1. Lecture 11 13
Exchange Rates

2. Exchange Rates Nominal Exchange Rate
The rate at which two currencies can be traded for each other

3. Exchange Rates Nominal Exchange Rates
The exchange rate between British and Canadian currencies
British pounds = $1 U.S.
1.009 Canadian $s = $1 U.S.
British pounds = Canadian $s
0.4889/1.009 = pounds = 1 Canadian $
British/Canadian exchange pounds per Canadian dollar

4. Major Currency Cross Rates
Nominal Exchange Rates for the U.S. Dollar
Major Currency Cross Rates
Currency
U.S. $
¥en
Euro
Can $
U.K. £
AU $
Swiss Franc
Last Trade
N/A
8:46am ET
 1 U.S. $ =
1.000
0.680
1.006
0.489
1.136
1.125
 1 ¥en
0.009
0.006
0.004
0.010
 1 Euro
1.472
1.481
0.720
1.672
1.656
 1 Can $
0.994
0.675
0.486
1.130
1.118
 1 U.K. £
2.045
1.390
2.058
2.324
2.301
 1 AU $
0.880
98.293
0.598
0.885
0.430
0.990
 1 Swiss Franc
0.889
99.280
0.604
0.894
0.435
1.010

5. Fixed Exchange Rates Economic Naturalist
Should China change the way it manages its exchange rate?

6. U.S. Dollar to Chinese Yuan
11.4% Decline
in value

7. Exchange Rates Appreciation Depreciation
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

8. 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 (base) currency.
If e decreases, it is a depreciation of the domestic (base) currency.

9. Exchange Rates
Flexible Exchange Rate
Fixed Exchange Rates

10. 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

11. 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

12. 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

13. 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
Thus a decrease in rates, decreases demand for dollars

14. 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

15. Foreign Exchange Market Equilibrium (example)
The dollar price of the English pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds in exchange for dollars.
Dollar price of foreign exchange (for pounds)
S(sales to foreigners)
D(purchases from foreigners)
The demand and supply of pounds are in equilibrium at the exchange rate of $1.50 = 1 English pound.
Excess supply of pounds
At this price, quantity demanded equals quantity supplied.
$1.80
A higher price of pounds (like $1.80 = 1 pound), would lead to an excess supply of pounds ...
$1.50 e
Excess demand for pounds
$1.20
causing the dollar price of the pound to fall (depreciate).
A lower price of pounds (like $1.20 = 1 pound), would lead to an excess demand for pounds …
Quantity of
foreign exchange (pounds) Q
causing the dollar price of the pound to rise (appreciate).

16. Foreign Exchange Market Equilibrium
Other things constant, if incomes increase in the United States, U.S. imports of foreign goods and services will grow.
Dollar price of foreign exchange (for pounds) D2
S(sales to foreigners)
The increase in imports will increase the demand for pounds (in the foreign exchange market)
$1.80 b
causing the dollar price of the pound to rise from $1.50 to $1.80.
$1.50 a D1
Quantity of
foreign exchange (pounds) Q1 Q2

17. Inflation with Flexible Exchange Rates
If prices were stable in England while the price level in the U.S. increased by 50 percent …
Dollar price of foreign exchange (for pounds) D2 S1
the U.S. demand for British goods (and pounds) would increase …
$2.25
as U.S. exports to Britain would be relatively more expensive they would decline and thereby cause the supply of pounds to fall. b
$1.50 a
These forces would cause the dollar to depreciate relative to the pound. D1
Quantity of
foreign exchange (pounds) Q1

18. 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.

19. Fixed Exchange Rates Devaluation Revaluation
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)

20. 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

21. 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

22. Fixed Exchange Rates How to Fix an Exchange Rate
Responses to an overvalued currency
Devalue the currency
Impose trade barriers
Purchase the currency
To purchase its own currency, a country must hold international reserves. International Reserves
Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market.

23. Fixed Exchange Rates Speculative Attack
A massive selling of domestic currency assets by financial investors

24. 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

25. Fixed Exchange Rates Balance-of-Payments Deficit
The net decline in a country's stock of international reserves over a year

26. Fixed Exchange Rates Balance-of-Payment Surplus
The net increase in a country's stock of international reserves over a year

27. Fixed Exchange Rates Example Latinia’s balance-of-payments deficit
Demand = 25, ,000e
Supply = 17, ,000e
Official value of the peso = dollars

28. 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

29. Fixed Exchange Rates Example As the official rate -- 0.125
Excess supply = 1,850 pesos
Balance of payments deficit = 1,850 pesos
1,850 x = $231.25

30. 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

31. 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.

32. 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.

33. 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.

34. 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.

35. Fixed Rate, Unified Currency Regime
Some examples of fixed rate, unified currency systems:
the U.S., Panama, Ecuador, El Salvador, and Hong Kong all of which use currencies that are unified with the U.S. dollar
the 12 countries of the European Monetary Union, all of which use the euro, which is managed by the European Central Bank
Countries such as El Salvador & Hong Kong, that link their currency to the dollar at a fixed rate, are no longer in a position to conduct monetary policy. They merely accept the monetary policy of the Federal Reserve.
The same can be said for the 12 countries of the European Monetary Union that accept the monetary policy of the European Central Bank.

