Download Chapter 15

Chapter 15
Exchange Rates and
the Open Economy
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15–1
Chapter 15: Exchange Rates and the Open
Economy
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Nominal exchange rates
The real exchange rate
Determining the exchange rate
A supply and demand analysis
Monetary policy and the exchange rate
Fixed exchange rates
Should exchange rates be fixed or flexible?
Copyright  2005 McGraw-Hill Australia Pty Ltd
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15–2
Nominal Exchange Rate (NER)
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NER = Value of the AUD = Forex/AUD
Rise in value of AUD: appreciation of AUD
Fall in value of AUD: depreciation of AUD
TWI: a weighted average of NERs
Weights are the relative importance of each
currency in Australia’s trade
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15–3
TWI for the AUD
15–4
Flexible vs Fixed Rates
• Flexible: NER determined in free markets
• Fixed: NER influenced by RBA intervention
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Real Exchange Rate (RER)
• Allows us to compare price levels in two different
countries by expressing those prices in the same
currency
• RER between AUD and JPY = [Pa x JPY/AUD] / Pj
where P refers to the average price level in the
respective countries
• Numerator is the Australian price level Pa in JPY
• Denominator is the Japanese price level Pj in JPY
Copyright  2005 McGraw-Hill Australia Pty Ltd
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15–6
Uses of the RER
• A rise in RER indicates of fall in international
competitiveness
• A fall in RER indicates a rise in international
competitiveness
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The Law of One Price (LOP)
• LOP says that for goods which are freely traded,
their price should be the same in all countries
when expressed in a common currency using the
NER between those currencies
• That is, [Pa x JPY/AUD = Pj]
• Otherwise, there is a profit to be made by buying a
commodity where it is cheaper and selling it where
it is dearer
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LOP Holds for Gold, Oil etc.
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Homogeneous
Traded electronically
Title passes instantaneously
Buyers need not take physical delivery, so no time
lags and no transport costs
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No LOP for Hamburgers/Cars
• Hamburgers not traded internationally
• Hamburgers have non-traded inputs – labour,
bread, rents – whose prices may persistently differ
between countries over the long run
• Cars are heterogeneous
• Cars traded, but physical delivery is costly and
takes time, so price differences not eliminated
immediately
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Purchasing Power Parity (PPP)
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PPP is a theory of NER
LOP says: Pa x JPY/AUD = Pj
PPP accepts LOP which implies: JPY/AUD = Pj /Pa
PPP further implies that the time rate of change of
JPY/AUD = Japanese inflation rate – Australian
inflation rate
• So if the Australian inflation rate is 3% p.a. and the
Japanese inflation rate is 1% p.a., then JPY/AUD
(the JPY value of the AUD) will fall by 2% p.a.
Copyright  2005 McGraw-Hill Australia Pty Ltd
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15–11
PPP and RER
• Assumes competitiveness (RER) remains constant
• So the currency of a high inflation country must
depreciate to keep that country competitive and its
RER at a constant level
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Inflation and Depreciation
15–13
Qualifications to PPP
• LOP does not hold for non-traded items such as
services, only freely-traded goods
• LOP does not hold for differentiated products
• LOP and PPP may not hold in the short run
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PPP, RER and Competitiveness
• According to PPP, NER changes at a rate equal to
inflation differences between trading partners
• If so, the RER and international competitiveness
remain constant
• However on occasions, a country needs to
become more, or less, competitive
• A fall in export income due to drought/ fall in export
prices necessitates Australia becoming more
competitive to replace that lost export income
• Then the AUD will fall independently of inflation
rate differences: RER falls
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15–15
The Sources of Supply of AUD
• Supply of AUD reflects demand for forex
• Sources
– imports of goods and services
– purchase of foreign assets
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The Sources of Demand for AUD
• Demand for AUD reflects supply of forex
• Sources
– exports of goods and services
– sales of Australian assets to foreigners
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15–17
Demand and Supply of AUD
15–18
Shifts in Supply of AUD
• Strengthened desire to import, resulting from
change in preferences or increased GDP
• Strengthened desire to buy foreign assets,
because of higher foreign interest rates, rents etc.
• Supply curve shifts to right, forex price of AUD falls
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15–19
Shift in Supply of AUD
15–20
Shift in Demand for AUD
• Increased export income resulting from higher
quantities and/or higher export prices resulting
from stronger preferences or higher GDP in
customer countries
• Increased sales of Australian assets to foreigners
because of higher Australian interest rates, rents
etc.
