Download Fixed exchange rate - McGraw Hill Higher Education

Chapter 25: Exchange
Rates and the Open
Economy
©2012 The McGraw-Hill Companies, All Rights Reserved
1
Learning Objectives
1. Define the nominal exchange rate and apply the
terms appreciation and depreciation to movements in
the nominal exchange rate
2. Use supply and demand to analyze how the nominal
exchange rate is determined in the short run
3. Distinguish between flexible exchange rates and
fixed exchange rates, and discuss the advantages
and disadvantages of each system
4. Define the real exchange rate and show it is related
to the prices of goods across pairs of countries
5. Understand the law of one price and apply the
purchasing power parity theory of exchange rates
to long-run exchange rate determination.
©2012 The McGraw-Hill Companies, All Rights Reserved
2
Exchange Rates
 Domestic purchases are made with local
currency
 Purchases
of goods abroad requires converting
your local currency to their local currency

The exchange rate is the price for that transaction
 Exchange rates are set in the foreign exchange
market, with a small number of exceptions
 Rates
are determined by supply and demand
 Affect the value of imported goods and the costs
of foreign investment

Changes in exchange rates can have a significant effect
on most economies
©2012 The McGraw-Hill Companies, All Rights Reserved
3
Nominal Exchange Rates
The nominal exchange rate is the rate
at which two currencies can be traded for
each other
©2012 The McGraw-Hill Companies, All Rights Reserved
4
Nominal Exchange Rates
 Domestic
/ foreign currency
©2012 The McGraw-Hill Companies, All Rights Reserved
5
Nominal Exchange Rates
 Foreign
/ domestic currency
©2012 The McGraw-Hill Companies, All Rights Reserved
6
Nominal Exchange Rates
 Suppose that you need to find the exchange rate
between the British pound and the Canadian dollar
 The table tells us that we can purchase one UAE
dirham for 0.2647 Canadian dollars
 It also tells us that we can buy one UAE dirham for
0.1673 British pound
0.2647 Canadian dollars = 0.1673 British pound
1 Canadian dollar = 0.1673/0.2647 = 0.6320 British pounds
1 British pound = 0.2647/0.1673 = 1.5821 Canadian dollars
©2012 The McGraw-Hill Companies, All Rights Reserved
7
The Nominal Effective Exchange Rate for
Morocco and the UAE, 1975–2010
The Nominal Effective Exchange Rate expresses the value of a currency as an average of
its values against other major currencies.
©2012 The McGraw-Hill Companies, All Rights Reserved
8
Changes in Exchange Rates
 Appreciation is an increase in the value of a
currency relative to other currencies
 Example:
the nominal effective exchange rate
(NEER) for the Moroccan dirham was 100 in 2005
(base year) and 102.5 in 2009.

The Moroccan dirham appreciated by 2.5 percent
against other currencies between 2005 and 2009.
 Depreciation is a decrease in the value of a
currency relative to other currencies
 Example:
the NEER for the UAE was 100 in 2005
and 96.62 in 2009.

The UAE dirham depreciated by 3.38 percent against
other currencies.
©2012 The McGraw-Hill Companies, All Rights Reserved
9
Exchange Rates
Definition
e
= the number of units of foreign currency
that the domestic currency will buy


