Download the exchange rate

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Open Economy phenomenon - Countries are
involved in economic transaction:
◦ international trade (i.e. buying and selling goods
and services)
◦ International buying and selling of physical and
financial assets
◦ International borrowing and lending
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Balance of Payment is a system of accounts,
which measures all economic transactions
between residents (Households, businesses
and governments) and foreign residents (rest
of the world)
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Any transaction that leads to a PAYMENT by a
country’s residents is a DEFICIT item,
identified by negative sign (-)
Any transaction that leads to a RECEIPT by a
country’s residents is a SURPLUS item,
identified by plus sign (+)
RULE OF THUMB: “Follow the Cash Flows”
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A Chinese tourist purchases a Jewellary item (+)
A heart patient went to U.S for his heart surgery (-)
A Saudi student gets admission in Agha Khan Medical
university to do MBBS (+)
Standard chartered in Pakistan repatriate profits to its
parent in U.S (-)
PIA buys a hotel Roosevelt in New York (-)
Pak. Government rented a building in Paris to open its
embassy (-)
A Turkish hotel hired five Pakistani waiters (+)
A Pakistani investor bought 5% shareholding in General
Motors, U.S. (-)
A Saudi refinery buys a refining unit in Pakistan (FDI) (+)
IMF gives a loan worth $ 200 million (+) on which Pakistan
will pay 10% annual interest (-)
(1)Current Account (CA)
(i) Imports and Exports of goods
(ii) Imports and exports of services
(iii) Factor Income (investment income from direct &
portfolio investment plus employee compensation)
(iv) Unilateral transfers (grants, donations, workers’
remittances)
(2)Capital and Financial Account (KFA)
(i) foreign direct investment
(ii) foreign portfolio investment
(iii) purchase and sale of assets
(3) Net Official Reserves
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If you are running a current account deficit, you
will have capital account surplus
Some economists reasoned U.S. current account
deficit to huge capital inflows from rest of the
world, mainly China and Middle east – Saving
Glut
Asian and Latin American crises of late 1990s
devastated investments and increased savings in
poor countries
These countries now started sending their
savings i.e. capital outflow towards U.S. due to its
deep and sophisticated capital markets
This cheap money from abroad gave birth to
“saving slut” which then fueled the housing
bubble.
A.
Current Account
A. Net exports/imports goods&services (Balance of Trade)
B. Net Income (investment income from direct portfolio investment
plus employee compensation
C. Net transfers (Donations, sums sent to back home by migrant
abroad)
B.
Capital and Financial Account
Capital transfers related to purchase and sale of fixed assets such as real estate
(OR opening accounts in foreign banks)
C.
D.
E.
Financial Account
A. Net foreign direct investment
B. Net portfolio investment
C. Other financial items
Basic Balance = A+B+C
Net Errors and Omissions
Overall Balance = A+B+C+D
Missing data (illegal activities) and statistical discrepencies
Reserves and Related Items
Changes in official monetary reserves including gold and foreign exchange
reserves
9
Σ (A:E) = Overall Balance
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Current Account + Capital and Financial Account = zero (if
there is no government/central bank’s intervention)
Current Account + Capital and Financial Account =
Change in Reserves (due to central bank’s intervention)
(Foreign) Reserves are assets, other than domestic money
or securities, held by central bank, to make international
payments (Foreign currencies, gold, SDRs)
Central bank can change the quantity of reserve assets by
buying or selling them in open market
Cognitive Dissonance: when reserves rise, they are a
net use of funds (you're spending money to buy reserves,
just like you spend money to buy imports) and take
a minus sign. And when you draw on your reserves they
are a net source of funds, and take a plus sign.