• Forex value of AUD rises
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15–21
Monetary Policy and the NER
• Monetary tightening will raise interest rates
• Increased demand for AUD
• Forex value of AUD rises
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15–22
Shift in Demand for AUD
15–23
The Rise of AUD in 2003
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Relatively high interest rates
Rise in export prices and terms of trade (TOT)
More export income and shift in demand for AUD
Rise in NER and RER and fall in competitiveness
Departure from PPP because NER changed
independently of inflation rate differences
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15–24
Relative Interest Rates in 2003
15–25
Monetary Policy and AD
• Monetary tightening raises interest rates
• Fall in C, I and AD
• Rise in value of AUD reduces competitiveness and
NX and AD
• Exchange rate effects of higher interest rates
support direct effects
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15–26
Fixing NER
• Fundamental value given by intersection of supply
and demand curves
• Official value is the target of the authorities
• If official value is higher than fundamental value
there is excess supply of AUD at official value
• If official value is less than fundamental value
there is excess demand for AUD at official value
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15–27
Fixing NER
15–28
Three Methods of Fixing NER
1. RBA directly regulates forex transactions through
foreign exchange controls – rations the available
supply of forex to approved buyers of forex
2. RBA buys forex/sells AUD or sells forex/buys AUD
3. RBA changes interest rates to change demand for
AUD, even though this may be inappropriate for
AD (see later)
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Balance of Payments (BOP)
• With free exchange rates, demand for AUD =
supply, so there is a balance in international
payments
• With fixed exchange rates, demand for AUD may
differ from supply
• Excess demand for AUD: BOP surplus
• Excess supply of AUD: BOP deficit
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Monetary Policy With Free NER
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Assume inflation
RBA raises interest rates
AD falls
AUD also appreciates
AD falls
Inflation controlled
Free exchange rates make monetary policy more
potent
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15–31
Monetary Policy with Fixed NER
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Assume inflation
RBA raises interest rates
AUD appreciates
RBA lowers interest rates to prevent appreciation
Monetary policy ineffective with fixed NER
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Speculative Attacks on Currency
• Lead to shift in demand
• Motivated by expectation that the forex value of
the currency will fall
• This expectation may be rationally based on
expectations that:
– export income will fall
– official interest rates will fall
– the central bank will be unable to keep fixing the NER
• Expectation may not be rationally based, e.g. it is
expected to fall simply because it has already
fallen. This creates instability and can lead to
financial panic (see slide 36)
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15–33
Speculative Attack
15–34
Monetary Policy Again
• Should interest rates be set with a view to
stabilising AD?
• Or should they be set with a view to NER?
• There is no virtue in a particular NER
• But there is some value in avoiding excessive
volatility in NER, which justifies the RBA smoothing
the rate of change in NER by short-run intervention
in forex markets
• Incidentally, this will generate profits for the RBA
because this stabilising role means it will be buying
the AUD when it is too low and selling when it is
too high
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15–35
Handling Financial Panics
• The RBA seeks to avoid panics by limiting NER
volatility through ‘smoothing’ of changes in NER
• Once they start, panics are driven by fear, not
reason, are difficult to stop, and create bankruptcy
• Choices
– Sky-high interest rates, which may not work and
also create bankruptcy, or
– temporary exchange controls until the panic
subsides
• What would you choose?
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15–36
Exchange Rates & Inflation
• A high-inflation country can remain internationally
competitive by simply allowing its currency to fall
with the rate of inflation
• Fixed exchange rates mean it loses its
international competitiveness and this will create
political pressure to control the rate of inflation
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Exchange Rates & Inflation (cont.)
• So if a country’s institutions and central bank make
it prone to inflation, it is less likely to end up with
hyper-inflation with fixed rates than with flexible
rates
• If not inflation-prone, flexible rates with smoothing
are better
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Exchange Rates and Shocks
• Imagine a negative [positive] shock to the
economy such as drought [break in drought] or a
fall [rise] in export prices, both of which reduce
[raise] export income
• The fall [rise] in export income will have a negative
[positive] multiplier effect on spending
• But with variable exchange rates, the currency will
fall [rise], and we will be more [less] competitive
• This will raise [lower] the value of other sources of
export income, and so reduce the impact of the
shock to the economy
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
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15–39