2. Economics: Principles and Applications, 2e by Robert E. Hall & Marc Lieberman © 2001 South-Western, a division of Thomson Learning

3. Exchange Rates and Macroeconomic Policy © 2001 South-Western, a division of Thomson Learning

4. Foreign Exchange Markets and Exchange Rates Exchange Rate The amount of one country’s currency that is traded for one unit of another country’s currency. © 2001 South-Western, a division of Thomson Learning

5. The Demand for British Pounds The Demand for Pounds CurveThe Demand for Pounds Curve Shifts in the Demand for Pounds CurveShifts in the Demand for Pounds Curve © 2001 South-Western, a division of Thomson Learning

6. The Demand for British Pounds In our model of the market for pounds, we assume that American households and businesses are the only buyers. © 2001 South-Western, a division of Thomson Learning

7. The Demand for British Pounds Demand Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that Americans will want to buy, during a given period, at each different exchange rate. © 2001 South-Western, a division of Thomson Learning

8. The Demand for British Pounds Variables That Shift the Demand for Pounds Curve U.S. Real GDPU.S. Real GDP Relative Price LevelsRelative Price Levels Americans’ Tastes for British GoodsAmericans’ Tastes for British Goods Relative Interest RatesRelative Interest Rates Expected Changes in the Exchange RateExpected Changes in the Exchange Rate © 2001 South-Western, a division of Thomson Learning

9. The Supply of British Pounds The Supply of Pounds CurveThe Supply of Pounds Curve Shifts in the Supply of Pounds CurveShifts in the Supply of Pounds Curve © 2001 South-Western, a division of Thomson Learning

10. The Supply of British Pounds Supply Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that will be supplied, during a given period, at each different exchange rate. © 2001 South-Western, a division of Thomson Learning

11. The Supply of British Pounds Variables That Shift the Supply of Pounds Curve Real GDP in BritainReal GDP in Britain Relative Price LevelsRelative Price Levels British Tastes for U.S. GoodsBritish Tastes for U.S. Goods Relative Interest RatesRelative Interest Rates Expected Changes in the Exchange RateExpected Changes in the Exchange Rate © 2001 South-Western, a division of Thomson Learning

12. The Equilibrium Exchange Rate Floating Exchange Rate An exchange rate that is freely determined by the forces of supply and demand. © 2001 South-Western, a division of Thomson Learning

13. The Equilibrium Exchange Rate When the exchange rate floats--that is, when the government does not intervene in the foreign currency market--the equilibrium exchange rate is determined at the intersection of the demand curve and the supply curve. © 2001 South-Western, a division of Thomson Learning

14. What Happens When Things Change? How Exchange Rates Change over TimeHow Exchange Rates Change over Time The Very Short Run: “Hot Money”The Very Short Run: “Hot Money” The Short Run: Macroeconomic FluctuationsThe Short Run: Macroeconomic Fluctuations The Long Run: Purchasing Power ParityThe Long Run: Purchasing Power Parity © 2001 South-Western, a division of Thomson Learning

15. What Happens When Things Change? Appreciation An increase in the price of a currency in a floating-rate system. Depreciation A decrease in the price of a currency in a floating-rate system. © 2001 South-Western, a division of Thomson Learning

16. What Happens When Things Change? When a floating exchange rate changes, one country’s currency will appreciate (rise in price) and the other country’s currency will depreciate (fall in price). © 2001 South-Western, a division of Thomson Learning

17. What Happens When Things Change? Relative interest rates and expectations of future exchange rates are the dominant forces moving exchange rates in the very short run. © 2001 South-Western, a division of Thomson Learning

18. What Happens When Things Change? In the short run, movements in exchange rates are caused largely by economic fluctuations. All else equal, a country whose GDP rises relatively rapidly will experience a depreciation of its currency. A country whose GDP falls more rapidly will experience an appreciation of its currency. © 2001 South-Western, a division of Thomson Learning

19. What Happens When Things Change? Purchasing Power Parity (PPP) Theory The idea that the exchange rate will adjust in the long run so that the average price of goods in two countries will be roughly the same. © 2001 South-Western, a division of Thomson Learning