One way to reduce this cognitive dissonance is to look at
"Overall balance“ instead of “change in reserves” (Refer to
previous slide)
SURPLUS ITEMS
DEFICIT ITEMS
Export of merchandise
Imports of merchandise
Private and governmental gifts from foreign
residents
Private and governmental gifts to foreign
residents
Foreign use of domestically operated travel and
transportation services
Use of foreign operated travel and
transportation services
Foreign tourist expenditures in this country
U.S tourists’ expenditures abroad
Foreign military spending in this country
Military spending abroad
Interest and dividend receipts from foreign
entities
Interest and dividends paid to foreign
individuals and businesses
Sales of domestic assets to foreign residents
Purchase of foreign assets
Funds deposited in this country by foreign
residents
Funds placed in foreign depository institutions
Sales of gold to foreign residents
Purchases of gold from foreign resident
Sales of domestic currency to foreign residents
Purchase of foreign currency
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Capital and Financial Account is a measure of capital
inflows i.e. foreign savings that are available to finance
domestic investment spending
Determinants of capital inflows:
◦ Excess savings are “exported” from countries where it is
cheap/abundant to countries where it would be needed/expensive
(i.e. interest rate consideration)
◦ Capital moves quickly to rapidly growing economies as these
economies offer high returns to investors (e.g. flow of capital from
Britain and EU to Argentina, Australia, Canada and U.S. from
1870-1914, known as golden age of capital flows)
◦ Two-way capital flows:
 Big individual investors often seek to diversify against risk by buying
stocks in number of countries
 Big corporations make strategic business decisions to buy and operate
in different countries
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Capital Flight: transfer by bearer (smuggling),, money
laundering (Swiss bank accounts, tax heavens, offshore
zones)
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Capital and Financial account signifies the
differences in the supply of loanable funds
from savings and the demand for loanable
funds for investment lead to capital flows
Current account signifies the international
difference in supply and demand of goods
and services
What ensures that two accounts actually
offset each other (CA – CFA = Zero):
EXCHANGE RATE
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BOP shows surplus:
◦ D > S for that currency.
◦ Allow currency value to increase,
◦ Or accumulate foreign reserves.
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BOP shows deficit:
◦ S > D for that currency.
◦ Devalue currency,
◦ Or use official reserves to support currency.
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Goods, services, and assets produced in a country
must be paid for in that country’s currency
Occasionally, sellers will accept payment in foreign
currency, but they will then exchange that currency
for domestic money
International transactions, then, require a market,
foreign exchange market, in which currencies can be
exchanged for each other
This market determines exchange rates, the prices at
which currencies trade
This market is not located in one geographical spot –
it is global electronic market that traders around the
world use to buy and sell currencies
U.S. Dollars
Yen
Euros
1 U.S. $ exchanged for
1
76.6850
0.7412
1 Yen exchanged for
0.0130
1
0.0097
1 Euro exchanged for
1.3492
103.4596
1
• There are two ways to write any given exchange rate: $ 1 can be
exchanged for 76.6850 Yen OR 1 Yen can be exchanged for 0.0130.
• There is no fixed rule – mostly, people tend to express the exchange
rate as the price of a dollar in domestic currency.
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When discussing movements in exchange rates,
economists use specialized terms to avoid
confusion.
When a currency becomes more valuable in
terms of other currencies, currency appreciates
When a currency becomes less valuable in terms
of other currencies, currency depreciates
For example, value of 1 euro went from 1 dollar
to 1.25 dollars, which means that value of 1
dollar went from 1 Euro to 0.80 Euros
(1/1.25=0.80).
In this case, we would say that euro appreciated
and dollar depreciated
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Movements in exchange rates affect the relative price of
goods, services and assets in different countries.
For example, price of a hotel room in U.S. is $ 100 and
price of a hotel room in a France is € 100.
If exchange rate is $1=€1, these rooms have same price
If exchange rate is $1=€1.25, French room is cheaper than
American room (100/1.25=$80)
If exchange rate is $1=€0.80, French room is expansive
than American room (100/0.80=$125)
Local example: USD-PKR exchange rate is $1=Rs. 105.
price of Pakistani cotton shirt @ Rs. 1000 bought by an
American would cost him (1000/105=$9.50)
USD-PKR exchange rate reduces to $1=Rs. 98. price of
Pakistani cotton shirt @ Rs. 1000 bought by an American
would cost him (1000/98=$10.20)
What determines exchange rates? Supply and Demand in
exchange rate markets
DEMAND: If dollar appreciates, number of Euros needed to buy dollar rise
so demand for dollar falls (as Europeans will buy less from U.S).
