1. Exchange Rates and The Open Economy

2. Chapter 18: Exchange Rates and the Open Economy
Nominal Exchange Rate
The rate at which two currencies can be traded for each other
Chapter 18: Exchange Rates and the Open Economy

3. Nominal Exchange Rates for the U.S. Dollar
Country Foreign currency/dollar Dollar/foreign currency
United Kingdom (pound)
Canada (Canadian dollar)
Mexico (peso)
Japan (yen)
Switzerland (Swiss franc)
South Korea (won) 1,
Chapter 18: Exchange Rates and the Open Economy

4. Chapter 18: Exchange Rates and the Open Economy
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
0.5442/ = pounds = 1 Canadian $
British/Canadian exchange pounds per Canadian dollar
Chapter 18: Exchange Rates and the Open Economy

5. Chapter 18: Exchange Rates and the Open Economy
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
Chapter 18: Exchange Rates and the Open Economy

6. The U.S. Nominal Exchange Rate, 1973-2004
Chapter 18: Exchange Rates and the Open Economy

7. Chapter 18: Exchange Rates and the Open Economy
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.
Chapter 18: Exchange Rates and the Open Economy

8. Chapter 18: Exchange Rates and the Open Economy
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
Chapter 18: Exchange Rates and the Open Economy

9. Chapter 18: Exchange Rates and the Open Economy
Foreign Exchange Market
The market on which currencies of various nations are traded for one another
Chapter 18: Exchange Rates and the Open Economy

10. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rate
An exchange rate whose value is set by official government policy
Chapter 18: Exchange Rates and the Open Economy

11. The Supply and Demand for Dollars in the Yen-Dollar Market
Supply of dollars e*
The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded
Yen/dollar exchange rate
Quantity of dollars traded
Chapter 18: Exchange Rates and the Open Economy

12. The Determination of the Exchange Rate in the Short Run
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
Chapter 18: Exchange Rates and the Open Economy

13. An Increase in the Supply of Dollars Lowers the Value of the Dollar
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*’ D S e* E
Yen/dollar exchange rate
Quantity of dollars traded
Chapter 18: Exchange Rates and the Open Economy

14. The Determination of the Exchange Rate in the Short Run
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
Chapter 18: Exchange Rates and the Open Economy

15. The Determination of the Exchange Rate in the Short Run
Economic Naturalist
Does a strong currency imply a strong economy?
Chapter 18: Exchange Rates and the Open Economy

16. A Tightening of Monetary Policy Strengthens the Dollar
Tighter monetary policy raises the domestic real interest rate
Foreign demand for U.S. assets increase
The demand for dollars rises D'
e*' F S'
The increased demand for U.S. assets by American Savers decreases the supply of dollars
Exchange rate appreciates from e* to e*’ S D e* E
Yen/dollar exchange rate
Quantity of dollars traded
Chapter 18: Exchange Rates and the Open Economy

17. Monetary Policy and the Exchange Rate
Economic Naturalist
Why did the dollar appreciate nearly 50 percent in the first half of the 1980s?
Chapter 18: Exchange Rates and the Open Economy

18. Monetary Policy and the Exchange Rate
Economic Naturalist
Why did the dollar depreciate more than 25 percent in 2002 – 2004?
Chapter 18: Exchange Rates and the Open Economy

19. 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.
Monetary policy is more effective in an open economy with flexible exchange rates.
Chapter 18: Exchange Rates and the Open Economy

20. Chapter 18: Exchange Rates and the Open Economy
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.
Chapter 18: Exchange Rates and the Open Economy

21. Chapter 18: Exchange Rates and the Open Economy
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)
Chapter 18: Exchange Rates and the Open Economy

22. Chapter 18: Exchange Rates and the Open Economy
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
Chapter 18: Exchange Rates and the Open Economy

23. An Overvalued Exchange Rate
Official value
Market equilibrium value
0.10 dollar/
peso
0.125 dollar/
The peso’s official value is greater than the fundamental value; the peso is overvalued A B
To maintain the value, the government must purchase a quantity of pesos (A-B)
Demand for pesos
Supply of pesos
Dollar/peso exchange rate
Quantity of pesos traded
Chapter 18: Exchange Rates and the Open Economy

24. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
How to Fix an Exchange Rate
Responses to an overvalued currency
Devalue the currency
Impose trade barriers
Purchase the currency
Chapter 18: Exchange Rates and the Open Economy

25. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
How to Fix an Exchange Rate
To purchase its own currency, a country must hold international reserves.
Chapter 18: Exchange Rates and the Open Economy

26. Chapter 18: Exchange Rates and the Open Economy
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.
Chapter 18: Exchange Rates and the Open Economy

27. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Balance-of-Payments Deficit
The net decline in a country's stock of international reserves over a year
Chapter 18: Exchange Rates and the Open Economy

28. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Balance-of-Payment Surplus
The net increase in a country's stock of international reserves over a year
Chapter 18: Exchange Rates and the Open Economy

29. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Example
Latinia’s balance-of-payments deficit
Demand = 25, ,000e
Supply = 17, ,000e
Official value of the peso = dollars
Chapter 18: Exchange Rates and the Open Economy

30. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Example
Latinia’s balance-of-payments deficit
Fundamental value
25, ,000e = 17, ,000e
Solving for e:
7,400 = 74,000e
e = 0.10
Chapter 18: Exchange Rates and the Open Economy

31. Chapter 18: Exchange Rates and the Open Economy
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
1,850 x = $231.25
Chapter 18: Exchange Rates and the Open Economy

32. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Economic Naturalist
Should China change the way it manages its exchange rate?
Chapter 18: Exchange Rates and the Open Economy

33. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Speculative Attack
A massive selling of domestic currency assets by financial investors
Chapter 18: Exchange Rates and the Open Economy

34. A Speculative Attack on the PesoB D S
Official value
0.125 dollar/
peso
Peso overvalued at 0.125
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
Dollar/peso exchange rate
Quantity of pesos traded
Chapter 18: Exchange Rates and the Open Economy

35. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Economic Naturalist
Can a speculative attack occur under flexible exchange rates?
Chapter 18: Exchange Rates and the Open Economy

36. A Tightening of Monetary Policy Eliminates an Overvaluation
Pesos overvalued at 0.125 D S'
Official value
0.125 dollar/
peso F E
0.10 dollar/
peso D'
Tightening monetary policy increases D to D’ and the supply will fall S to S'.
Official value = fundamental value S
Dollar/peso exchange rate
Quantity of pesos traded
Chapter 18: Exchange Rates and the Open Economy

37. Chapter 18: Exchange Rates and the Open Economy
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.
Chapter 18: Exchange Rates and the Open Economy

38. Chapter 18: Exchange Rates and the Open Economy
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.
Chapter 18: Exchange Rates and the Open Economy

39. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Economic Naturalist
What were the causes and consequences of the East Asian crisis of ?
Chapter 18: Exchange Rates and the Open Economy

40. Chapter 18: Exchange Rates and the Open Economy
Fixed Exchange Rates
Economic Naturalist
How did policy mistakes contribute to the Great Depression?
Chapter 18: Exchange Rates and the Open Economy

41. 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.
Chapter 18: Exchange Rates and the Open Economy

42. 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.
Chapter 18: Exchange Rates and the Open Economy

43. Should Exchange Rates Be Fixed or Flexible?
Economic Naturalist
Why have 11 European countries adopted a common currency?
Chapter 18: Exchange Rates and the Open Economy

44. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

45. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

46. Determination of the Exchange Rate in the Long Run
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
Price in dollars = 242,000 yen/110 = $2,200
Chapter 18: Exchange Rates and the Open Economy

47. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

48. Determination of the Exchange Rate in the Long Run
Real Exchange Rate
Chapter 18: Exchange Rates and the Open Economy

49. Determination of the Exchange Rate in the Long Run
The Computer Example, revisited
e = 110/$1
P = $2,400
Pf = 242,000 yen
Chapter 18: Exchange Rates and the Open Economy

50. Determination of the Exchange Rate in the Long Run
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.
Chapter 18: Exchange Rates and the Open Economy

51. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

52. Determination of the Exchange Rate in the Long Run
Law of One Price
If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations
Chapter 18: Exchange Rates and the Open Economy

53. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

54. Determination of the Exchange Rate in the Long Run
Purchasing Power Parity (PPP)
The theory that nominal exchange rates are determined as necessary for the law of one price to hold
Chapter 18: Exchange Rates and the Open Economy

55. Determination of the Exchange Rate in the Long Run
Purchasing Power Parity (PPP)
In the long run, the currencies of countries that experience significant inflation will tend to depreciate.
Chapter 18: Exchange Rates and the Open Economy

56. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

57. Determination of the Exchange Rate in the Long Run
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
Chapter 18: Exchange Rates and the Open Economy

58. Inflation and Currency Depreciation in South America, 1995-2004
Chapter 18: Exchange Rates and the Open Economy

59. Determination of the Exchange Rate in the Long Run
Shortcomings of the PPP Theory
The theory has been successful in the long run but not the short run.
Chapter 18: Exchange Rates and the Open Economy

60. Determination of the Exchange Rate in the Long Run
Example
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
Not all internationally traded goods and services are perfectly standardized commodities.
Chapter 18: Exchange Rates and the Open Economy

61. End of
Chapter