Download Fixed Exchange Rates

Exchange Rates and
The Open Economy
MB
MC
MB MC
Exchange Rates

Nominal Exchange Rate

The rate at which two currencies can be
traded for each other
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 2
MB MC
Nominal Exchange Rates
for the U.S. Dollar
Country
Foreign currency/dollar
Dollar/foreign currency
United Kingdom (pound)
0.6393
1.5643
Canada (Canadian dollar)
1.5674
0.6380
Mexico (peso)
9.9850
0.1002
118.000
0.00848
1.4760
0.6775
Japan (yen)
Switzerland (Swiss franc)
South Korea (won)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
1,190.1000
Chapter 29: Exchange Rates and the Open Economy
0.00084
Slide 3
MB MC
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 4
MB MC
The U.S. Nominal
Exchange Rate, 1973-2002
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 5
MB MC
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 6
MB MC
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 currency.
 If e decreases, it is a depreciation of the
domestic currency.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 7
MB MC
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 8
MB MC
Exchange Rates

Foreign Exchange Market

The market on which currencies of various
nations are traded for one another
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 9
MB MC
Exchange Rates

Fixed Exchange Rate

An exchange rate whose value is set by
official government policy
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 10
MB MC
Exchange Rates

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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 11
MB MC
Exchange Rates

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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 12
MB MC
Exchange Rates

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
o Price in dollars = 242,000 yen/110 = $2,200
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 13
MB MC
Exchange Rates

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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 14
MB MC
Exchange Rates

Real Exchange Rate
Real Exchange Rate 
Price of domestic good (P )
Price of foreign good, in dollars (P f )
Real Exchange Rate 
P
P f /e
eP
Real Exchange Rate  f
P
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 15
MB MC
Exchange Rates

The Computer Example, revisited



E = 110/$1
P = $2,400
Pf = 242,000 yen
(110 yen/$1) x $2,400
Real Exchange Rate 
242,000 yen
264,000 yen
Real Exchange Rate 
 1.09
242,000 yen
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 16
MB MC
Exchange Rates

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.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 17
MB MC
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

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 18
MB MC
Exchange Rates

Economic Naturalist

Does a strong currency imply a strong
economy?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 19
MB MC

The Determination of the
Exchange Rate
Law of One Price

If transportation costs are relatively small,
the price of an internationally traded
commodity must be the same in all
locations
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 20
MB MC

The Determination of the
Exchange Rate
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 21
MB MC

The Determination of the
Exchange Rate
Purchasing Power Parity (PPP)

The theory that nominal exchange rates
are determined as necessary for the law of
one price to hold
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 22
MB MC

The Determination of the
Exchange Rate
Purchasing Power Parity (PPP)

In the long run, the currencies of countries
that experience significant inflation will tend
to depreciate.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 23
MB MC

The Determination of the
Exchange Rate
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 24
MB MC

The Determination of the
Exchange Rate
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 25
MB MC
Inflation and Currency Depreciation
in South America, 1995-2001
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 26
MB MC

The Determination of the
Exchange Rate
Example

Shortcomings of the PPP Theory
 The
theory has been successful in the long run
but not the short run.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 27
MB MC

The Determination of the
Exchange Rate
Example

Limits to the PPP Theory
 Not
all goods and services are traded
internationally.
o 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.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 28
MB MC
The Supply and Demand for
Dollars In The Yen-Dollar Market
Yen/dollar exchange rate
The equilibrium exchange rate
(e*) or fundamental exchange rate
equates the quantity of dollars
supplied and demanded
Supply of dollars
e*
Demand for dollars
Quantity of dollars traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 29
MB MC

The Determination of the
Exchange Rate
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 30
MB MC
An Increase In The Supply of
Dollars Lowers The Value of The Dollar
Yen/dollar exchange rate
•Increase in demand for Japanese video games
•Supply of dollars increases from S to S’
•The value of the dollar in terms of yen falls
•e* falls to e*’
S
S’
E
e*
e*’
F
D
Quantity of dollars traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 31
MB MC

