1. Exchange Rates and The Open Economy Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

2. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy2 Introduction  Have you visited any foreign countries?  What currency did they use there?  What was the exchange rate of that currency with the dollar?

3. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy3 Exchange Rates  To make a transaction with a foreign country, first you need to get that country’s currency. € $ Pickle Co., in the US, sends him $36 worth of pickles. Pierre takes his €30 to the foreign exchange market and gets $36. Pierre wants American pickles. He has €30.

4. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy4 Exchange Rate Policy  The choice of an exchange rate policy is tremendously important.  A flexible exchange rate –allows fluctuations in the value of a currency. It generates some uncertainty but it leaves monetary policy free to pursue national objectives.  A fixed exchange rate –generates more certainty, but it ties monetary policy to this single overriding goal, and it is open to speculative attacks.

5. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy5 Sources of Information  Exchange rates from the real world are available at a number of on-line sites.  The St. Louis Federal Reserve (http://research.stlouisfed.org/fred2/categories/13) offers tables as well as graphs for a limited number of countries. The graphs show the number of units of foreign currency that can be purchased for one US dollar for a five (or more) year period. http://research.stlouisfed.org/fred2/categories/13  The New York Federal Reserve provides daily reports of current rates for many countries. The exchange rate is reported as units of foreign currency per US dollar. Go to (http://www.ny.frb.org) link to “markets” and then to “Foreign Exchange.” http://www.ny.frb.org  You will also find an “Exchange Rate Calculator” or “Currency Converter” at http://www.oandnda.com/convert/classic. This converter has a database that includes 164 currencies and can provide historical data (back as far as three decades in some cases) in tabular or graphic form. http://www.oandnda.com/convert/classic

6. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy6 Imagine  Imagine a business trip to Montreal, Canada. The trip is to be made May 10-14, 2006 and the meetings are to be held in the Hilton Montreal Bonaventure Hotel – one of the premium hotels near the city center.  Like most major hotels in Canadian cities, the Montreal Bonaventure will accept either Canadian currency ($CAN) or U.S. currency ($US).  The following nightly rates have been given to you: $225.00CAN per night $171.40US per night

7. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy7 Imagine  The exchange rate at the time of the trip is quoted as 1.3876 indicating that $1US will exchange for $1.3876 CAN.  Should you pay using Canadian or U.S. currency?  If you choose U.S. currency, you will pay the $171.40, but if you exchange the $171.40 for Canadian currency, you will receive $1.3876 CAN for each U.S. dollar for a total of

8. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy8 Imagine  $171.40 US X $1.3876CAN/1$US = $237.83 CAN  After exchanging the currency, you can pay in US dollars and pay the equivalent of $237.83 CAN.  Or you can pay the hotel its $225CAN per night and keep the $12.83CAN + as a surplus that you earned as a result of being aware of exchange rates.  This kind of calculation and transaction is very familiar and almost continuous among travelers who cross from one country (currency) to another.

9. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy9 Imagine Again  You are a business person. Your firm is an importer-exporter.  You buy de Beers diamonds from South Africa, French wines, Japanese automobiles, Indian cashews, and sell American DVDs and computer software.  If you don’t know everything about exchange rates, you’ll go broke in two months.

10. Exchange Rates: Definitions

11. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy11 Exchange Rates  Nominal Exchange Rate –The rate at which two currencies can be traded for each other € € € € $ $ $ $ €1$€1$ € € € € $ $ $ $ €0.5 $ $ $ $ $

12. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy12 Exchange Rates  Nominal Exchange Rate –The rate at which two currencies can be traded for each other € € € € $ $ $ $ $1€$1€ € € € € $ $ $ $ $2€$2€ $ $ $ $

13. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy13 Exchange Rates  Nominal Exchange Rates –The exchange rate between British and Canadian currencies  0.6393 British pounds = $1 U.S.  1.5674 Canadian $s = $1 U.S.  0.6393 British pounds = 1.5674 Canadian $s  0.6393/1.5674 = 0.4079 pounds = 1 Canadian $  British/Canadian exchange 0.4079 pounds per Canadian dollar

14. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy14 CountryForeign currency/dollarDollar/foreign currency Nominal Exchange Rates for the U.S. Dollar Nov 28, 2005 The dollar has weakened since 2002 (except against the peso) United Kingdom (pound) 0.5811.7221 Canada (Canadian dollar) 1.16560.8579 Mexico (peso) 10.57150.09459 Japan (yen) 119.250.00839 Switzerland (Swiss franc) 1.3110.76278 South Korea (won) 1039.40.000962 Euro 0.84311.18603

15. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy15 Imagine Again  You are a business person. Your firm is an importer-exporter. –You buy de Beers diamonds from South Africa, French wines, Japanese automobiles, Indian cashews, and sell American DVDs and computer software.  Every time you carry out one of these transactions, you must exchange one currency for another, at the nominal exchange rate.

16. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy16 The U.S. Nominal Exchange Rate, 1973-2002

17. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy17 Exchange Rates  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

18. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy18 Visiting Austria  Suppose you are going to Austria next semester.  You’ve saved up $2,000 for traveling. At an exchange rate of $1.18/€, that means €1,695. –That’s about 90 meals.  But then, alas! The Euro appreciates to $1.92/€. Now you only have €1,041. –That’s about 54 meals.

19. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy19 Exchange Rates  Some Definitions –e = nominal exchange rate –e = the number of units of foreign currency that the domestic currency will buy e = the number of units of foreign currency that 1 unit of domestic currency will buy

20. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy20 Exchange Rates  When e increases, the domestic currency appreciates  When e decreases, the domestic currency depreciates e = the number of units of foreign currency that 1 unit of domestic currency will buy

21. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy21 Imagine Again  You are a business person. Your firm is an importer-exporter. –You buy de Beers diamonds from South Africa, French wines, Japanese automobiles, Indian cashews, and sell American DVDs and computer software.  If the Dollar appreciates, US goods become more expensive and harder to sell to foreign lands; foreign goods become cheaper and more attractive.

22. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy22 Exchange Rates  Some Definitions –The exchange rate can also be defined as the number of units of domestic currency needed to buy a unit of foreign currency. –Then an appreciation of the domestic currency is an decrease in the nominal exchange rate. –This is the more common way of defining exchange rates, but it can be confusing.

23. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy23 Exchange Rates  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.  Foreign Exchange Market –The market on which currencies of various nations are traded for one another

24. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy24 Exchange Rates  Fixed Exchange Rate –An exchange rate whose value is set by official government policy

25. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy25 Exchange Rates  The Real Exchange Rate –Nominal exchange rate  The number of units of foreign currency that the domestic currency will buy

26. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy26 Exchange Rates  The Real Exchange Rate –Real exchange rate  The number of units of foreign GDP that 1 unit of domestic GDP can buy.  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.  How many loaves of French bread are needed to buy an American loaf of sliced bread?

27. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy27 Exchange Rates  The Real Exchange Rate –Real exchange rate  While knowing the magnitude of the real exchange rate is likely of little interest to an individual traveler making a one-week trip to Iceland, it is important and useful to importers and exporters who need information regarding the general relationship between two currencies and two economies.

28. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy28 Imagine Again  You are a business person. Your firm is an importer-exporter. –You buy de Beers diamonds from South Africa, French wines, Japanese automobiles, Indian cashews, and sell American DVDs and computer software.  What you are really interested in, ultimately, is how many DVDs you have to sell to get so many bottles of wine.

29. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy29 Exchange Rates  Example –You are the Director of Purchases for Consumer Services, Inc. –You are considering whether to buy 1,000,000 computers. Should you buy Japanese or American computers?  Price in yen = price in dollars x (yen-dollar exchange rate)  Price in dollars = price in yen / (yen-dollar exchange rate) e = the number of units of foreign currency that 1 unit of domestic currency will buy

30. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy30 Price in the original country Currency Conversion Price in the other country US computer $2,400 $2,400 * 110 yen/dollar ¥264,000 JapaneseComputer ¥242,000 ¥242,000 / 110 yen/dollar $2,200 e = 110 yen/dollar= the number of units of foreign currency that 1 unit of domestic currency will buy e = 110 yen/dollar = the number of units of foreign currency that 1 unit of domestic currency will buy

31. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy31 Exchange Rates  Example –Should you buy Japanese or American computers for your company?  Japanese computers are cheaper.  Price of U.S. computer = $2,400  Price in of Japanese computer in dollars = 242,000 yen/110 = $2,200 242,000 yen/110 = $2,200  Real exchange rate = $2,400/$2,200 = 1.09 e = the number of units of foreign currency that 1 unit of domestic currency will buy

32. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy32 Exchange Rates  Real Exchange Rate P$P$ P € =P $ /e

33. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy33 Exchange Rates  The Computer Example, revisited –E = 110/$1 –P = $2,400 –P f = 242,000 yen e = the number of units of foreign currency that 1 unit of domestic currency will buy

34. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy34 Exchange Rates  The Real Exchange Rate –A high real exchange rate makes it difficult for domestic producers to export to other countries: domestic goods are too expensive. –A high (appreciated) real exchange rate attracts imports. e = the number of units of foreign currency that 1 unit of domestic currency will buy This is an important topic of International Monetary Economics, ECO 421

35. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy35 Austria, Revisited  You’d saved up $2,000. If e = $1.18/€, that means €1,695, about 90 meals.  But the dollar depreciates to $1.92/€, you only have €1,041, about 54 meals.  The dollar depreciation made the Euro appreciate.  This made European meals more expensive and less attractive.

36. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy36 Exchange Rates  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 e = the number of units of foreign currency that 1 unit of domestic currency will buy

37. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy37 Exchange Rates  Economic Naturalist –Does a strong currency imply a strong economy?  A currency will get strong if there is a high demand for the country’s goods (and therefore its currency).  But if an economy has a big trade deficit (Imports > Exports), a devaluation of the currency will solve the problem: it makes domestic goods more competitive.

38. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy38 Real Exchange Rates, US/CAN, US/MEX

39. Determination of Exchange Rates Purchasing Power Parity This is an important topic of International Monetary Economics, ECO 421

40. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy40  A blank DVD is a blank DVD, right? So it should cost the same everywhere.  Law of One Price –If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations. The Determination of the Exchange Rate

41. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy41 Imagine Again  Your firm is an importer-exporter.  Suppose you could get the exact same diamond from South Africa and also from Australia.  After taking into account the nominal exchange rate, either 1.prices are exactly the same, so you’re indifferent or 2.prices are different, and you’d buy from the cheapest until prices came to equality.

42. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy42  Purchasing Power Parity (PPP) –“Nominal exchange rates move so that the law of one price can hold.” The Determination of the Exchange Rate P$P$ P € =P $ /e =

43. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy43  Purchasing Power Parity (PPP) The Real Exchange rate = e P / P f PPP implies Pe = P f and e=P f /P  This way, if I have domestic blank DVD, I can sell it, get home currency, change it into foreign currency, and a foreign blank DVD. The Determination of the Exchange Rate : PPP implies e=P f /P It also implies  e=  P f –  P Currency depreciates if  P >  P f

44. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy44  Purchasing Power Parity (PPP) –In the long run, the currencies of countries that experience significant inflation will tend to depreciate. The Determination of the Exchange Rate

45. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy45  Example –How many Indian rupees equal to one Australian dollar?  A Bushel of grain is the same bushel of grain in India or in Australia.  A bushel of grain costs 5 Australian dollars or 150 rupees  5 Australian dollars = 150 rupees  Nominal exchange should equal 30 rupees/Australian dollar The Determination of the Exchange Rate

46. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy46  Example –How many Indian rupees equal one Australian dollar?  Suppose the Price of grain in India increases from 150 to 300 rupees  But Price of Indian grain in Australia stays equal to 5 Australian dollars The Determination of the Exchange Rate

47. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy47  Example –Now, 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 The Determination of the Exchange Rate

48. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy48  Example –Shortcomings of the PPP Theory  The theory has been successful in the long run but not the short run. The Determination of the Exchange Rate

49. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy49  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. The Determination of the Exchange Rate

50. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy50 The Big Mac Index  The Economist's Big Mac index seeks to make exchange-rate theory more digestible.  It is arguably the world's most accurate financial indicator to be based on a fast-food item.

51. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy51 The Big Mac Index  The Big Mac index, which The Economist has compiled since 1986, is based on the notion that a currency's price should reflect its purchasing power.  In other words, a unit of currency should buy the same amount of burger anywhere.

52. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy52 The Big Mac Index  According to the late, great economist Rudiger Dornbusch, this idea can be traced back to the Salamanca school in 16th- century Spain.  Since then, he wrote, the doctrine of purchasing-power parity (PPP) has been variously seen as a “truism, an empirical regularity or a grossly misleading simplification.”

53. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy53 The Big Mac Index  Their index shows that burger prices can certainly fall out of line with each other.  If he could keep the burgers fresh, an ingenious arbitrageur could buy Big Macs for the equivalent of $1.27 in China, whose yuan is the most undervalued currency in our table, and sell them for $5.05 in Switzerland, whose franc is the most overvalued currency.

54. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy54 The Big Mac Index  The impracticality of such a trade highlights some of the flaws in the PPP idea. Trade barriers, transport costs and differences in taxes drive a wedge between prices in different countries.

55. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy55 The Big Mac Index  More important, the $5.05 charged for a Swiss Big Mac helps to pay for the retail space in which it is served, and for the labor that serves it. Neither of these two crucial ingredients can be easily traded across borders.

56. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy56 The Big Mac Index

57. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy57 The Big Mac Index

58. Determination of Exchange Rates Supply and Demand Analysis

59. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy59 Imagine Again  You are a business person. Your firm is an importer-exporter.  Every time you buy some Indian cashews, you must buy Indian rupees (their currency), that is, demand rupees.  Every time you sell some American DVDs to an Indian firm, it must sell rupees to buy dollars, that is, supply rupees.

60. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy60 Supplying A Currency  A recent newspaper account indicates that Wal- Mart sells approximately 10 percent of all Chinese- made items sold in the United States economy.  Since Wal-Mart does not earn large amounts of yuan in China, the retail giant must go to the currency market to get the yuan with which to buy Chinese goods.  Wal-Mart must selling a lot of dollars to buy the Chinese currency.  Wal-Mart is a supplier of dollars.

61. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy61 Demanding A Currency  The People’s Bank of China buys billions of dollars worth of U.S. assets (government securities) and in that way it finances a large part of the US current account deficit.  Since the PBoC does not print dollars, it must buy them in the market for currency.  The bank then becomes a demander of dollars.

62. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy62 Demand and Supply for Currency  The Demand for Dollars in the Forex Market –Happens in the foreign exchange market –Someone wants to get rid of some currency to buy dollars. –Is distinct from “money demand”, which is the allocation of wealth.

63. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy63 Demand and Supply for Currency  The Supply of Dollars in the Forex Market –Happens in the foreign exchange market –Someone wants to buy another currency with some dollars, and so sells the dollars. –Is distinct from “money supply”, set by the CB.

64. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy64 Quantity of dollars traded Yen/dollar exchange rate Demand for dollars Supply of dollars e* The equilibrium exchange rate (e*) or fundamental exchange rate makes the quantities of dollars supplied and demanded equal The Supply and Demand for Dollars In The Yen-Dollar Market

65. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy65  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 The Determination of the Exchange Rate

66. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy66  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 The Determination of the Exchange Rate ¥ $ A Toyota goes to US

67. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy67 Quantity of dollars traded Yen/dollar exchange rate D S e* E 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*’ An Increase In The Supply of Dollars Lowers The Value of The Dollar

68. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy68  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 The Determination of the Exchange Rate

69. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy69  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 The Determination of the Exchange Rate ¥ $ The Bank of Japan buys a US bond

70. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy70 Quantity of dollars traded Yen/dollar exchange rate D S e* E Tighter monetary policy raises the domestic real interest rate Foreign demand for U.S. assets increase e*’ F D’ The demand for dollars rises Exchange rate appreciates from e* to e*’ A Tightening of Monetary Policy Strengthens the Dollar

71. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy71 Demand and Supply of Currency  The equilibrium exchange rate (e*) or fundamental exchange rate makes the quantities of dollars supplied and demanded equal.

72. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy72  Economic Naturalist –Why do people think the dollar will depreciate brutally in the next few months?  Right now, there’s a tremendous demand for US dollars by foreigners to pay for the $700 billion current account annual deficit.  If they chose not to buy dollars, the demand for the dollar (and its foreign-exchange value) would collapse. Monetary Policy and the Exchange Rate

73. This is an important topic of International Monetary Economics, ECO 421

74. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy74  The Exchange Rate as a Tool of Monetary Policy –When the exchange rate is flexible:  Tighter monetary policy reduces net exports. –By raising the interest rate, the exchange rate appreciates.  Easier monetary policy stimulates net exports. –By lowering the interest rate, the exchange rate depreciates.  Monetary policy is more effective in an open economy with flexible exchange rates. Monetary Policy and the Exchange Rate

75. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy75  The Exchange Rate is a Tool of Monetary Policy –When the exchange rate is flexible:  Tighter monetary policy reduces net exports. –A higher interest rate makes purchasing domestic assets (such as bonds) bonds more attractive. –As people buy domestic assets, the exchange rate appreciates. –As e appreciates, imports become cheaper. –As e appreciates, exports become more expensive. Monetary Policy and the Exchange Rate M ↓ i ↑ e ↑ NX ↓ Y ↓

76. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy76  The Exchange Rate is a Tool of Monetary Policy  Tighter monetary policy reduces net exports. –As e appreciates, imports become cheaper. –As e appreciates, exports become more expensive. –Ex: suppose e = €1/$. –French wine costs €30. Notice €30 / €1/$ = $30. –Californian wine costs $30. Notice $30 x €1/$ = €30. –Suppose e = €2/$, so the dollar is worth more euros. –French wine costs €30. Now €30 / €2/$ = $15. –Californian wine costs $30. Now $30 x €2/$ = €60. Monetary Policy and the Exchange Rate

77. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy77  The Exchange Rate as a Tool of Monetary Policy  Easier monetary policy stimulates net exports. –By lowering the interest rate, the exchange rate depreciates. –As e depreciates, imports become more expensive. –As e depreciates, exports become cheaper. –Suppose e = €0.5/$, so the dollar is worth fewer euros. –French wine costs €30. Now €30 / €0.5/$ = $60. –Californian wine costs $30. Now $30 x €0.5/$ = €15. Monetary Policy and the Exchange Rate M ↑ i ↓ e ↓ NX ↑ Y ↑

78. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy78 Imagine Again  You are a business person. Your firm is an importer-exporter.  If the Fed lowers interest rates, the dollar will be pressured downward.  Your import business will suffer (foreign goods will become more expensive) but your export business will benefit (US goods will become cheaper).