If dollar depreciates, less Euros will be needed to buy dollars, so demand
for dollars will increase
SUPPLY: if dollar appreciates, European products look cheap to
Americans, who will demand more for them. This will require more
dollars to be converted into Euros i.e. supply of dollars increases
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The foreign exchange market matches up the
demand for a currency from foreigners who want
to buy domestic goods, services, and assets with
the supply of a currency from domestic residents
who want to buy foreign goods, services, and
assets.
In previous figure, the equilibrium in the market
for dollars is at point E, corresponding to an
equilibrium exchange rate of €0.95 per $1.00.
The equilibrium exchange rate is the exchange
rate at which the quantity of a currency
demanded in the foreign exchange market is
equal to the quantity supplied.
At equilibrium exchange rate, total quantity of U.S $ Europeans want to
buy is equal to the total quantity of U.S $ Americans want to sell.
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Capital flows from Europe to U.S increases, for some
reason
This is resulted in increased demand for U.S $ in
FOREX market because European investors convert
Euros into dollar to fund their investment in U.S.
As a result, U.S $ appreciates against Euro
IN BOP, this rise in KFA (surplus) must be matched by
a decline in CA (deficit)
What caused decline in CA? Appreciation of U.S $: rise
in number of Euros per dollar leads American to buy
more European goods and services and Europeans to
buy fewer American goods and services
Thus, movements in exchange rate ensures that
changes in CA and KFA offsets each other
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To take account of the effects of differences in inflation
rates, economists calculate real exchange rates.
Real exchange rates are exchange rates adjusted for
international differences in aggregate price levels.
In 1993, $1 exchanged for 3.1 Mexican Pesos
In 2011, $1 exchanged for 12.4 Mexican Pesos i.e. peso
depreciated by 75%
Did price of Mexican products expressed in terms of $
also declined by 75%.
No, because Mexico had much higher inflation than U.S.
over these years
So, let PUS and PMex be indexes of aggregate price level in
U.S and Mexico.
Real Exchange rate = Mexican Pesos per U.S. $ × PUS /PMex
To distinguish, exchange rates unadjusted for aggregate
price levels (just like we were talking till now) is called
Nominal Exchange Rate
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Peso depreciates against $, with exchange rate going
from 10pesos/$ to 15 peso/$ i.e. a 50% change
Prices of everything in Mexico, measured in pesos,
also increased by 50%, so Mexican price index went
from 100 to 150
Prices of everything in U.S. remains same, so U.S
price index remains at 100
Peso per $ before depreciation × PUS /Pmex
 10 × 100/100 = 10
Peso per $ after depreciation × PUS /Pmex
 15 × 100/150 = 10
Peso depreciated substantially in terms of $, but real
exchange rate remain unchanged, if it is adjusted
against aggregate price level
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USD-PKR exchange rate went from $1=Rs. 80 to $1=Rs.
100 i.e. 25% depreciation of PKR
Aggregate price level in Pakistan rises by 15% whereas
aggregate price level in U.S rises by 5%
PKR per $ before depreciation × PUS /Ppak
 80 × 100/100 = 90
PKR per $ after depreciation × PUS /Ppak
 100 × 105/115 = 91
PKR depreciated substantially in terms of $ (25%), but real
exchange rate remain unchanged, if it is adjusted against
aggregate price levels in both countries
Thus, country’s products become cheaper/expensive to
foreigners
only
when
country’s
currency
depreciates/appreciates in real terms
As a result, economists who are analyzing movements in
exports and imports of goods and services focus on real
exchange rate, not the nominal exchange rate
Between 1990 and 2007, the price of a dollar in Mexican pesos
increased dramatically. But because Mexico had higher inflation
than the United States, the real exchange rate, which measures the
relative price of Mexican goods and services, ended up roughly
where it started.
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The purchasing power parity between two countries’
currencies is the nominal exchange rate at which a
given basket of goods and services would cost the
same amount in each country.
