchange Rate Regime

©2012 The McGraw-Hill Companies, All Rights Reserved 27 An Overvalued Exchange Rate Persabia's exchange rate is pegged at $0.125 = 1 dinar The qt. of dinar supplied Q B is greater than the qt. demanded Q A The eq. rate for the dinar is $0.10 = 1 dinar  The dinar is overvalued, when its fixed value is greater than its eq. value  If the dinar's official value were less than the eq., it would be undervalued Quantity of dinars Dollar/dinar exchange rate Demand for dinars Supply of dinars Official value Equilibrium value AB QAQA QBQB

©2012 The McGraw-Hill Companies, All Rights Reserved 28 Fixed Exchange Rates The government of Persabia has a problem: there is an excess supply of dinar at the fixed exchange rate Government options 1. Devalue the currency to $0.10 = 1 dinar  Devaluation is reluctantly used with fixed exchange rates – defeats the idea of fixed exchange rates 2. Impose trade barriers to reduce the supply of dinars  Limit the amount of imports or make them costly  Prohibit purchase of foreign assets  Limits the efficient functioning of markets 3. Sell dollars to buy dinars – if it holds dollars

©2012 The McGraw-Hill Companies, All Rights Reserved 29 Fixed Exchange Rate and Overvalued Currency To defend the fixed exchange rate at $0.125 = 1 dinar, the government could buy dinars for dollars  Purchase (Q B – Q A ) each period The central bank holds international reserves, supplies of foreign currencies, to use to defend the dinar's value  Over time, reserves will decrease and the dinar's value will be costly to defend Quantity of dinars Dollar/dinar exchange rate Demand for dinars Supply of dinars Official value Equilibrium value AB QAQA QBQB

©2012 The McGraw-Hill Companies, All Rights Reserved 30 International Reserves and Balance of Payments Balance-of-payments deficit is the net decline in a country's stock of international reserves in a year  A balance-of-payments surplus is the net increase in a country's stock of international reserves in a year Suppose Persabia faces the following conditions in the foreign exchange market Demand: Q PD = 25,000 – 5,000 e Supply: Q PS = 17, ,000 e The government set e = so  Q PD = 25,000 – 5,000 (0.125) = 18,750  Q PS = 17, ,000 (0.125) = 20,600 Balance of payments deficit is 1,850 dinars

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Equilibrium Exchange Rates Demand: Q PD = 25,000 – 5,000 e Supply: Q PS = 17, ,000 e Equilibrium exchange rate equates the quantity of dinars demanded and the quantity of dinars supplied 25,000 – 50,000 e* = 17, ,000 e* 7,400 = 74,000 e e* = 0.10

©2012 The McGraw-Hill Companies, All Rights Reserved 32 Monetary Policy and The Fixed Exchange Rates Fixed rates cannot remain overvalued indefinitely Tightening the money supply can eliminate the overvalued currency  Tighter money increases real interest rates  Demand for the dinar increases and supply of dinars decrease  New equilibrium is at F  Equilibrium exchange rate is at the official value Quantity of dinars Dollar/dinar exchange rate D Official value E S' D' S F

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Monetary Policy and Fixed Exchange Rates Monetary policy can be used to set the fundamental value of the exchange rate equal to the official value  In this case, monetary policy is no longer available for stabilizing the domestic economy Suppose the economy has a recessionary gap at the same time that the currency is overvalued  Recessionary gap remedy is a lower interest rate  Overvalued currency remedy is a higher interest rate Limiting monetary policy as a stabilization tool is a strong argument against fixed exchange rates

©2012 The McGraw-Hill Companies, All Rights Reserved 34 Dollar Peg in the GCC and Monetary Policy Can GCC member countries vary their interest rates as a monetary policy tool?  Short answer: No.  Long answer: Interest rates in countries that maintain a dollar peg must be set in coordination with the U.S. Federal Reserve.  This prevents the excessive flow of currencies (from arbitrage), which could threaten the dollar peg

