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Chapter 15 Exchange Rates and the Open Economy Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–1 Chapter 15: Exchange Rates and the Open Economy • • • • • • • 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 PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–2 Nominal Exchange Rate (NER) • • • • • 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–3 TWI for the AUD 15–4 Flexible vs Fixed Rates • Flexible: NER determined in free markets • Fixed: NER influenced by RBA intervention Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–5 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 PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–7 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–8 LOP Holds for Gold, Oil etc. • • • • Homogeneous Traded electronically Title passes instantaneously Buyers need not take physical delivery, so no time lags and no transport costs Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–9 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–10 Purchasing Power Parity (PPP) • • • • 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 PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–12 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–14 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–16 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–21 Monetary Policy and the NER • Monetary tightening will raise interest rates • Increased demand for AUD • Forex value of AUD rises Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–22 Shift in Demand for AUD 15–23 The Rise of AUD in 2003 • • • • • 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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) Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–29 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–30 Monetary Policy With Free NER • • • • • • • Assume inflation RBA raises interest rates AD falls AUD also appreciates AD falls Inflation controlled Free exchange rates make monetary policy more potent Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–31 Monetary Policy with Fixed NER • • • • • Assume inflation RBA raises interest rates AUD appreciates RBA lowers interest rates to prevent appreciation Monetary policy ineffective with fixed NER Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–32 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) Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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? Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–37 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 Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 15–38 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 by Bernanke, Olekalns and Frank 15–39