For example, a basket of goods and services that
costs $100 in U.S costs 1,000 Pesos in Mexico
PPP is 10 Pesos per $ i.e. at this exchange rate, 1000
Pesos = 100 dollars, so the market basket costs same
both countries
PPP is estimated for buying cost of a broad market
basket, from automobiles to groceries to houses.
The Economist, once every year, publishes a list of
PPP based on cost of buying a market basket which
contains only one item – McDonald’s Big Mac
Country
Big Mac Price
In local
currency
Local Currency per $
In U.S. $
Implied
PPP
Actual
Exchange
rate
India
Rupee 84.0
1.6642
20.7
50.475
China
Yuan 14.7
2.289
3.6
6.422
Mexico
Peso 32.00
2.2988
7.87
13.9205
Britain
£ 2.39
3.7233
0.59
0.6419
U.S.
$4.07
4.07
-
1
Japan
¥320
4.2503
78.7
77.103
EU
€3.44
4.6032
0.85
0.74
Brazil
Real 9.50
5.1271
2.34
1.8529
Switzerland
SFr 6.5
7.1539
1.6
0.9086
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The Big Mac index looks at the price of a Big Mac in
local currency and computes the following:
◦ the price of a Big Mac in U.S. dollars using the prevailing
exchange rate.
◦ the exchange rate at which the price of a Big Mac would
equal the U.S. price.
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If purchasing power parity held, the dollar price of
a Big Mac would be the same everywhere – which is
not the case shown in previous Table.
PPP = price of good ‘A’ in currency 1/price of good
‘A’ in currency 2 (e.g. 84 Indian rupees / $4.7 = 20
PPP)
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Nominal exchange rates are almost always
different from PPP.
Some of these differences are systematic: in
general, aggregate price levels are lower in poor
than in rich countries because services tend to be
cheaper in poor countries
But even among countries at roughly same level
of economic development, nominal exchange
rates vary quite a lot from PPP.
Comparison of PPP and Nominal exchange rate
between Canadian dollar and US $ from 1990 to
2011
The purchasing power parity between US and Canada—the exchange rate
at which a basket of goods and services would have cost the same
amount in both countries—changed very little over the period shown,
staying near C$1.20 per US$1. But the nominal exchange rate fluctuated
widely.
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Does exchange rate matter for business decisions? And
How?
Why were European automakers, such as Volvo and
BMW, flocking to America?
To some extent because they were being offered special
incentives.
But the big factor was the exchange rate.
In the early 2000s one euro was, on average, worth less
than a dollar; by the summer of 2008 the exchange rate
was around €1 = $1.50.
This change in the exchange rate made it substantially
cheaper for European car manufacturers to produce in
the United States than at home.
Automobile manufacturing wasn’t the only U.S industry
benefiting from weak $ - across the board, U.S exports
surged after 2006 while imports fell
After a long period of decline, US net exports—exports minus
imports—increased sharply after 2006 as the dollar depreciated
against other major currencies, making US-produced goods more
attractive to foreign buyers.
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Exchange Rate is the price of a country’s money,
in terms of another country’s money
Nominal exchange rate is very important price for
many countries as it determines price of imports
and exports
Economies where imports and exports are large
percentages of GDP, movements in exchange rate
can have major impact on aggregate output and
price level
What governments do with their power to
influence this price? ….it depends
At different times and in different places,
governments have adopted a variety of exchange
rate regimes.
An exchange rate regime is a rule governing policy
toward the exchange rate.
 There are two main kinds of exchange rate regimes:
1. A country has a fixed exchange rate when the
government keeps the exchange rate against some
other currency at or near a particular target. E.g.
Hong Kong has an official policy of setting an
exchange rate @ HK$7.80 per 1 U.S.$
2. A country has a floating exchange rate when the
government lets the exchange rate go wherever the
market takes it. E.g. Britain, Canada, U.S. follows
floating exchange rate regime
3. Fixed and Floating are not the only possibilities: At
various times, countries adopted compromise policies
that lie somewhere between fixed and floating
exchange rates. Such regime is known as “managed
float” or “dirty float”.
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Exchange rates are fixed at any given time
but are adjusted frequently OR
Exchange rates that are not fixed but are
“managed” by the government to avoid wide
swings OR
Exchange rates that float within a “target
zone” but are prevented from leaving that
zone.
