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C h a p t e r 1 4 Exchange Rates and Their Determination: A Basic Model To accompany International Economics, 3e by Sawyer/Sprinkle PowerPoint slides created by Jeff Heyl Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER ORGANIZATION • • • • • • • • Introduction Exchange Rates The Demand for Foreign Exchange The Supply of Foreign Exchange Equilibrium in the Foreign Exchange Market Changes in the Equilibrium Exchange Rate Exchange Rate Volatility and International Trade Summary Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 2 INTRODUCTION • The international value of a country’s currency has • • • become an inescapable part of the daily flow of economic information Most people don’t have a clear understanding of why the exchange rate matters and what causes it to change Why does the supply and demand model work for foreign exchange? What do economists know about the effects of exchange-rate volatility on international markets? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 3 EXCHANGE RATES • Exchange rates are the price of one country’s • • • • currency in terms of another Demand for foreign currency comes from demand for foreign goods and services Demand for foreign currency relative to supply of foreign currency determines the exchange rate An increase in the value of a currency is referred to as appreciation A decrease in the value of a currency is referred to as depreciation Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 4 EXCHANGE RATES • The way exchange rates are reported can create • • • some confusion Quoting as domestic currency per unit of foreign currency is a direct quote Quoting as units of foreign currency per unit of domestic currency as an indirect quote Each country has its own conventions concerning how the exchange rate is reported for each foreign currency Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 5 EXCHANGE RATES • In the spot market transactions are concluded at • the same time the price is agreed on The percentage appreciation or depreciation of the spot rate over time using direct quotes can be measured using beginning rate ending rate %Δ in Spot Rate 100 begining rate Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 6 EXCHANGE RATES • A rise in the exchange rate means the domestic • currency has depreciated If the exchange rate falls the domestic currency has appreciated Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 7 EXCHANGE RATES Figure 14.1(a) Foreign Exchange Rates of the U.S. Dollar U.S. Dollars per Canadian Dollar 0.95 – 0.90 – 0.85 – 0.80 – 0.75 – 0.70 – 0.65 – 0.60 – 1980 1983 1986 1989 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1992 1995 1998 2001 2004 14 – 8 EXCHANGE RATES Figure 14.1(b) Foreign Exchange Rates of the U.S. Dollar U.S. Dollars per Japanese Yen 0.012 – 0.010 – 0.008 – 0.006 – 0.004 – 0.002 – 1980 1983 1986 1989 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1992 1995 1998 2001 2004 14 – 9 EXCHANGE RATES Figure 14.1(c) Foreign Exchange Rates of the U.S. Dollar U.S. Dollars per UK Pound 2.4 – 2.2 – 2.0 – 1.8 – 1.6 – 1.4 – 1.2 – 1.0 – 1980 1983 1986 1989 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1992 1995 1998 2001 2004 14 – 10 EXCHANGE RATES Figure 14.1(d) Foreign Exchange Rates of the U.S. Dollar U.S. Dollars per Euro 1.4 – 1.3 – 1.2 – 1.1 – 1.0 – 0.9 – 0.8 – 1999 2000 2001 2002 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 2003 2004 2005 2006 14 – 11 THE DEMAND FOR FOREIGN EXCHANGE • The demand for foreign exchange is a result of • • domestic residents demanding foreign goods and services The exchange rate is price of foreign exchange As the exchange rate changes, the quantity demanded of foreign goods and services will change Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 12 THE DEMAND FOR FOREIGN EXCHANGE Figure 14.2 The Demand for Foreign Exchange $/Pounds $3 A B $2 C $1 Demand for Pounds (D) £1 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall £2 £3 Pounds 14 – 13 THE DEMAND FOR FOREIGN EXCHANGE • Shifts in the Demand for Foreign Exchange • Changes in the demand for foreign exchange are • related to the income level, the relative price levels, and tastes and preferences The most important factors are changes in income and prices relative to the foreign country Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 14 THE DEMAND FOR FOREIGN EXCHANGE • Changes in Domestic Income • As U.S. income increases, demand for all goods • • including imports increases This leads to an increase in the demand for foreign currency and a shift in the demand curve to the right If income declines, the effect will be the opposite and the demand curve will shift to the left Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 15 THE DEMAND FOR FOREIGN EXCHANGE Figure 14.3 The Change in Demand for Foreign Exchange $/Pounds D’ D” D Pounds Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 16 THE DEMAND FOR FOREIGN EXCHANGE • Changes in Relative Prices • A change in the relative prices between countries • • will change or shift the demand curve If the prices for goods rise in a foreign country and the exchange rate did not change, then prices of those foreign goods would ride in the U.S. as well If the demand curve for foreign currency shifts to the left, less of the foreign currency is demanded at a given exchange rate Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 17 THE DEMAND FOR FOREIGN EXCHANGE • In practice, price level changes in a country are not • • • so discrete Most countries experience a continuous change in prices as measured by the inflation rate Thus the discussion of relative prices changes and their impact on demand for foreign currency can be generalized to relative inflation rates between countries Countries with high levels of inflation tend to experience increases in demand for foreign goods and foreign exchange Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 18 THE DEMAND FOR FOREIGN EXCHANGE Figure 14.4 U.S. Trade Balance and GDP Growth Differential Percent Index, March 1973 = 100 0– – 1.5 –50 – – 1.0 Trade Balance –100 – – 0.5 –150 – – –200 – – –0.5 –250 – – –1.0 –300 – – –1.5 –350 – – –2.0 –400 – – –2.5 –450 – – –3.0 1992 1995 1998 2001 0 2004 GDP Growth Differential (Foreign minus U.S.) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 19 THE SUPPLY OF FOREIGN EXCHANGE • Supply of Foreign Exchange • The supply in the foreign exchange in the • • foreign exchange market is determined by the demand for foreign goods in a domestic market Demand for foreign goods is influenced by the exchange rate and as the exchange rate increases, the quantity of currency supplied to the foreign exchange market increases The amount of currency supplied to the foreign exchange market depends on the foreign demand for imported goods Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 20 THE SUPPLY OF FOREIGN EXCHANGE Figure 14.5 The Supply for Foreign Exchange $/Pounds Supply of Pounds (S) $3 F $2 E $1 D £1 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall £2 £3 Pounds 14 – 21 THE SUPPLY OF FOREIGN EXCHANGE • Shifts in the Supply of Foreign Exchange • There are two important factors that shift the • supply of foreign exchange Changes in Foreign Income • If foreign income rises, demand for imported goods increases • As a result, more foreign currency is sold in the foreign exchange market and the supply of foreign currency increases Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 22 THE SUPPLY OF FOREIGN EXCHANGE • Changes in Relative Prices • If domestic prices rise relative to foreign prices, • demand for imports will rise This will cause a right shift in the supply curve for foreign exchange Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 23 THE SUPPLY OF FOREIGN EXCHANGE Figure 14.6 The Change in Supply for Foreign Exchange $/Pounds S” S S’ Pounds Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 24 EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET • The equilibrium exchange rate occurs when the • • quantity demanded of foreign exchange equals the quantity supplied Because exchange rates fluctuate over the course of a trading day, a precise equilibrium would only be achieved if everything else remained constant However, exchange rates move very quickly as economic conditions and expectations change Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 25 EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET Figure 14.7 The Equilibrium Exchange Rate $/Pounds Supply of Pounds (S) $3 $2 E $1 Demand for Pounds (D) £1 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Pounds 14 – 26 CHANGES IN THE EQUILIBRIUM EXCHANGE RATE • If U.S. incomes increase, the demand for imports • • • in the U.S. will increase which will cause an increase in the demand for foreign exchange If supply is held constant, the exchange rate will increase If U.S. inflation is greater than a foreign inflation rate, demand for foreign exchange will increase as consumers demand less expensive foreign goods The supply of foreign currency to the market falls as U.S. goods have become relatively more expensive Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 27 CHANGES IN THE EQUILIBRIUM EXCHANGE RATE • The exchange rate attempts to correct for changes • • • • in relative prices between countries Countries with relatively high inflation rates will tend to have currencies that depreciate over time Countries with relatively low inflation rates will tend to have currencies that appreciate over time Depreciation is the market’s way of compensating for differential rates of inflation Many combinations of factors could occur leading to a very large number of possible changes to the equilibrium exchange rate Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 28 CHANGES IN THE EQUILIBRIUM EXCHANGE RATE Figure 14.8 Changes in the Equilibrium Exchange Rate $/Pounds S $3 F $2 E $1 D’ D £0 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall £1 Pounds 14 – 29 CHANGES IN THE EQUILIBRIUM EXCHANGE RATE Table 14.1 The Impact of Changes in the Demand and Supply of Foreign Exchange and the Equilibrium Exchange Rate Changes in Determinant Changes in the DollarPound Exchange Rate Changes in the Value of the U.S. Dollar Increase in U.K. Demand for U.S. Exports Decreases Appreciation Decrease in U.K. Demand for U.S. Exports Increases Depreciation Increase in U.S. Demand for U.K. Exports Increases Depreciation Decrease in U.S. Demand for U.K. Exports Decreases Appreciation Increase in U.S. Prices Increases Depreciation Decrease in U.S. Prices Decreases Appreciation Increase in U.K. Prices Decreases Appreciation Decrease in U.K. Prices Increases Depreciation Increase in U.S. Incomes Increases Depreciation Decrease in U.S. Incomes Decreases Appreciation Increase in U.K. Incomes Decreases Appreciation Decrease in U.K. Incomes Increases Depreciation Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 30 EXCHANGE RATE VOLATILITY AND INTERNATIONAL TRADE • Changes in exchange rates make international • • • trade different from interregional trade within a large country In the short run, changes can be partially mitigated through use of forward or futures markets for foreign exchange The reduction of risk can be purchased only at some additional cost Changes in the exchange rate are difficult to forecast in the long run Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 31 EXCHANGE RATE VOLATILITY AND INTERNATIONAL TRADE • Risk and uncertainty depress international trade • • • • and investment However, the magnitude of effect is not known This creates a bias toward domestic transactions if exchange rates are allowed to fluctuate in response to changes in the factors that determine them Forecasting exchange rate changes is a difficult exercise A forecast should consider at least changes in the two countries’ GDP and price levels Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 32 EXCHANGE RATE VOLATILITY AND INTERNATIONAL TRADE • There are many other factors that influence • • exchange rates Long run forecasts based on pronounced trends might be reasonably accurate Short run forecasts are especially difficult and could misforecast the exchange rate by a considerable margin Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 33 SUMMARY 1. The exchange rate is the price of one country’s currency in terms of another country’s currency 2. Appreciation of the domestic currency is a decrease in the number of units of domestic currency necessary to buy a unit of foreign currency 3. The demand for foreign exchange is related to changes in domestic income and changes in relative prices Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 34 SUMMARY 4. The supply of foreign exchange is related to changes in foreign income and changes in foreign prices 5. The interaction of the supply and demand for foreign exchange determines the equilibrium exchange rate in a free market 6. Everything else equal, a country that has faster economic growth than its trading partners will tend to find that its currency is depreciating in the foreign exchange market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 35 SUMMARY 7. A country that has higher inflation than its trading partners will tend to find that the value of its currency is depreciating in the foreign exchange market 8. Fluctuations in the exchange rate tend to depress the amount of international trade in goods and services relative to domestic trade in goods and services Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 – 36