Example, e is the number of Japanese yen you can
buy with 1 UAE dirham
e is the nominal exchange rate
Domestic currency appreciates if e
increases
Domestic currency depreciates if e
decreases
©2012 The McGraw-Hill Companies, All Rights Reserved
10
Exchange Rate Strategies
 Foreign exchange market is the market on
which currencies of various nations are traded
 Flexible exchange rate is a system that sets
the exchange rate according to demand and
supply of a country's currency
 Fixed exchange rate is an exchange rate set
by official government policy
 Can
be set independently or by agreement with a
number of other governments
 Fixed rates can be set relative to the dollar, the
euro, or even gold
©2012 The McGraw-Hill Companies, All Rights Reserved
11
Flexible Exchange Rate in the Short Run
Exchange rates are set by supply and
demand in the foreign exchange market
US supplies dollars to buy foreign exchange
to buy foreign goods or foreign assets
 Not
the same as the money supply controlled
by the central bank
 Supply of dollars in the foreign exchange
market is the number of dollars offered for
sale for a given foreign currency
©2012 The McGraw-Hill Companies, All Rights Reserved
12
A Supply and Demand Analysis
 To date, about 60 percent of the world’s
foreign currency reserves are in U.S. dollars,
followed by about 26 percent in euros
 This illustrates the importance and influence
of the dollar in world markets
 In this section, we analyze the foreign
exchange market and discuss the factors that
affect the supply of and demand for dollars,
and thus the U.S. dollar exchange rate
©2012 The McGraw-Hill Companies, All Rights Reserved
13
A Supply and Demand Analysis: The Supply of
Dollars
 Anyone who holds dollars is a potential supplier

US households and firms are the most common suppliers
 In 2010, emerging and developing economies controlled
about 66 percent of total foreign exchange holdings and
45 percent of U.S. dollar holdings.
 Supply curve has a positive slope

The more foreign currency per dollar, the larger the
quantity of dollars supplied

This makes foreign goods cheaper
 When $1 = ¥ 100, a ¥ 5,000 item costs $50


If $1 = ¥ 200, that same ¥ 5,000 item costs $25
When the dollar appreciates, quantity of dollars supplied
increases
©2012 The McGraw-Hill Companies, All Rights Reserved
14
A Supply and Demand Analysis: The Demand
of Dollars
 Anyone who holds yen can demand dollars
 Japanese
households and firms are the most
common demanders
 Demand curve has a negative slope
 The
more foreign currency per dollar, the smaller
the quantity of dollars demanded

This makes US goods more expensive
 When $1 = ¥ 100, a $30 item costs ¥ 3,000
 If
$1 = ¥ 200, that same $30 item costs ¥ 6,000
 When the dollar appreciates, quantity of dollars
demanded decreases
©2012 The McGraw-Hill Companies, All Rights Reserved
15
The Dollar – Yen Market
Dollar appreciates
Market for Dollars
Yen/dollar exchange rate
 Market equilibrium
equates the number of
dollars supplied and the
number demanded at an
exchange rate, e*
 Dollar appreciates if the
exchange rate exceeds e*
 Dollar depreciates if the
exchange rate is less than
e*
Supply
of dollars
e*
Demand for
dollars
Q*
Quantity of dollars
©2012 The McGraw-Hill Companies, All Rights Reserved
16
Changes in the Supply of Dollars
 Supply of dollars for Japanese yen is
determined by
 The

 US

preference for Japanese goods
The stronger the preference, the greater the supply of
dollars
real GDP
The higher GDP, the greater the supply of dollars
 Real
interest rate on Japanese assets and the real
interest rate on US assets

Supply of dollars will be greater if
• Real interest rate on Japanese assets are higher
• Real interest rate on US assets is lower
©2012 The McGraw-Hill Companies, All Rights Reserved
17
Changes in the Demand of Dollars
 Demand for dollars by holders of yen is
determined by
 The

The stronger the preference, the greater the demand
for dollars
 Real

preference for goods denominated in dollars
GDP in Japan
The higher GDP, the greater the demand for dollars
 Real
interest rate on Japanese assets and real
interest rate on US assets

