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Slide 17 - 0 Exchange Rates and the Open Economy Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 1 Dealing with Foreign Currency Translating the value of foreign money into dollars is a problem every international traveler faces Exchanges rates The rates at which one country’s money trades for another They may change unpredictably Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 2 Importance of Exchange Rates Exchange rates make a difference in the following Competitiveness of U.S. exports Prices Americans pay for imported goods Value of financial investments made across borders Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 3 Trade Involves Currency Trade in goods, services, and assets within a nation normally involves a single currency Trade between nations usually involves dealing in different currencies American manufacturers want to be paid in dollars South Korean manufacturers want to be paid in won Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 4 Nominal Exchange Rates Nominal exchange rate The rate at which one national currency trades for another Suppose one U.S. dollar can be exchanged for 110 Japanese yen The exchange rate is 110 yen/dollar e = 110 yen/dollar Can be equivalently expressed either as The amount of foreign currency needed to purchase one dollar The number of dollars needed to purchase one unit of the foreign currency They are simply reciprocal Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 5 Changes in Value Exchange rates can also be expressed as an average of its values against other major currencies Appreciation An increase in the value of a currency relative to other currencies An increase in e Depreciation A decrease in the value of a currency relative to other currencies A decrease in e Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 6 Fig. 17.1 The U.S. Nominal Exchange Rate, 1973-2000 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 7 Flexible 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 AKA Floating exchange rate Varies according to the supply and demand for the currency Foreign exchange market The market on which currencies of various nations are traded for one another Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 8 Fixed Exchange Rates Fixed exchange rate An exchange rate whose value is set by official government policy Argentina fixes their currency to the U.S. dollar Under the gold standard, currency values were fixed in terms of ounces of gold Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 9 Comparing Prices U.S made computer costs $2,400 Similar Japanese computer costs 242,000 yen e = 110 yen/dollar Measure prices of both computers in terms of the same currency Convert the Japanese computer’s price into dollars Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 10 Comparing Prices The Japanese computer is a better deal U.S. computer costs $2,400 The value of a dollar in terms of yen is just the yen-dollar exchange rate: price in yen price in dollars value of dollar in terms of yen yen to dollar exchange rate price in dollars price of yen yen110 / $1 price in dollars $2,200 yen242,000 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 11 Competitiveness The price of the U.S. good relative to the price of the foreign good is $2,400/$2,200 = 1.09 U.S. computer is 9% more expensive than the Japanese computer Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 12 Real Exchange Rates Real exchange rate The price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency There are important implications for the ability to sell its exports abroad Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 13 Defining the Real Interest Rate e equals the nominal exchange rate The number of units of foreign currency per dollar P equals the domestic price level Pf equals the foreign price level We can compare P and Pf if we convert one into a common currency To convert foreign prices into dollars: Divide the foreign price by the exchange rate Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 14 Formula for the Real Interest Rate Price of domestic good Real exchange rate price of foreign good , in$ Real exchange rate P P f e Real exchange rate eP Pf Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 15 Checking the Real Price of Computers ( yen 110 / $1) $2400 Real exchange rate yen 242,000 yen 264,000 Real exchange rate yen 242,000 Real exchange rate 109 . Confirms the earlier result Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 16 Net Exports and Real Exchange Rates High real exchange rate implies Domestic producers will have difficulty exporting to to other countries Foreign goods will sell well in the home country Net exports will tend to be low when the real exchange rate is high Net exports will tend to be high when the real exchange rate is low Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 17 Real and Nominal Exchange Rates Real exchange rate tends to move in the same direction as the nominal exchange rate e Net exports will be Hurt with a high nominal exchange rate Helped by a low nominal exchange rate Real exchange rate eP Pf Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 18 Determination of Flexible Exchange Rates 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 price of a bushel of wheat should be the same in Bombay, India and Sydney, Australia Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 19 Purchasing Power Parity Purchasing power parity PPP The theory nominal exchange rates are determined as necessary for the law of one price to hold The currencies of countries that experience significant inflation tend to depreciate Inflation implies a nation’s currency is losing purchasing power in domestic and international markets Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 20 Fig. 17.2 Inflation and Currency Depreciation in South America, 1992-1999 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 21 Shortcomings of PPP PPP works Well long-run movements in exchange rates Explains why countries with high inflation tend to have exchange rate depreciation Law of one price works well for standardized commodities traded widely Less well in short-run movements in exchange rates Not all goods and services are traded internationally High transportation costs Not all goods and services are standardized commodities Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 22 Supply and Demand and Exchange Rates Supply and demand analysis is More useful than PPP when studying