1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 6 International Trade, Exchange Rates, and Macroeconomic Policy

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-2 The International “Trilemma” The international “trilemma” is the impossibility for any nation of maintaining simultaneously all three of the following: – Independent control of monetary policy – Fixed exchange rates – Free flows of capital with other nations How has the U.S. been affected by this trilemma? – The U.S. has an independent monetary policy and allows free flows of capital, but it cannot fix its exchange rate with other countries. Note: This does not stop other countries (like China and Japan) from pegging their currencies to the U.S. dollar!

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-3 Exchange Rate Definitions The foreign Exchange Rate for a nation’s currency is the amount of one nation’s money that can be obtained in exchange for a unit of another nation’s money. – The foreign exchange rate of the dollar is conventionally quoted as units of foreign currency per dollar. Example: e´ = 106.00 ¥ / $ = Value of the Dollar – Exception: The Euro-USD and the pound-USD exchange rates are quoted as dollars per Euro and dollars per pound. Example: $1.41 / € = Value of the Euro The USD is said to appreciate (depreciate) if the value of the dollar rises (falls) relative to another currency.

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-4 Table 6-1 Daily Quotations of Foreign Exchange Rates

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-5 The Market for USD and Euros Why do foreigners demand USD and/or Euros? – USD and Euros may be safer than the foreigner’s currency – USD and Euros are more convenient for international transactions Purchase and sale of goods and services (from the current account) Purchase and sale of financial assets (from the capital account) What affects the slope of the demand for USD? – The price elasticity of demand for U.S. imports and financial assets What about the supply of USD? – Holders of USD sell (i.e. supply) USD in order to buy foreign goods and foreign financial assets. – The U.S. price elasticity of demand for imports and financial assets determines the slope of the supply curve.

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-6 Figure 6-1 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2007 (1 of 2)

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-7 Figure 6-1 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2007 (2 of 2) Source: Federal Reserve Bank of St. Louis

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-8 Figure 6-1 Foreign Exchange Rates of the Dollar Against Four Major Currencies, Quarterly, 1970–2007 Source: Federal Reserve Bank of St. Louis

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-9 Figure 6-2 Determination of the Price in Euros of the Dollar

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-10 How Can Governments Affect e´? Suppose the government of Thailand wants to keep its currency (the Baht) from depreciating against the USD. – What happens to the supply and demand for Baht to make the Baht depreciate? Lots of people are selling Baht / few people are buying Baht  S Baht shifts right and D Baht shifts left  Value of Baht  How can the Thai government “protect” the Baht? – The government must sell USD and/or Euros to buy Baht!

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-11 Definition: Real Exchange Rate The Real Exchange Rate (e) is equal to the average nominal foreign exchange rate between a country and its trading partners, with an adjustment for the difference in inflation rates. Algebraically, e = e´  ( P / P f ) – where e´ is the nominal exchange rate quoted as foreign currency/$, and (P / P f ) is the ratio of domestic to foreign price levels – If e rises (falls), then there has been a real appreciation (real depreciation).

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-12 Purchasing Power Parity (PPP) The Purchasing Power Parity (PPP) theory holds that the prices of identical goods should be the same in all countries, differing only by the cost of transport and any import duties. – Implication: The real exchange rate (e) should be constant – We can choose e = 1  – The theory can also be expressed in terms of rates of growth:

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-13 International Perspective: Big Mac Meets PPP

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-14 Figure 6-3 Nominal and Real Effective Exchange Rates of the Dollar, 1970–2007 Source: Federal Reserve Board of Governors H.10 Foreign Exchange Rates

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-15 Fixed Exchange Rates In a Fixed Exchange Rate System, the foreign exchange rate is fixed for long periods of time by the participating countries’ central banks. – Central banks maintain the fixed exchange rate by holding Foreign Exchange Reserves, which are foreign central bank holdings of foreign currencies and financial assets. Under a fixed exchange rate system, a nation devalues or reduces the value of its money in terms of foreign money, it runs out of foreign exchange reserves. – A nation revalues or raises the value of its money, when its foreign exchange reserves become so excessive that they cause domestic inflation.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-16 Figure 6-4 Foreign Official Holdings of Dollar Reserves as a Percent of U.S. GDP Source: Department of Commerce. See Appendix C-4.

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-17 Net Exports and the Foreign Exchange Rate Net Exports (NX) are affected by both income (Y) and the real foreign exchange rate (e): – If Y   spending on imports   NX  – If e   exports are more expensive, and imports are cheaper  NX  Algebraically, NX = NX a – nxY – ue where NX a is autonomous net exports nx and u are positive parameters

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-18 Figure 6-5 U.S. Real Net Exports and the Real Exchange Rate of the Dollar, 1970–2007 Source: Bureau of Economic Analysis NIPA Tables and Federal Reserve Board H.10 Foreign Exchange Rates.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-19 The Real Exchange Rate and the Interest Rate The demand for dollars stems from two sources: – The desire to buy U.S. goods and services – The desire to buy USD-denominated financial assets The relative attractiveness of U.S. and foreign securities depends on the Interest Rate Differential: the average U.S. interest rate minus the average foreign interest rate. – When r US   U.S. financial assets become relatively more attractive  additional demand for USD  Value of $  – Conversely, when r US   Value of $  This mechanism requires capital mobility between countries.

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-20 Figure 6-6 The U.S. Real Corporate Bond Rate and the Real Exchange Rate of the Dollar, 1970–2007 Source: Moody’s and Federal Reserve Board of Governors. See Appendix C-4.

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-21 Adjustment Mechanisms: Fixed vs. Flexible Rates Assume perfect capital mobility and a small open economy Fixed Exchange Rate System – Monetary policy is ineffective: If M S   r   huge capital outflows  Fed must intervene to maintain fixed e  M S  – Fiscal policy is very effective: If G   Y   M D   r   capital inflows  Fed intervenes to maintain fixed e  M S   r  back to initial level  no crowding out! Flexible Exchange Rate System – Monetary policy is very effective: If M S   r   I  plus r  causes capital outflows  Value of $   NX   Y  – Fiscal policy is ineffective: If G   Y   M D   r   capital inflows  Value of $   NX   So, G crowds out NX, which cancels out the initial effect on Y!

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-22 Summary of Monetary and Fiscal Policy Effects in Open Economies

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-23 Chapter Equations

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-24 Chapter Equations

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-25 Chapter Equations