Supply of dollars will be greater if
• Real interest rate on Japanese assets are lower
• Real interest rate on US assets is higher
©2012 The McGraw-Hill Companies, All Rights Reserved
18
An Increase in the Supply of Dollars
S
Yen / dollar exchange rate
 Initial equilibrium at E
 Suppose consumers prefer the
new video game system made
in Japan
 Shift in preferences
 Increase in the supply of dollars
shifts dollar supply curve to the
right
 New equilibrium at F
 Dollar depreciates to e*'
 Quantity of dollars traded
increases to Q*'
S'
e*
e*'
©2012 The McGraw-Hill Companies, All Rights Reserved
E
F
D
Q* Q*'
Quantity of dollars
19
Does a Strong Currency Imply a Strong
Economy?
 A strong currency means its value is high in
terms of other countries
 A strong currency is unrelated to a strong
economy
 Strong currencies reduce net exports
 UAE
Dirham strengthens against Euro
 European goods are cheaper and UAE goods are
more expensive, so European NX increases and
UAE NX declines
 NX affects spending and aggregate demand
©2012 The McGraw-Hill Companies, All Rights Reserved
20
Monetary Policy and The Exchange Rate
Monetary policy affects interest rates which
affect the exchange rate
 Tighter
Turkish monetary policy, leading to a
higher real interest rate
 Higher interest rates make Turkish assets
more attractive than foreign assets

Demand for the Lira increases by foreigners
• Demand curve shifts to the right

Supply of Lira by Turkey decreases
• Supply curve shifts to the left
 Lira
appreciates
©2012 The McGraw-Hill Companies, All Rights Reserved
21
Tighter Monetary Policy
S'
Yen / Lira exchange rate
 Higher real interest rates
in Turkey increase
demand for Lira and
decrease supply
 Lira appreciates
 Change in quantity of Lira
traded depends on
 Size of shifts in demand
and supply
 Slopes of supply and
demand
F
e
*'
S
E
e
*
©2012 The McGraw-Hill Companies, All Rights Reserved
D'
D
Quantity of Lira
22
The Exchange Rate As A Tool of Monetary
Policy
 Flexible exchange rates make monetary policy
more effective
 When
the central bank tightens money, it sets off
a chain of domestic events
r
 And
r
C, IP
PAE 
Y
a chain of international events
e*
NX 
PAE 
Y
 Monetary policy is more effective in an open
economy with flexible exchange rates
©2012 The McGraw-Hill Companies, All Rights Reserved
23
Fixed Exchange Rates
Most large industrial countries use a flexible
exchange rate
 Small
and developing countries may use fixed
exchange rate
Fixed exchange rates greatly reduce the
effectiveness of monetary policy as a
stabilization tool
©2012 The McGraw-Hill Companies, All Rights Reserved
24
How to Fix An Exchange Rate
 To establish a fixed exchange rate system, the
government states the value of its currency in
terms of a major currency
 May
use an average of the currencies of its major
trading partners
 Government attempts to maintain fixed
exchange rate at its existing level
 The government may change the value of its
currency in response to market events
 Devaluation
is a reduction in the official value
 Revaluation is an increase in the official value
 Analogous to depreciation and appreciation
©2012 The McGraw-Hill Companies, All Rights Reserved
25
Selected Countries with a Fixed Exchange
Rate Regime
©2012 The McGraw-Hill Companies, All Rights Reserved
26
An Overvalued Exchange Rate
 The
dinar is overvalued,
when its fixed value is
greater than its eq. value
 If the dinar's official value
were less than the eq., it
would be undervalued
Supply
of dinars
Dollar/dinar exchange rate
 Persabia's exchange rate
is pegged at $0.125 = 1
dinar
 The qt. of dinar supplied
QB is greater than the qt.
demanded QA
The eq. rate for the dinar
is $0.10 = 1 dinar
0.125
A
Official
value
Equilibrium
value
0.100
©2012 The McGraw-Hill Companies, All Rights Reserved
B
Demand for
dinars
QA
QB
Quantity of dinars
27
Fixed Exchange Rates
 The government of Persabia has a problem:
there is an excess supply of dinar at the fixed
exchange rate
 Government options
1.
Devalue the currency to $0.10 = 1 dinar