20. What Happens When Things Change? Some Important Caveats Some Goods Are Difficult to TradeSome Goods Are Difficult to Trade High Transportation CostsHigh Transportation Costs Artificial Barriers to TradeArtificial Barriers to Trade © 2001 South-Western, a division of Thomson Learning

21. Interdependent Markets: The Role of Arbitrage Arbitrage Simultaneous buying and selling of a foreign currency in order to profit from a difference in exchange rates. © 2001 South-Western, a division of Thomson Learning

22. Interdependent Markets: The Role of Arbitrage Bilateral Arbitrage Arbitrage involving one pair of currencies. Bilateral arbitrage ensures that the exchange rate between any two currencies is the same everywhere in the world. © 2001 South-Western, a division of Thomson Learning

23. Interdependent Markets: The Role of Arbitrage Triangular Arbitrage Arbitrage involving trades among three (or more) currencies. © 2001 South-Western, a division of Thomson Learning

24. Interdependent Markets: The Role of Arbitrage Triangular arbitrage ensures that the price of a foreign currency is the same whether it is purchased directly--in a single foreign exchange market--or indirectly, by buying and selling a third currency. © 2001 South-Western, a division of Thomson Learning

25. Government Intervention in Foreign Exchange Markets Managed FloatManaged Float Fixed Exchange RatesFixed Exchange Rates The EuroThe Euro © 2001 South-Western, a division of Thomson Learning

26. Government Intervention in Foreign Exchange Markets Managed Float A policy of frequent central bank intervention to move the exchange rate. © 2001 South-Western, a division of Thomson Learning

27. Government Intervention in Foreign Exchange Markets Under a managed float, a country’s central bank actively manages its exchange rate, buying its own currency to prevent depreciations and selling its own currency to prevent appreciations. © 2001 South-Western, a division of Thomson Learning

28. Government Intervention in Foreign Exchange Markets Fixed Exchange Rate A government-declared exchange rate maintained by central bank intervention in the foreign exchange market. © 2001 South-Western, a division of Thomson Learning

29. Government Intervention in Foreign Exchange Markets When a country fixes its exchange rate below the equilibrium value, the result is an excess demand for the country’s currency. To maintain the fixed rate, the country’s central bank must sell enough of its own currency to eliminate the excess demand. © 2001 South-Western, a division of Thomson Learning

30. Government Intervention in Foreign Exchange Markets When a country fixes its exchange rate above the equilibrium value, the result is an excess supply of the country’s currency. To maintain the fixed rate, the country’s central bank must buy enough of its own currency to eliminate the excess supply. © 2001 South-Western, a division of Thomson Learning

31. Government Intervention in Foreign Exchange Markets Devaluation A change in the exchange rate from a higher fixed rate to a lower fixed rate. © 2001 South-Western, a division of Thomson Learning

32. Government Intervention in Foreign Exchange Markets A foreign currency crisis arises when people no longer believe that a country can maintain a fixed exchange rate above the equilibrium rate. As a consequence, the supply of the currency increases, demand for it decreases, and the country must use up its reserves of dollars and other key currencies even faster in order to maintain the fixed rate. © 2001 South-Western, a division of Thomson Learning

33. Government Intervention in Foreign Exchange Markets Optimum Currency Area A region whose economies perform better with a single currency than with separate national currencies. © 2001 South-Western, a division of Thomson Learning

34. Exchange Rates and the Macroeconomy Exchange Rates and Spending ShocksExchange Rates and Spending Shocks Exchange Rates and Monetary PolicyExchange Rates and Monetary Policy © 2001 South-Western, a division of Thomson Learning

35. Exchange Rates and the Macroeconomy A depreciation of the dollar causes net exports to rise--a positive spending shock that increases real GDP in the short run. An appreciation of the dollar causes net exports to drop--a negative spending shock that decreases real GDP in the short run. © 2001 South-Western, a division of Thomson Learning

36. Exchange Rates and the Macroeconomy Monetary policy has a stronger effect when we include the impact on exchange rates and net exports, rather than just the impact on interest- sensitive consumption and investment spending. © 2001 South-Western, a division of Thomson Learning