36. Pegged Exchange Rate Regimes
Pegged exchange rate system: a system where the country commits to using monetary and fiscal policy to maintain the exchange-rate value of the domestic currency at a fixed rate or within a narrow band relative to another currency (or bundle of currencies).
Unlike the case of a currency board, however, countries with a pegged exchange rate continue to conduct monetary policy.

37. When Pegged Regimes Lead to Problems A nation can either:
follow an independent monetary policy, allowing its exchange rate to fluctuate, or,
tie its monetary policy to the maintenance of the fixed exchange rate.
It cannot, however:
maintain currency convertibility at a fixed exchange rate while following a monetary policy more expansionary than that of the country to which its currency is tied.

38. When Pegged Regimes Lead to Problems
Attempts to peg rates and follow a monetary policy that is too expansionary have led to several recent financial crises—a situation where falling foreign reserves eventually force the country to forego the pegged rate.
The experiences of Mexico in and of Brazil, Thailand, South Korea, Indonesia, and Malaysia in illustrate this point very clearly.

39. Balance of Payments
Revisited

40. Balance of Payments
Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners
Any transaction that creates a demand for foreign currency (and a supply of the domestic currency) in the foreign exchange market is recorded as a debit item.
Example: Imports
Transactions that create a supply of foreign currency (and demand for the domestic currency) on the foreign exchange market are recorded as a credit item.
Example: Exports

41. Balance of Payments
Under a pure flexible rate system, the foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits.

42. Balance of Payments
Current account transactions: all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period
Four categories of current account transactions:
Merchandise trade (import and export of goods)
Service trade (import and export of services)
Income from investments
Unilateral transfers (gifts to and from foreigners)

43. Balance of Payments
Capital account transactions: transactions that involve changes in the ownership of real and financial assets
The capital account includes both
direct investments by foreigners in the U.S. and by Americans abroad, and,
loans to and from foreigners.
Under a pure flexible-rate system, official reserve transactions are zero; therefore:
a current-account deficit implies a capital-account surplus.
a current-account surplus implies a capital-account deficit.

44. U.S. Balance of Payments, 2003*
Debits
Credits
deficit (-) / surplus (+)
Current account:
1. U.S. merchandise exports
2. U.S. merchandise imports
3. Balance of merchandise trade (1 + 2)
4. U.S. service exports
5. U.S. service imports
6. Balance on service trade (4 + 5)
+ 51.1
7. Balance on goods and services (3 + 6)
8. Income receipts of Americans from abroad
9. Income receipts of foreigners in the U.S.
10. Net income receipts (8 + 9)
33.3
11. Net unilateral transfers
- 67.4
12. Balance on current account ( )
Source: * Figures are in Billions of Dollars
Continued on next page …

45. U.S. Balance of Payments, 2003*
Debits
Credits
deficit (-) / surplus (+)
Current account:
12. Balance on current account ( )
Capital account:
13. Foreign investment in the U.S. (capital inflow)
14. U.S. investment abroad (capital outflow)
-297.1
15. Balance on capital account ( )
Official Reserve Transactions:
16. U.S. official reserve assets
-1.5
17. Foreign official assets in the U.S.
18. Balance, Official Reserve Account ( )
17. Total ( )
0.0
Source: * Figures are in Billions of Dollars

46. Capital Flows and
the Current Account

47. Leading Trading Partners of the U.S.
Current Account as % of GDP surplus (+) or deficit (-)
+ 2
- 2
- 4
1973
1978
1983
1988
1993
1998
2003
Net Foreign Investment as % of GDP surplus (+) or deficit (-)
+ 4
+ 2
- 2
1973
1978
1983
1988
1993
1998
2003
Under a flexible exchange rate system the inflow and outflow of capital will exert a major impact on the current account and trade balances.
The figures for the U.S. (above) illustrate this linkage.

48. Are Trade Deficits Bad?
An inflow of capital implies a trade (current account) deficit; an outflow of capital implies a trade (current account) surplus.
While the term “deficit” generally has negative connotations, this is not necessarily true for a trade deficit.
If a nation’s investment environment is attractive, it is likely to result in a net inflow of capital, which will tend to cause a trade deficit.
Similarly, rapid economic growth will tend to stimulate imports, which is likely to result in a trade deficit.

49. Trade Deficits: Points to Ponder
Although they often cause trade (and current account) deficits, both rapid growth and a healthy investment environment are signs of a strong economy, not a weak one.
A trade deficit (or surplus) is an aggregate that reflects the voluntary choices of individuals and businesses. In contrast with a budget deficit, no legal entity is responsible for the trade deficit.
The trade deficits of the U.S. during the 1980s and 90s were largely the result of rapid growth and a favorable investment climate.

50. Should Trade Between Countries Balance?
Political leaders often imply that U.S. exports to a country, China or Japan for example, should be approximately equal to our imports from that country.
This is a fallacious view.
Under a flexible exchange rate system, overall purchases from foreigners will balance with overall sales to foreigners, but there is no reason why bilateral trade between any two countries will balance.