2.
Impose trade barriers to reduce the supply of
dinars



3.
Devaluation is reluctantly used with fixed exchange
rates – defeats the idea of fixed exchange rates
Limit the amount of imports or make them costly
Prohibit purchase of foreign assets
Limits the efficient functioning of markets
Sell dollars to buy dinars – if it holds dollars
©2012 The McGraw-Hill Companies, All Rights Reserved
28
Fixed Exchange Rate and Overvalued
Currency
 To defend the fixed exchange rate at $0.125 = 1
dinar, the government could buy dinars for dollars
Purchase (QB – QA) each period
 The central bank holds
international reserves,
supplies of foreign
currencies, to use to
defend the dinar's value

Over time, reserves will
decrease and the dinar's
value will be costly to
defend
Dollar/dinar exchange rate

Supply
of dinars
A
0.125
0.100
©2012 The McGraw-Hill Companies, All Rights Reserved
B
Official
value
Equilibrium
value
Demand
for dinars
QA
QB
Quantity of dinars
29
International Reserves and Balance of
Payments
 Balance-of-payments deficit is the net decline in
a country's stock of international reserves in a year

A balance-of-payments surplus is the net increase
in a country's stock of international reserves in a year
 Suppose Persabia faces the following conditions in
the foreign exchange market
Demand: QPD = 25,000 – 5,000 e
Supply: QPS = 17,600 + 24,000 e
 The government set e = 0.125 so
Balance of


QPD = 25,000 – 5,000 (0.125) = 18,750
QPS = 17,600 + 24,000 (0.125) = 20,600
©2012 The McGraw-Hill Companies, All Rights Reserved
payments
deficit is
1,850 dinars
30
Equilibrium Exchange Rates
Demand: QPD = 25,000 – 5,000 e
Supply: QPS = 17,600 + 24,000 e
Equilibrium exchange rate equates the
quantity of dinars demanded and the
quantity of dinars supplied
25,000 – 50,000 e* = 17,600 + 24,000 e*
7,400 = 74,000 e
e* = 0.10
©2012 The McGraw-Hill Companies, All Rights Reserved
31
Monetary Policy and The Fixed Exchange
Rates
 Fixed rates cannot remain overvalued indefinitely
 Tightening the money supply can eliminate the
overvalued currency



Tighter money increases real interest rates
Demand for the dinar
increases and supply
of dinars decrease
New equilibrium is
0.125
at F
Equilibrium exchange
0.100
rate is at the official
value
Dollar/dinar exchange rate

©2012 The McGraw-Hill Companies, All Rights Reserved
S'
S
Official
value
F
E
D'
D
Quantity of dinars
32
Monetary Policy and Fixed Exchange Rates
 Monetary policy can be used to set the fundamental
value of the exchange rate equal to the official value

In this case, monetary policy is no longer available for
stabilizing the domestic economy
 Suppose the economy has a recessionary gap at the
same time that the currency is overvalued


Recessionary gap remedy is a lower interest rate
Overvalued currency remedy is a higher interest rate
 Limiting monetary policy as a stabilization tool is a
strong argument against fixed exchange rates
©2012 The McGraw-Hill Companies, All Rights Reserved
33
Dollar Peg in the GCC and Monetary Policy
Can GCC member countries vary their
interest rates as a monetary policy tool?
 Short
answer: No.
 Long answer: Interest rates in countries that
maintain a dollar peg must be set in
coordination with the U.S. Federal Reserve.

