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Open-Economy
Macroeconomics: The
Balance of Payments
and Exchange Rates
20 Part 2
CHAPTER OUTLINE
The Open Economy with Flexible Exchange Rates
The Market for Foreign Exchange
Factors That Affect Exchange Rates
The Effects of Exchange Rates on the Economy
An Interdependent World Economy
Appendix: World Monetary Systems Since 1900
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Exchange Rate
When people in countries with different currencies buy from and sell to each
other, an exchange of currencies must also take place.
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Appreciation and Depreciation
appreciation of a currency The rise in value of one currency relative to
another.
depreciation of a currency The fall in value of one currency relative to
another
E ↓  Home currency appreciates and foreign currency depreciates.
Similarly,
E ↑  Home currency depreciates and foreign currency appreciates.
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The Open Economy with Flexible/Floating Exchange Rates
floating, or market-determined, exchange rates Exchange rates that are
determined by the unregulated forces of supply and demand.
The Market for Foreign Exchange
foreign exchange All currencies other than the home currency of a given
country.
The Supply of and Demand for USD (Home Currency is Baht)
Governments, private citizens, banks, and corporations exchange USD for
Baht, and Baht for USD every day.
Those who demand/buy USD are holders of Baht seeking to exchange them for
USD.
Those who supply/sell USD are holders of USD seeking to exchange them for
Baht.
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Some Buyers and Sellers in International Exchange Markets: US and Thailand
The Demand for USD
1. Firms, households, or governments that import US goods into Thailand or want to
buy US-made goods and services (IMPORTS—Buy US goods)
2. Thai citizens traveling to/in US (Buy US scenery)
3. Holders of Baht who want to buy US stocks or bonds (Buy US assets)
4. Thai companies that want to invest in US (Buy US factories)
5. Speculators who anticipate a decline in the value of Baht relative to USD (Buy
US currency)
The Supply of USD
1. Firms, households, or governments that export Thai goods into US or want to buy
Thailand-made goods and services (EXPORTS—Sell Thai goods to US)
2. US citizens traveling to or in Thailand (Sell Thai scenery to US)
3. Holders of USD who want to buy Thai stocks or bonds (Sell Thai assets to US)
4. US companies that want to invest in Thailand (Sell Thai factories to US)
5. Speculators who anticipate a rise in the value of Baht relative to USD
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Price of USD
(Baht/USD)
Price of USD
(Baht/USD)
USD
USD
FIGURE20.2
20.2 The
TheDemand
Demand for
for USD in
FIGURE
the Foreign Exchange Market (Thai
Pounds
in the Foreign Exchange Market
Imports)
When
falls,
Whenthe
theprice
priceofofpounds
USD falls,
USmade goodsgoods
and services
appear
British-made
and services
less expensive
to Thaito
buyers.
appear
less expensive
U.S.
If US prices are constant, Thai
buyers.
buyers prices
will buyare
more
US goods
and
If British
constant,
U.S.
services
quantity
ofgoods
USD
buyers
willand
buythe
more
British
demanded
and
serviceswill
andrise.
the quantity of
pounds demanded will rise.
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FIGURE
20.3
Supply
of of
USD
in the in
FIGURE
20.3The
The
Supply
Pounds
Foreign Exchange Market (Thai Exports)
the Foreign Exchange Market
When the price of USD rises,
When the can
priceobtain
of pounds
rises,for
the
Americans
more Baht
British
can obtain more dollars for
each
USD.
eachmeans
pound.that Thailand-made
This
This means
that U.S.-made
goods
goods
and services
appear less
and services
appear
less expensive
expensive
to US
buyers.
Thus,
the quantity
to British
buyers. of USD supplied
isThus,
likelythe
to rise
with the
exchange
quantity
of pounds
rate.
supplied is likely to rise with the
exchange rate.
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 FIGURE 20.4 The Equilibrium
Exchange Rate
When exchange rates are allowed to
float, they are determined by the forces
of supply and demand.
An excess demand for USD will cause
the USD to appreciate against the
Baht.
An excess supply of USD will lead to a
depreciating USD.
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Factors That Affect Exchange Rates
The Law of One Price
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Factors That Affect Exchange Rates
Purchasing Power Parity
A high rate of inflation in one country relative to another puts pressure on the
exchange rate between the two countries, and there is a general tendency for
the currencies of relatively high-inflation countries to depreciate.
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 FIGURE 20.5 Exchange Rates
Respond to Changes in Relative Prices
The higher price level in Thailand
makes imports relatively less
expensive.
Thai citizens are likely to increase
their spending on imports from US,
shifting the demand for USD to the
right, from D0 to D1.
At the same time, Americans see
Thai goods getting more expensive
and reduce their demand for
exports from Thailand.
The supply of USD shifts to the left,
from S0 to S1.
The result is an increase in the
price of USD.
The USD appreciates, and the Baht
is worth less.
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Relative Interest Rates
 FIGURE 20.6 Exchange Rates Respond
to Changes in Relative Interest Rates
If Thailand’s interest rates rise relative
to US interest rates, US citizens
holding USD may be attracted into the
Thai securities market.
To buy bonds/assets in Thailand,
American buyers must exchange USD
for Baht.
The supply of USD shifts to the right,
from S0 to S1.
However, Thai citizens are less likely to
be interested in US securities because
interest rates are higher at home.
The demand for USD shifts to the left,
from D0 to D1.
The result is a depreciated USD and a
stronger Baht.
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Exchange Rates and the Balance of Trade: The J Curve
J-curve effect Following a currency depreciation, a country’s balance of trade
may get worse before it gets better. The graph showing this effect is shaped
like the letter J, hence the name J-curve effect.
 FIGURE 20.7 The Effect of a
Depreciation on the Balance of Trade
(the J Curve)
Initially, a depreciation of a country’s currency
may worsen its balance of trade.
The negative effect on the price of imports may
initially dominate the positive effects of an
increase in exports and a decrease in imports.
Baht prices of exports and imports change due
to depreciation but both quantity of exports and
imports remain unchanged as they take time to
adjust.
balance of trade (Thailand) =
Baht price of exports × quantity of exports
− Baht price of imports × quantity of imports
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Exchange Rates and Prices
The depreciation of a country’s currency tends to increase its price level.
Monetary Policy with Flexible Exchange Rates
A cheaper Baht is a good thing if the goal of the Central Bank is to stimulate the
domestic economy.
Process is described as follows.
Money supply increases Thai interest rate decreases Thai citizens want to
buy more assets in foreign countries and foreigners wants to buy less assets in
Thailand  demand for USD increases and supply of USD decreases 
exchange rate increases  Baht depreciates  Exports increase and imports
decrease  AD shifts to the right.
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REVIEW TERMS AND CONCEPTS
appreciation of a currency
marginal propensity to import (MPM)
balance of payments
net exports of goods and services (EX − IM)
balance of trade
price feedback effect
balance on capital account
purchasing-power-parity theory
balance on current account
trade deficit
depreciation of a currency
trade feedback effect
exchange rate
Planned aggregate expenditure in an open
economy:
floating, or market-determined,
exchange rates
AE ≡ C + I + G + EX − IM
foreign exchange
Open-economy multiplier =
J-curve effect
1
1  ( MPC  MPM )
law of one price
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