We’ll elaborate only fixed and floating.
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How it is possible for governments to fix the
exchange rate when the exchange rate is
determined by supply and demand?
Let’s consider a hypothetical country,
Genovie, which fixed its currency, Geno for
U.S $ 1.50
Obvious problem is that U.S $ 1.50 per Geno
may not be equilibrium exchange rate; it
might be either below or above equilibrium
exchange rate
In both panels the imaginary country of Genovia is trying to keep the
value of its currency, the geno, fixed at US$1.50.
In panel (a), there is a surplus of genos on the foreign exchange
market. To keep the geno from falling, the Genovian government can
buy genos and sell U.S. dollars. In panel (b), there is a shortage of
genos. To keep the geno from rising, the Genovian government can sell
genos and buy U.S. dollars.
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There are three mechanisms through which
governments/central banks try to maintain
fixed exchange rate regime:
1. Exchange market intervention
2. Changing Monetary Policy
3. Foreign exchange controls
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One way to keep geno at fixed rate is to buy and sell
currencies
Government purchases or sales of currency in the
foreign exchange market are exchange market
interventions.
To buy genos in FOREX market, Genovian government
must have US $ to exchange for genos
Thus, most countries maintain Foreign exchange
reserves which are the stocks of foreign currency that
governments maintain to buy their own currency on
the foreign exchange market.
Recall capital flows in BOP, now we can see why
governments sell foreign assets: they are supporting
their currency through exchange market intervention
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Governments try to shift supply and demand
curves for their currencies in FOREX market
Government usually do this by changing the
monetary policy
For example, to support PKR, SBP might increase
interest rate. This will increase capital inflows
into Pakistan, increasing the demand for PKR.
At the same time, it reduces capital flows out of
Pakistan, reducing the supply of PKR.
So, other things equal, an increase in country’s
interest rate will increase the value of its currency
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A government can support its currency by
reducing its supply in FOREX market.
It can do so by requiring residents who want to
buy foreign currency to get a license
They give license only to those people who
engage in approved transactions e.g. purchase of
imported goods that government thinks are
essential
Foreign exchange controls are licensing systems
that limit the right of individuals to buy foreign
currency.
Other things equal, foreign exchange controls
increase the value of a country’s currency
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We discussed a situation when government is trying
to prevent a depreciation of its currency.
Instead, if equilibrium exchange rate is above the
target or fixed exchange rate (panel b on slide 39),
there is shortage of local currency
Thus, government will apply same three mechanisms
in reverse direction:
1.Forex Market intervention to sell its currency and to
acquire US $ which it can add to its foreign exchange
reserves
2. Reduction of interest rates to increase supply of its
currency and reduce the demand
3. Imposition of foreign exchange controls that limit
the ability of foreigners to buy local currency
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Choice of exchange rates regime poses a dilemma for
policy makers, because fixed and floating exchange
rates each have both advantages and disadvantages
Uncertainty about value of our goods/services/assets
in terms of foreign currencies has deterring effect on
trade between countries. So one benefit of fixed
exchange rate is certainty about future value of a
currency
Thus, there are economic payoffs to stable exchange
rates, but the policies used to fix the exchange rate
have costs.
◦ Exchange market intervention requires large reserves on
hand, usually a low-return investment
◦ Foreign exchange controls, like quotas and tariffs, distort
incentives for importing and exporting goods and services
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If monetary policy is used to help fix the exchange
rate, it isn’t available to use for domestic policy
(particularly, price stability and inflation control)
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Should a country let its currency float, which
leaves
monetary
policy
available
for
macroeconomic
stabilization
BUT
creates
uncertainty for businesses? OR
Should it fix the exchange rate, which eliminates
the uncertainty but means giving up monetary
policy, adopting exchange controls, or both?
Different countries reach different conclusions at
different times: most of European economies,
except Britain, which do most of their trade with
each other, believe that exchange rate should be
fixed (transition towards Euro) whereas Canada is
satisfied with floating exchange regime despite
of most of its trade with U.S.
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China’s spectacular success as an exporter led to a
rising surplus on current account.