This prevents the excessive flow of currencies
(from arbitrage), which could threaten the dollar
peg
©2012 The McGraw-Hill Companies, All Rights Reserved
34
Policy Mistakes and the Great Depression
 Tariffs were imposed in 1930, with other
countries increasing their tariffs in retaliation
 Virtual
collapse of international trade
 Money supply decreased sharply between
1929 and 1933
 Interest
rates increased and stock market crashed
 Fed let banks fail to weed out the weak
 The government also erred in exchange rate
policy
©2012 The McGraw-Hill Companies, All Rights Reserved
35
Policy Mistakes and the Great Depression
 Most of the world was on the gold standard
 All
countries set a local currency value for an
ounce of gold
 This effectively sets fixed exchange rates for one
currency in terms of the others
 U.S. Congress pressed the Fed to ease
monetary policy to dampen the Great
Depression
 With
the fixed exchange rate policy, the Fed
feared an increase in the money supply would lead
to a speculative attack on the dollar
©2012 The McGraw-Hill Companies, All Rights Reserved
36
Policy Mistakes and the Great Depression
The Fed put greater emphasis on the gold
standard than on stabilization policy
Countries not on the gold standard and
those that abandoned it recovered faster
from the Great Depression
Beginning in 1933, FDR suspended the gold
standard as part of his recovery program
 Also
helped restore the banking system to
normal operations
 Money supply began to grow
©2012 The McGraw-Hill Companies, All Rights Reserved
37
International Monetary Fund
IMF was set up after World War II
 Original
purpose was to manage the fixed
exchange rate system
 IMF would loan countries reserves to maintain
their fixed exchange rates at official values
 Fixed exchange rate system ended in 1973
IMF's new mission is to make loans to
developing countries
 Helped
fight the currency slumps of Mexico
(1994) and East Asia (1997 – 1998)
©2012 The McGraw-Hill Companies, All Rights Reserved
38
International Monetary Fund
IMF critiques
 Conditions
attached to loans set target money
supply growth, size of government sector, etc.

Some argue that these policies are not always
constructive
 Loans
help the highest income group in the
country receiving the loan
 World Bank and IMF have conflicting programs

World Bank makes loans to help poor nation
develop while the IMF may be targeting stabilization
in the same country
©2012 The McGraw-Hill Companies, All Rights Reserved
39
Should Exchange Rates Be Fixed Or Flexible?
 Flexible exchange rates strengthen the effectiveness
of monetary policy for stabilization
 Fixed rates require the central bank to choose
between defending the currency and stabilizing the
economy
 Fixed rates can be beneficial for small economies

Argentina fought hyperinflation by valuing its dinar on
par with the dollar


Inflation quickly decreased and stayed stable for more than 10
years
Fixed exchange system broke down because unsound
domestic policies created fears that Argentina would default
on international loans
©2012 The McGraw-Hill Companies, All Rights Reserved
40
Exchange Rates, Trade, and Integration
Fixed exchange rates have benefits
 Predictability
and stability in foreign
transactions
 Certainty of future value of the currencies
However, fixed rates are not fixed forever
 Sudden
and unforeseen large changes are
possible
 Predicting exchange rates over the long term is
difficult under either fixed or flexible rates
©2012 The McGraw-Hill Companies, All Rights Reserved
41
Has Kuwait benefited from abandoning the
dollar peg?
 In 2003, Kuwait adopted the dollar peg
 Following years of persistent inflation, Kuwait
abandoned the dollar peg in 2007 in favor of
an undisclosed basket of currencies
 The Kuwaiti dinar appreciated by 4.19 percent
against the U.S. dollar between May 25, 2007
and April 13, 2011.
 Abandoning the dollar peg has resulted in
higher appreciation rates and lower
depreciation rates against major currencies for
Kuwait relative to its neighboring countries, at
least in nominal terms
©2012 The McGraw-Hill Companies, All Rights Reserved
42
Has Kuwait benefited from abandoning the
dollar peg?
©2012 The McGraw-Hill Companies, All Rights Reserved
43
The Euro: A Common Currency For Europe
 European Common Market was formed in 1957


Free trade between member countries
Fixed exchange rate system set up in the 1970s was
abandoned in 1992
 European Union was created by the Maastricht
Treaty in 1991


Agreed to work toward adopting a common currency
The euro was phased in


Began as an accounting unit
Euro currency was phased in and local currency phased out in
11 member countries
©2012 The McGraw-Hill Companies, All Rights Reserved
44
The Euro: A Common Currency For Europe
Countries with a single currency must have
a common monetary policy
 The
European Central Bank became the
central bank for the euro countries
Countries sacrifice some control to be part
of the euro
 Economic
conditions vary between countries
and the central bank cannot respond to each