©2012 The McGraw-Hill Companies, All Rights Reserved 35 Policy Mistakes and the Great Depression Tariffs were imposed in 1930, with other countries increasing their tariffs in retaliation  Virtual collapse of international trade Money supply decreased sharply between 1929 and 1933  Interest rates increased and stock market crashed  Fed let banks fail to weed out the weak The government also erred in exchange rate policy

©2012 The McGraw-Hill Companies, All Rights Reserved 36 Policy Mistakes and the Great Depression Most of the world was on the gold standard  All countries set a local currency value for an ounce of gold  This effectively sets fixed exchange rates for one currency in terms of the others U.S. Congress pressed the Fed to ease monetary policy to dampen the Great Depression  With the fixed exchange rate policy, the Fed feared an increase in the money supply would lead to a speculative attack on the dollar

©2012 The McGraw-Hill Companies, All Rights Reserved 37 Policy Mistakes and the Great Depression The Fed put greater emphasis on the gold standard than on stabilization policy Countries not on the gold standard and those that abandoned it recovered faster from the Great Depression Beginning in 1933, FDR suspended the gold standard as part of his recovery program  Also helped restore the banking system to normal operations  Money supply began to grow

©2012 The McGraw-Hill Companies, All Rights Reserved 38 International Monetary Fund IMF was set up after World War II  Original purpose was to manage the fixed exchange rate system  IMF would loan countries reserves to maintain their fixed exchange rates at official values  Fixed exchange rate system ended in 1973 IMF's new mission is to make loans to developing countries  Helped fight the currency slumps of Mexico (1994) and East Asia (1997 – 1998)

©2012 The McGraw-Hill Companies, All Rights Reserved 39 International Monetary Fund IMF critiques  Conditions attached to loans set target money supply growth, size of government sector, etc.  Some argue that these policies are not always constructive  Loans help the highest income group in the country receiving the loan  World Bank and IMF have conflicting programs  World Bank makes loans to help poor nation develop while the IMF may be targeting stabilization in the same country

©2012 The McGraw-Hill Companies, All Rights Reserved 40 Should Exchange Rates Be Fixed Or Flexible? Flexible exchange rates strengthen the effectiveness of monetary policy for stabilization Fixed rates require the central bank to choose between defending the currency and stabilizing the economy Fixed rates can be beneficial for small economies  Argentina fought hyperinflation by valuing its dinar on par with the dollar  Inflation quickly decreased and stayed stable for more than 10 years  Fixed exchange system broke down because unsound domestic policies created fears that Argentina would default on international loans

©2012 The McGraw-Hill Companies, All Rights Reserved 41 Exchange Rates, Trade, and Integration Fixed exchange rates have benefits  Predictability and stability in foreign transactions  Certainty of future value of the currencies However, fixed rates are not fixed forever  Sudden and unforeseen large changes are possible  Predicting exchange rates over the long term is difficult under either fixed or flexible rates

©2012 The McGraw-Hill Companies, All Rights Reserved 42 Has Kuwait benefited from abandoning the dollar peg? In 2003, Kuwait adopted the dollar peg Following years of persistent inflation, Kuwait abandoned the dollar peg in 2007 in favor of an undisclosed basket of currencies The Kuwaiti dinar appreciated by 4.19 percent against the U.S. dollar between May 25, 2007 and April 13, Abandoning the dollar peg has resulted in higher appreciation rates and lower depreciation rates against major currencies for Kuwait relative to its neighboring countries, at least in nominal terms

©2012 The McGraw-Hill Companies, All Rights Reserved 43 Has Kuwait benefited from abandoning the dollar peg?