At the same time, non-Chinese private investors
became increasingly eager to shift funds into
China, to take advantage of its growing domestic
economy.
As a result of the current account surplus and
private capital inflows, at the target exchange rate,
the demand for Yuan exceeded the supply.
To keep the rate fixed, China had to engage in
large-scale exchange market intervention—selling
Yuan, buying up other countries’ currencies (mainly
U.S. dollars) on the foreign exchange market, and
adding them to its reserves.
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The fact that modern economies are open to
international trade and capital flows adds a
new level of complication to analysis of
macroeconomic policy
Let’s look at three policy issues raised by
open-economy macroeconomics:
1. devaluation and revaluation of fixed
exchange rates
2. monetary policy under floating exchange
rates
3. international business cycles
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Historically, fixed exchange rates haven’t been
permanent; some countries switch to floating
regime AND some countries change target rate
from time to time
A devaluation is a reduction in the value of a
currency that previously had a fixed exchange
rate – a devaluation is a depreciation that is due
to a revision in a fixed exchange rte target
◦ Devaluation makes domestic goods cheaper in terms of
foreign currency, which leads to higher exports.
◦ Devaluation makes foreign goods expansive in terms of
domestic currency, which reduces imports
◦ Thus, net effect of devaluation is to increase the BOP on
CA
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A revaluation is an increase in the value of a
currency that previously had a fixed exchange
rate.
◦ Revaluation makes domestic goods more expensive
in terms of foreign currency, which reduces exports
◦ Revaluation makes foreign goods cheaper in terms
of domestic currency, which increases imports
◦ Thus, net effect of revaluation is to reduce the BOP
on CA
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Devaluation and Revaluation serves two purposes
under fixed exchange rates:
◦ They can be used to eliminate shortage or surpluses in
the FOREX market. E.g. economists and politicians
around the world were urging china to revalue Yuan as
they believed that China’s fixed exchange rate policy
unfairly aided Chinese exports (subsidizing effect of
devaluation)
◦ Devaluation and revaluation can be used as
macroeconomic policy tools.
 Devaluation, by increasing exports and reducing imports,
increased aggregate demand – fill the recessionary gap i.e.
aggregate output < potential output
 Revaluation, by reducing exports and increasing imports,
reduces aggregate demand – eliminate inflationary gap i.e.
aggregate output > potential output
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Under floating exchange rates, expansionary
monetary policy works in part through the
exchange rate:
◦ Reduction in domestic interest rate leads foreigner to
have less incentive to move funds into your country and
residents have more incentive to move funds out of
country due to low interest rates
◦ As a result, they want to exchange more local currency
for U.S $, so supply of local currency increased which
leads to depreciation
◦ Depreciation of local currency result in higher exports
and lower imports, which increases aggregate demand.
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Contractionary monetary policy has the reverse
effect.
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The fact that one country’s imports are another country’s
exports creates a link between the business cycle in
different countries.
However, extent of this link depends on exchange rate
regime:
 Recession in U.S reduces demand for Canadian exports.
 Reduction in foreign demand for Canadian goods and services is also a
reduction in demand for Canadian dollar in FOREX market
 In case of fixed regime, Canada might respond to this decline with
exchange market interventions
 In case of floating regime, Canadian dollar will depreciate
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Such depreciation, under floating regime, makes Canadian
goods cheaper to foreigners, and foreign goods expensive
for Canadians - leading to increase in exports and
decrease in imports.
Both effects limit the decline in aggregate demand
compared to what it would have been under a fixed regime
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One of the virtues of floating exchange rate is
that they help insulate countries from recessions
originating abroad.
This theory looked pretty goods in early 2000s:
Britain, with floating exchange rate, managed to
stay out of a recession that affected rest of
Europe.
However, GFC of 2007-08 that began in U.S. led
to a recession in virtually every country.
International linkages among financial markets
were much stronger than any insulation from
overseas disturbances provided by floating
exchange rate.
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Lecture
Lecture
Lecture
Lecture
5
6
7
8
(Slides and chapter 5)
(slides)
(slides and chapter 7)
(slides and chapter 8, 9 & 11)