Slow growth in Germany and rapid growth in
Ireland
©2012 The McGraw-Hill Companies, All Rights Reserved
45
Real Exchange Rate – An Example
 Choose between an Egyptian computer and a
comparable Japanese computer, based on price



Egyptian computer costs 2,400 pounds
Japanese computer costs ¥ 24,200
1 pound = ¥ 11
 The Japanese computer cost is
¥ 24,200 / (¥ 11/1 pound) or 2,200 pounds

The Japanese computer is cheaper
 The relative price of the Egyptian computer to the
Japanese computer is
2,400 pounds / 2,200 pounds= 1.09

Egyptian computer costs 9% more than the Japanese one
©2012 The McGraw-Hill Companies, All Rights Reserved
46
Real Exchange Rates
 In the short run, domestic prices of goods are
fixed
 In
the long run, this assumption is relaxed
 Real exchange rate is the price of the
average domestic good relative to the price of
the average foreign good
 Prices
are expressed in a common currency
 The exchange rate, e, is the number of units of
foreign currency per pound
 To
convert a foreign price to the pound price,
divide Pf by e
Pf / e = ¥ 24,200 / (¥ 11/1 pound) = 2,200 pounds
©2012 The McGraw-Hill Companies, All Rights Reserved
47
Real Exchange Rates
Price of domestic good
Real exchange rate =
Price of foreign good in pounds
Real exchange rate =
P
Pf / e
(P) (e)
Real exchange rate =
Pf
(2,400 pounds) (¥ 11 / 1 pound)
Real exchange rate =
¥24,200
Real exchange rate = 1.09
©2012 The McGraw-Hill Companies, All Rights Reserved
48
Real Exchange Rate
 In our example, the real exchange rate of 1.09
meant the Egyptian computer is more
expensive than the Japanese computer
 In the general case, the real exchange rate
uses an average price of all goods and services
in both countries
 If
the real exchange rate is high, domestic goods
are expensive relative to foreign goods

Net exports will tend to be low when the real exchange
rate is high
 An increase in e increases the real exchange
rate if P and Pf are constant
©2012 The McGraw-Hill Companies, All Rights Reserved
49
Law of One Price
 The law of one price is that the price of an
internationally traded commodity must be the
same in all locations
 Assumes
transportation costs are relatively small
 Suppose wheat in Amman, Jordan was half the
price of wheat in Bombay, India
 Buy
wheat in Amman, increasing demand and price
 Sell wheat in Bombay, increasing supply and
decreasing the price
 The law of one price implies that real
exchange rates prevail in the long run
©2012 The McGraw-Hill Companies, All Rights Reserved
50
Purchasing Power Parity (PPP)
Purchasing power parity is the theory that
nominal exchange rates are determined as
necessary for the law of one price to hold
 In
the long run, the currencies of countries
that experience significant inflation will tend to
depreciate
©2012 The McGraw-Hill Companies, All Rights Reserved
51
PPP – An Example
 A bushel of grain costs
5
Jordanian dinars in Jordan and
 150 Rupees in Bombay
 For the price of the bushel of grain to be the same
in both countries, the implied nominal exchange
rate is Dinar 1 = Rs 30
 Suppose that India experiences inflation and
the bushel of grain now costs Rs 300 in
Bombay
 The
Jordanian Dinar appreciates to Dinar 1 = Rs
60
 Price of wheat is the same in both countries
©2012 The McGraw-Hill Companies, All Rights Reserved
52
Inflation and Currency Depreciation
in South America, 1995-2004
©2012 The McGraw-Hill Companies, All Rights Reserved
53
Shortcomings of the PPP Theory
 Shortcomings of the PPP Theory
 The
theory predicts well in the long run but not
the short run
 Limits to the PPP Theory
 Not
all goods and services are traded
internationally

The greater the share of non-traded goods, the less
precise the PPP theory
• For example, the market for haircuts is very local
 Not
all internationally traded goods and services
are perfectly standardized commodities
©2012 The McGraw-Hill Companies, All Rights Reserved
54