short-run behavior of exchange rates Dollars are demanded in the foreign exchange market by Foreigners wanting to purchase U.S. goods and assets Dollars are supplied in the foreign exchange market by U.S. residents wanting foreign currencies to buy foreign products Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 23 Supply of Dollars U.S. households supply dollars in the foreign exchange market To purchase foreign goods and services To buy a Japanese car To purchase foreign assets To buy a Japanese government bond Upward-sloping supply of dollars The more yen each dollar can buy, the cheaper those goods, services, and assets Americans buying more Japanese products need to trade more dollars for yen Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 24 Demand for Dollars Demanders of dollars in the yen-dollar market mainly Japanese households and firms wanting to buy U.S. goods and services U.S. assets Downward sloping The more yen a Japanese citizen must pay to get one dollar, the more expensive U.S. goods, services, and assets Japanese buying less American products need to trade fewer yen for dollars Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 17.3 Slide 17 - 25 The Supply and Demand for Dollars in the yen-dollar Market Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 26 Equilibrium Value of the Dollar Fundamental value of the exchange rate [Equilibrium exchange rate] The exchange rate that equates the quantities of the currency supplied and demanded in the foreign exchange market Flexible or floating exchange rates Exchange rates that are determined by the forces of supply and demand in the foreign exchange market Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 27 Changing Supply of Dollars The supply of dollars increases when There’s increased preference for Japanese goods U.S. real GDP increases Real interest rate on Japanese assets increases The supply of dollars decreases when There’s lower demand for Japanese goods U.S. real GDP decreases Real interest rate on Japanese assets falls Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 17.4 Slide 17 - 28 An Increase in the Supply of Dollars Lowers the Value of the Dollar Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 29 Monetary Policy and Exchange Rates Monetary policy affects the exchange rate mainly through Its effect on the real interest rate r Tighter monetary policy Raises domestic U.S. real interest rate r U.S. assets are more attractive Increases the demand for dollars Increases the exchange rate (i.e., the dollar has appreciated) Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Fig. 17.5 Slide 17 - 30 A Tightening of Monetary Policy Strengthens the Dollar Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 31 Another Fed Tool Open economies with flexible exchange rates provide Another tool for monetary policy Monetary policy is more effective in an open economy with a flexible exchange rate Suppose the Fed is worried about inflation and imposes a tighter monetary policy. It Increases the value of a dollar Reduces the cost of imported goods Imports increase Increases the cost of domestic goods Exports decrease Causes aggregate demand (AD) to fall Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 32 Fixed Exchange Rates Important for small or developing nations Ability to use monetary policy as a stabilization tool is greatly reduced A fixed exchange rate is determined by the government Usually set in terms of a major currency One-to-one with the dollar Relative to a “basket” of currencies Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 33 Revaluation and Devaluation Revaluation An increase in the official value of a currency in a fixed-exchange-rate system Devaluation A reduction in the official value of a currency in a fixed-exchange-rate system Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 34 Overvalued and Undervalued 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 International reserves Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 35 Fig. 17.6 An Overvalued Exchange Rate Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 36 Balance-of-Payments Balance-of-payments deficit The net decline in a country’s stock of international reserves over a year Balance-of-payments surplus The net increase in country’s stock of international reserves over a year Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 37 Speculative Attacks Speculative attacks A massive selling of domestic currency assets by financial investors Investors fear an overvalued currency will soon be devalued Often turn out to be the cause of devaluation Ends a government’s attempts to maintain an overvalued exchange rate Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 38 Fig. 17.7 A Speculative Attack on the Peso Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 39 Monetary Policy and Fixed Exchange Rates No way to maintain a fixed exchange rate above its fundamental value for extended periods Changing the fundamental value will eliminate the overvaluation problem Most effective way to change the fundamental value is through monetary policy Tighter monetary policy increases real interest rate Increasing demand for domestic currency raises the fundamental value Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 40 Fig. 17.8 A Tightening of Monetary Policy Eliminates an Overvaluation Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 41 Use of Stabilization Monetary Policy Monetary policy can be used to keep the fundamental value of the exchange rate equal to the official value However, then monetary policy is no longer available for stabilizing the domestic economy Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 42 One or the Other During a recession due to insufficient demand, at the same time the exchange rate is overvalued To solve the recession Central bank could lower real interest rate to increase spending and output To solve the overvaluation Central bank could raise the real interest rate Monetary policy cannot solve both problems at once Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Slide 17 - 43 Fixed or Flexible? Flexible exchange rate Strengthens the impact of monetary policy Large economies should nearly always employ flexible exchange rates Fixed exchange rate Prevents stabilization policy Small economies don’t lose much when fixing their exchange rates If all countries had fixed rates Less uncertainty about the future is reduced Fixed exchange rates are not guaranteed forever Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
