1. 15–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 15 Exchange Rates and the Open Economy

2. 15–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 15: Exchange Rates and the Open Economy Nominal exchange rates The real exchange rate Determining the exchange rate A supply and demand analysis Monetary policy and the exchange rate Fixed exchange rates Should exchange rates be fixed or flexible?

3. 15–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Nominal Exchange Rate (NER) NER = Value of the AUD = Forex/AUD Rise in value of AUD: appreciation of AUD Fall in value of AUD: depreciation of AUD TWI: a weighted average of NERs Weights are the relative importance of each currency in Australia’s trade

4. 15–4 TWI for the AUD

5. 15–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Flexible vs Fixed Rates Flexible: NER determined in free markets Fixed: NER influenced by RBA intervention

6. 15–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Real Exchange Rate (RER) Allows us to compare price levels in two different countries by expressing those prices in the same currency RER between AUD and JPY = [P a x JPY/AUD] / P j where P refers to the average price level in the respective countries Numerator is the Australian price level P a in JPY Denominator is the Japanese price level P j in JPY

7. 15–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Uses of the RER A rise in RER indicates of fall in international competitiveness A fall in RER indicates a rise in international competitiveness

8. 15–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Law of One Price (LOP) LOP says that for goods which are freely traded, their price should be the same in all countries when expressed in a common currency using the NER between those currencies That is, [P a x JPY/AUD = P j ] Otherwise, there is a profit to be made by buying a commodity where it is cheaper and selling it where it is dearer

9. 15–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank LOP Holds for Gold, Oil etc. Homogeneous Traded electronically Title passes instantaneously Buyers need not take physical delivery, so no time lags and no transport costs

10. 15–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank No LOP for Hamburgers/Cars Hamburgers not traded internationally Hamburgers have non-traded inputs – labour, bread, rents – whose prices may persistently differ between countries over the long run Cars are heterogeneous Cars traded, but physical delivery is costly and takes time, so price differences not eliminated immediately

11. 15–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Purchasing Power Parity (PPP) PPP is a theory of NER LOP says: P a x JPY/AUD = P j PPP accepts LOP which implies: JPY/AUD = P j /P a PPP further implies that the time rate of change of JPY/AUD = Japanese inflation rate – Australian inflation rate So if the Australian inflation rate is 3% p.a. and the Japanese inflation rate is 1% p.a., then JPY/AUD (the JPY value of the AUD) will fall by 2% p.a.

12. 15–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank PPP and RER Assumes competitiveness (RER) remains constant So the currency of a high inflation country must depreciate to keep that country competitive and its RER at a constant level

13. 15–13 Inflation and Depreciation

14. 15–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Qualifications to PPP LOP does not hold for non-traded items such as services, only freely-traded goods LOP does not hold for differentiated products LOP and PPP may not hold in the short run

15. 15–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank PPP, RER and Competitiveness According to PPP, NER changes at a rate equal to inflation differences between trading partners If so, the RER and international competitiveness remain constant However on occasions, a country needs to become more, or less, competitive A fall in export income due to drought/ fall in export prices necessitates Australia becoming more competitive to replace that lost export income Then the AUD will fall independently of inflation rate differences: RER falls

16. 15–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Sources of Supply of AUD Supply of AUD reflects demand for forex Sources –imports of goods and services –purchase of foreign assets

17. 15–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Sources of Demand for AUD Demand for AUD reflects supply of forex Sources –exports of goods and services –sales of Australian assets to foreigners

18. 15–18 Demand and Supply of AUD

19. 15–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Shifts in Supply of AUD Strengthened desire to import, resulting from change in preferences or increased GDP Strengthened desire to buy foreign assets, because of higher foreign interest rates, rents etc. Supply curve shifts to right, forex price of AUD falls

20. 15–20 Shift in Supply of AUD

21. 15–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Shift in Demand for AUD Increased export income resulting from higher quantities and/or higher export prices resulting from stronger preferences or higher GDP in customer countries Increased sales of Australian assets to foreigners because of higher Australian interest rates, rents etc. Forex value of AUD rises