79. Fixed Exchange Rates This is an important topic of International Monetary Economics, ECO 421

80. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy80 Fixed Exchange Rates  Suppose you are an importer-exporter. –You buy de Beers diamonds from South Africa, French wines, Japanese automobiles, Indian cashews, and sell American DVDs and computer software.  Wouldn’t you like to know that the value of the US Dollar will stay constant relative to these currencies for the foreseeable future?

81. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy81 Fixed Exchange Rates  For many, many years, the US fixed the value of the dollar to Gold –Right now, many countries still fix the value of their currencies to the dollar or other currencies  (they “peg” their currency to the dollar, Euro, etc.). –Countries believe that fixing the exchange rate generates more stability and predictability.

82. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy82 Fixed Exchange Rates  Fixed Exchange Rates –The government will peg its currency to a major currency  or to a “basket” of currencies. –The Central Bank declares that it will buy and sell unlimited amounts of domestic currency at that particular price. –For example, the Thai baht may be pegged to the US dollar.

83. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy83 Fixed Exchange Rates  Fixed Exchange Rates –Suppose the exchange rate is fixed, but some event requires a change in the parity  (parity: the number, the precise value of e at which the exchange rate is fixed) –The government may have to devalue or revalue its currency.

84. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy84 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)

85. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy85 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

86. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy86 An Overvalued Exchange Rate Quantity of pesos traded Dollar/peso exchange rate Demand for pesos Supply of pesos Official value Fundamental value 0.10 dollar/ peso 0.125 dollar/ peso The peso’s official value is greater than the fundamental value; the peso is overvalued AB To maintain the value, the government must purchase a quantity of pesos (A-B)

87. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy87 Imagine Again  You are an importer. –If the dollar is overvalued vis-à-vis the Euro, you will lobby the Treasury to keep it overvalued, because your dollars will buy more European goods.  You are an exporter (or you compete with imports). –If the dollar is overvalued vis-à-vis the Chinese yuan, you will pressure the Treasury to make the Chinese revalue their currency, which will make Chinese goods more expensive and yours relatively cheaper.

88. Fixed Exchange Rates How to Fix an Exchange Rate

89. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy89 How to Fix an Exchange Rate  Suppose you’ve fixed your exchange rate at 0.125 dollar/peso = 8 pesos/dollar.  But the fundamental value is 0.1 dollar/peso = 10 pesos/dollar –This is the value at which quantity demanded and quantity supplied are equal.  The Dollar is undervalued  The peso is overvalued.

90. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy90 How to Fix an Exchange Rate  Suppose the peg was at 0.08 dollar/peso (= 12.5 pesos/dollar).  because the fundamental value is 0.1 dollar/peso = 10 pesos/dollar. –This is the value at which quantity demanded and quantity supplied are equal.  The Dollar is overvalued (it should be worth less).  The peso is undervalued.

91. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy91 How to Fix an Exchange Rate  Responses to an overvalued currency –Devalue the currency: adjust the official value of the currency to equal the fundamental value.

92. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy92 How to Fix an Exchange Rate  Responses to an overvalued currency –Impose trade barriers: prevent people from trading, either goods and services, or the currency (this last is called capital controls).  This reduces the supply of currency and ameliorates the excess supply. Hence, the price of currency (the exch. rate) doesn’t get pushed in any way.

93. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy93 How to Fix an Exchange Rate  Responses to an overvalued currency –The Central Bank can buy large amounts of the currency : increase the demand for domestic currency so the fundamental value rises to equal the official value.  To purchase your own currency (to keep its value high) you must sell other country’s currencies, that is, your international reserves.

94. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy94 How to Fix an Exchange Rate  International Reserves –Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market. –To purchase its own currency, a country must hold international reserves.

95. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy95 How to Fix an Exchange Rate  An overvalued currency leads to a balance of payments deficit –Leads to a net decline in international reserves over a year if exchange rates are fixed. –IM = 500 and X = 400.  NX = – 100. –Suppose it has KI = 80. Where does it get the extra 20 to pay for the extra imports?  NX + KI = – 100 + 80 = – 20 = BOP < 0.  This 20 is called a BOP deficit

96. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy96 How to Fix an Exchange Rate  An overvalued currency leads to a balance of payments deficit –If exchange rates are flexible, e depreciates: imports fall and exports rise. This makes BOP=0. –If exchange rates are fixed and BOP<0, the currency is overvalued and the CB sells international reserves to defend the exchange rate.  The currency is overvalued because if it were allowed to lose value, X would become more competitive and rise, increasing NX and BOP.

97. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy97 How to Fix an Exchange Rate  An undervalued currency leads to a balance of payments surplus –When a balance-of-payments surplus occurs, a country has a net increase in international reserves over a year.  Suppose X – IM = 100 and capital outflows = -50.  NX + KI = 100 – 50 = 50 = BOP > 0.

98. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy98 How to Fix an Exchange Rate  Example –Latinia’s balance-of-payments deficit  Official value of the peso = 0.125 dollars  Demand = 25,000 - 50,000e  Supply = 17,600 + 24,000e

99. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy99 How to Fix an Exchange Rate  Example –Latinia’s balance-of-payments deficit  Official value of the peso = 0.125 dollars  Demand = 25,000 - 50,000e  Supply = 17,600 + 24,000e  Fundamental value –25,000 - 50,000e = 17,600 + 24,000e  Solving for e: –7,400 = 74,000e –e = 0.10

100. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy100 How to Fix an Exchange Rate  Example –At the official rate -- 0.125, the demand for currency is… –D = 25,000 - 50,000(0.125) = 18,750 –And the supply of currency is … –S = 17,600 - 24,000 (0.125) = 20,600 –Excess supply = 1,850 pesos –Balance of payments deficit = 1,850 pesos

101. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy101 How to Fix an Exchange Rate  Latinia is running a P 1,850 BOP deficit because there’s an excess supply of pesos. –People are getting rid of pesos to buy imports and foreigners are not buying enough pesos back to buy exports.  The explanation for the excess supply is that the currency is overvalued: the fixed e is too high compared to the equilibrium value.

102. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy102 How to Fix an Exchange Rate  Latinia has an overvalued currency which generates an excess supply of pesos.  Its Central Bank will have to increase the demand for pesos until Q D = Q S.  It will buy pesos and sell dollars.  Buying pesos will reduce the money supply and raise interest rates. –Selling dollars will reduce the bank’s international reserves.

103. Fixed Exchange Rates Speculative Attacks

104. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy104 Fixed Exchange Rates  Suppose a currency is overvalued –That is, the fundamental value is below the official value. –There’s an excess supply of pesos, so the CB buys up the pesos (demand) by selling dollars (i.e., international reserves). –In other words, the CB defends the exchange rate peg by selling international reserves, but financial investors know that the CB doesn’t have an infinite amount of int’l reserves.

105. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy105 Fixed Exchange Rates  Suppose a currency is overvalued –That is, the fundamental value is below the official value. –The CB defends the exchange rate peg by selling international reserves, but financial investors know that int’l reserves will run out.  Speculative Attack –A massive selling of domestic currency assets by financial investors

106. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy106 A Speculative Attack on the Peso Quantity of pesos traded Dollar/peso exchange rate AB 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

107. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy107 Fixed Exchange Rates  Speculative Attack –It generates a large excess supply of currency at the fixed exchange rate. –This excess supply has to be covered by selling international reserves. –If the excess supply is large enough, and is maintained for long enough, the country runs out of international reserves and has to abandon the peg!

108. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy108 Fixed Exchange Rates  Economic Naturalist –Can a speculative attack occur under flexible exchange rates?  Not in the sense of investors forcing the CB to sell all of its reserves, because, by definition, the CB is not selling any reserves.  Yes, in the sense that they can come to believe that the exchange rate will depreciate in the near future, and so they sell massive amounts of the currency, shifting the Supply curve to the right.

109. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy109 Fixed Exchange Rates  What is the alternative to selling reserves (and risking a speculative attack)?  To defend an exchange rate peg, –Impose capital controls or tariffs –Change monetary policy  To defend an overvalued currency, tighten and raise interest rates.  To defend an undervalued currency, loosen and lower interest rates.

110. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy110 Quantity of pesos traded Dollar/peso exchange rate D S Official value E 0.10 dollar/ peso 0.125 dollar/ peso Pesos overvalued at 0.125 F D’ Tightening monetary policy increases D to D’ Official value = fundamental value A Tightening of Monetary Policy Eliminates An Overvaluation

111. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy111 Fixed Exchange Rates  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. –The Central Bank loses control of monetary policy when it pegs the exchange rate.

112. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy112 Fixed Exchange Rates  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. –Suppose an economy is in bad shape, so financial investors dump the currency, creating a speculative attack. The CB responds by raising the interest rate … which makes the economy worse!

113. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy113  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. Should Exchange Rates Be Fixed or Flexible?

114. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy114  Trade and Economic Integration –Fixed exchange rate proponents argue that fixed rates promote international trade. –Stable nominal exchange rates are good for predicting the future, for exporting and importing. –The risk of a speculative attack may make the country less attractive to investors and trade. Should Exchange Rates Be Fixed or Flexible?

115. Examples

116. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy116  What were the causes and consequences of the East Asian crisis of 1997-1998? –Over 1997, East Asian currencies lost half of their value. –To protect the pegs, central banks raised interest rates. –Exports should have boomed, but many debts were denominated in dollars. Because banks were badly run, their assets quickly became worthless. –The result was a sharp recession and the end of the Asian Miracle. Should Exchange Rates Be Fixed or Flexible?

117. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy117

118. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy118  How did policy mistakes contribute to the Great Depression? –Among many other mistakes, the US kept the dollar pegged to gold for too long. –This meant that exports were too expensive and imports pretty cheap, further depressing economic activity. Should Exchange Rates Be Fixed or Flexible?

119. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy119  Why have 11 European countries adopted a common currency? –Many Europeans believe that peace and prosperity can only happen if there is political union in Europe. This depends on economic union, which depends on trade. –There is more trade if exchange rates are predictable … or if the partners have the same currency. –But that means that Ireland and Germany must have the same monetary policy, which makes little sense.  (Neither does it make sense for Florida and Louisiana to have the same monetary policy, though). Should Exchange Rates Be Fixed or Flexible?

120. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy120  Should the Fed defend the dollar? Should the European Central Bank prop it up? –I mentioned that the US Current Account deficit suggests a massive dollar depreciation. –If foreigners did not by US dollars, interest rates would have to rise. –This would mean a collapse of the housing market. Should the Fed do anything about it? –If the dollar collapses, European goods will be more expensive, deepening the recession there. Should Exchange Rates Be Fixed or Flexible?

121. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy121 What have we learned today?  Nominal exchange rates: –The rate at which two currencies can be traded for each other.  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.  Appreciation versus depreciation

122. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy122 What have we learned today?  In the long run, the nominal exchange rate is determined by Purchasing Power Parity.  In the short run, the nominal exchange rate is determined by supply and demand for currency in the foreign exchange market. –The fundamental exchange rate is the equilibrium exchange rate in the market.

123. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy123 What have we learned today?  Monetary policy is more effective in the open economy because it affects expenditure through the exchange rate in addition to through the interest rate. –Higher interest rates appreciate the currency, which depresses net exports and output.

124. Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 29: Exchange Rates and the Open Economy124 What have we learned today?  A Central Bank may fix the value of the currency in terms of another currency. –If it does, it may have to raise or lower interest rates to defend the exchange rate peg, losing control over monetary policy. –Fixed exchange rates lead to balance of payments deficits or surpluses.