The Determination of the
Exchange Rate
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 32
MB MC
A Tightening of Monetary
Policy Strengthens the Dollar
Yen/dollar exchange rate
• Tighter monetary policy raises the domestic
real interest rate
• Foreign demand for U.S. assets increase
S
e*’
E
F
• The demand for dollars rises
• Exchange rate appreciates from
e* to e*’
e*
D’
D
Quantity of dollars traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 33
MB MC

Monetary Policy and
the Exchange Rate
Economic Naturalist

Why did the dollar appreciate nearly 50
percent in the first half of the 1980s?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 34
MB MC

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.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 35
MB MC
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.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 36
MB MC
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)
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 37
MB MC
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
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 38
MB MC
An Overvalued Exchange Rate
Dollar/peso exchange rate
• The peso’s official value is greater than the
fundamental value; the peso is overvalued
• To maintain the value, the government must
purchase a quantity of pesos (A-B)
Supply of pesos
0.125 dollar/
peso
A
B
Official value
Fundamental value
0.10 dollar/
peso
Demand for pesos
Quantity of pesos traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 39
MB MC
Fixed Exchange Rates

How to Fix an Exchange Rate

Responses to an overvalued currency
 Devalue
the currency
 Impose trade barriers
 Purchase the currency
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 40
MB MC
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.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 41
MB MC
Fixed Exchange Rates

How to Fix an Exchange Rate
To purchase its own currency, a country
must hold international reserves.
 A balance of payments deficit occurs when
a country has a net decline in international
reserves over a year.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 42
MB MC
Fixed Exchange Rates

How to Fix and Exchange Rate

A balance-of-payments surplus occurs
when a country has a net increase in
international reserves over a year.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 43
MB MC
Fixed Exchange Rates

Example

Latinia’s balance-of-payments deficit
 Demand
= 25,000 - 50,000e
 Supply = 17,600 - 24,000e
 Official value of the peso = 0.125 dollars
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 44
MB MC
Fixed Exchange Rates

Example

Latinia’s balance-of-payments deficit
 Fundamental
value
o 25,000 - 50,000e = 17,600 + 24,000e
 Solving
for e:
o 7,400 = 74,000e
o E = 0.10
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 45
MB MC
Fixed Exchange Rates

Example
As the official rate -- 0.125
 D = 25,000 - 50,000(0.125) = 18,750
 S = 17,600 - 24,000 (0.125) = 20,600
 Excess supply = 1,850 pesos
 Balance of payments deficit = 1,850 pesos

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 46
MB MC
Fixed Exchange Rates

Speculative Attack

A massive selling of domestic currency
assets by financial investors
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 47
MB MC
A Speculative Attack
on the Peso
• Peso overvalued at 0.125
• Central bank buys pesos
• Investors launch a speculative attack -- sell
peso dominated assets
Dollar/peso exchange rate
S
S’
0.125 dollar/
peso
A
B
C
Official value
• Supply of pesos increases
• Central bank must purchase
more pesos
0.10 dollar/
peso
D
Quantity of pesos traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 48
MB MC
Fixed Exchange Rates

Economic Naturalist

Can a speculative attack occur under
flexible exchange rates?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 49
MB MC
A Tightening of Monetary
Policy Eliminates An Overvaluation
•Pesos overvalued at 0.125
•Tightening monetary policy increases D to D’
•Official value = fundamental value
Dollar/peso exchange rate
S
F
0.125 dollar/
peso
Official value
E
0.10 dollar/
peso
D’
D
Quantity of pesos traded
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 50
MB MC
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.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 51
MB MC
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.
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 52
MB MC
Fixed Exchange Rates

Economic Naturalist

What were the causes and consequences
of the East Asian crisis of 1997-1998?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 53
MB MC
Fixed Exchange Rates

Economic Naturalist

How did policy mistakes contribute to the
Great Depression?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 54
MB MC

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.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 55
MB MC

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.

Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 56
MB MC

Should Exchange Rates Be
Fixed or Flexible?
Economic Naturalist

Why have 11 European countries adopted
a common currency?
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 29: Exchange Rates and the Open Economy
Slide 57
End of
Chapter
MB
MC