22. 15–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Monetary Policy and the NER Monetary tightening will raise interest rates Increased demand for AUD Forex value of AUD rises

23. 15–23 Shift in Demand for AUD

24. 15–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Rise of AUD in 2003 Relatively high interest rates Rise in export prices and terms of trade (TOT) More export income and shift in demand for AUD Rise in NER and RER and fall in competitiveness Departure from PPP because NER changed independently of inflation rate differences

25. 15–25 Relative Interest Rates in 2003

26. 15–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Monetary Policy and AD Monetary tightening raises interest rates Fall in C, I and AD Rise in value of AUD reduces competitiveness and NX and AD Exchange rate effects of higher interest rates support direct effects

27. 15–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Fixing NER Fundamental value given by intersection of supply and demand curves Official value is the target of the authorities If official value is higher than fundamental value there is excess supply of AUD at official value If official value is less than fundamental value there is excess demand for AUD at official value

28. 15–28 Fixing NER

29. 15–29 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Three Methods of Fixing NER 1.RBA directly regulates forex transactions through foreign exchange controls – rations the available supply of forex to approved buyers of forex 2.RBA buys forex/sells AUD or sells forex/buys AUD 3.RBA changes interest rates to change demand for AUD, even though this may be inappropriate for AD (see later)

30. 15–30 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Balance of Payments (BOP) With free exchange rates, demand for AUD = supply, so there is a balance in international payments With fixed exchange rates, demand for AUD may differ from supply Excess demand for AUD: BOP surplus Excess supply of AUD: BOP deficit

31. 15–31 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Monetary Policy With Free NER Assume inflation RBA raises interest rates AD falls AUD also appreciates AD falls Inflation controlled Free exchange rates make monetary policy more potent

32. 15–32 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Monetary Policy with Fixed NER Assume inflation RBA raises interest rates AUD appreciates RBA lowers interest rates to prevent appreciation Monetary policy ineffective with fixed NER

33. 15–33 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Speculative Attacks on Currency Lead to shift in demand Motivated by expectation that the forex value of the currency will fall This expectation may be rationally based on expectations that: –export income will fall –official interest rates will fall –the central bank will be unable to keep fixing the NER Expectation may not be rationally based, e.g. it is expected to fall simply because it has already fallen. This creates instability and can lead to financial panic (see slide 36)

34. 15–34 Speculative Attack

35. 15–35 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Monetary Policy Again Should interest rates be set with a view to stabilising AD? Or should they be set with a view to NER? There is no virtue in a particular NER But there is some value in avoiding excessive volatility in NER, which justifies the RBA smoothing the rate of change in NER by short-run intervention in forex markets Incidentally, this will generate profits for the RBA because this stabilising role means it will be buying the AUD when it is too low and selling when it is too high

36. 15–36 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Handling Financial Panics The RBA seeks to avoid panics by limiting NER volatility through ‘smoothing’ of changes in NER Once they start, panics are driven by fear, not reason, are difficult to stop, and create bankruptcy Choices –Sky-high interest rates, which may not work and also create bankruptcy, or –temporary exchange controls until the panic subsides What would you choose?

37. 15–37 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Exchange Rates & Inflation A high-inflation country can remain internationally competitive by simply allowing its currency to fall with the rate of inflation Fixed exchange rates mean it loses its international competitiveness and this will create political pressure to control the rate of inflation

38. 15–38 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Exchange Rates & Inflation (cont.) So if a country’s institutions and central bank make it prone to inflation, it is less likely to end up with hyper-inflation with fixed rates than with flexible rates If not inflation-prone, flexible rates with smoothing are better

39. 15–39 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Exchange Rates and Shocks Imagine a negative [positive] shock to the economy such as drought [break in drought] or a fall [rise] in export prices, both of which reduce [raise] export income The fall [rise] in export income will have a negative [positive] multiplier effect on spending But with variable exchange rates, the currency will fall [rise], and we will be more [less] competitive This will raise [lower] the value of other sources of export income, and so reduce the impact of the shock to the economy