©2012 The McGraw-Hill Companies, All Rights Reserved 44 The Euro: A Common Currency For Europe European Common Market was formed in 1957  Free trade between member countries  Fixed exchange rate system set up in the 1970s was abandoned in 1992 European Union was created by the Maastricht Treaty in 1991  Agreed to work toward adopting a common currency  The euro was phased in  Began as an accounting unit  Euro currency was phased in and local currency phased out in 11 member countries

©2012 The McGraw-Hill Companies, All Rights Reserved 45 The Euro: A Common Currency For Europe Countries with a single currency must have a common monetary policy  The European Central Bank became the central bank for the euro countries Countries sacrifice some control to be part of the euro  Economic conditions vary between countries and the central bank cannot respond to each  Slow growth in Germany and rapid growth in Ireland

©2012 The McGraw-Hill Companies, All Rights Reserved 46 Real Exchange Rate – An Example Choose between an Egyptian computer and a comparable Japanese computer, based on price  Egyptian computer costs 2,400 pounds  Japanese computer costs ¥ 24,200  1 pound = ¥ 11 The Japanese computer cost is ¥ 24,200 / (¥ 11/1 pound) or 2,200 pounds  The Japanese computer is cheaper The relative price of the Egyptian computer to the Japanese computer is 2,400 pounds / 2,200 pounds= 1.09  Egyptian computer costs 9% more than the Japanese one

©2012 The McGraw-Hill Companies, All Rights Reserved 47 Real Exchange Rates In the short run, domestic prices of goods are fixed  In the long run, this assumption is relaxed Real exchange rate is the price of the average domestic good relative to the price of the average foreign good  Prices are expressed in a common currency The exchange rate, e, is the number of units of foreign currency per pound  To convert a foreign price to the pound price, divide P f by e P f / e = ¥ 24,200 / (¥ 11/1 pound) = 2,200 pounds

©2012 The McGraw-Hill Companies, All Rights Reserved 48 Real Exchange Rates Price of domestic good Price of foreign good in pounds Real exchange rate = P P f / e Real exchange rate = (P) (e) P f Real exchange rate = (2,400 pounds) (¥ 11 / 1 pound) ¥24,200 Real exchange rate = 1.09

©2012 The McGraw-Hill Companies, All Rights Reserved 49 Real Exchange Rate In our example, the real exchange rate of 1.09 meant the Egyptian computer is more expensive than the Japanese computer In the general case, the real exchange rate uses an average price of all goods and services in both countries  If the real exchange rate is high, domestic goods are expensive relative to foreign goods  Net exports will tend to be low when the real exchange rate is high An increase in e increases the real exchange rate if P and P f are constant

©2012 The McGraw-Hill Companies, All Rights Reserved 50 Law of One Price The law of one price is that the price of an internationally traded commodity must be the same in all locations  Assumes transportation costs are relatively small Suppose wheat in Amman, Jordan was half the price of wheat in Bombay, India  Buy wheat in Amman, increasing demand and price  Sell wheat in Bombay, increasing supply and decreasing the price The law of one price implies that real exchange rates prevail in the long run

©2012 The McGraw-Hill Companies, All Rights Reserved 51 Purchasing Power Parity (PPP) Purchasing power parity is the theory that nominal exchange rates are determined as necessary for the law of one price to hold  In the long run, the currencies of countries that experience significant inflation will tend to depreciate

©2012 The McGraw-Hill Companies, All Rights Reserved 52 PPP – An Example A bushel of grain costs  5 Jordanian dinars in Jordan and  150 Rupees in Bombay  For the price of the bushel of grain to be the same in both countries, the implied nominal exchange rate is Dinar 1 = Rs 30 Suppose that India experiences inflation and the bushel of grain now costs Rs 300 in Bombay  The Jordanian Dinar appreciates to Dinar 1 = Rs 60  Price of wheat is the same in both countries

©2012 The McGraw-Hill Companies, All Rights Reserved 53 Inflation and Currency Depreciation in South America,

©2012 The McGraw-Hill Companies, All Rights Reserved 54 Shortcomings of the PPP Theory  The theory predicts well in the long run but not the short run Limits to the PPP Theory  Not all goods and services are traded internationally  The greater the share of non-traded goods, the less precise the PPP theory For example, the market for haircuts is very local  Not all internationally traded goods and services are perfectly standardized commodities