Download chapt 13 Exchange rate

Chapter 13
Open Economy Macroeconomics
Exchange Rate
The Nominal Exchange Rate

The nominal exchange rate (or just the exchange
rate) tells us the rate at which two currencies trade.



In our theory, we will find it convenient to assume that
there are just two countries.
We will think of the U.S. as the home country; the second
country is simply “the foreign country” (the rest of the
world).
The exchange rate will be defined as the value of
the dollar, or the price of a dollar in terms of the
foreign currency; for example, .85 Euro/$.
Definitions of Exchange Rates

Exchange rates are quoted as foreign currency per unit
of domestic currency or domestic currency per unit of
foreign currency.



Exchange rates allow us to denominate the cost or price
of a good or service in a common currency.


14-3
How much can be exchanged for one dollar? ¥89.40/$
How much can be exchanged for one yen? $0.011185/¥
How much does a Nissan cost? ¥2,500,000
Or, ¥2,500,000 x $0.011185/¥ = $27,962.50
Flexible and Fixed Exchange
Rates


Exchange rates between the dollar and other
currencies normally fluctuate, just as other
prices fluctuate in response to demand and
supply conditions
We will later see that it is possible for
countries to fix the rate at which currencies
trade (and some countries do fix their
exchange rate to another country’s currency)
Real Exchange Rates
How many unit of the foreign good can I get in exchange for one unit of my
domestic good (Relative prices)




We are often interested in the rate at which
domestic and foreign goods trade, not just the rate
at which currencies trade.
For simplicity, suppose that there is one domestic
output, called Cadillacs, and that there is one
foreign output, called Mercedes.
Suppose that the price of a Cadillac is $30,000. The
price of a Mercedes is €36,000. Also, suppose that
the nominal exchange rate is .8 €/$.
What is the price of a Cadillac in terms of
Mercedes? (Answer: 2/3 Mercedes)
Real Exchange Rates (Defined)



The real exchange rate is defined below
Using it with the data from the previous slide,
we illustrate its calculation
What are the units?

Mercedes/Cadillac
enom P
e
PFor
0.8  30, 000 2
e

36, 000
3
If the real exchange rate
rises …

If the real exchange rate rises, it takes more
Mercedes to buy a Cadillac, so domestic
goods are more expensive – this will affect
imports and exports
With Many Goods


In the real world, countries produce many goods
In this context, we can still define a real exchange
rate:
enom P
e
PFor

Now we would substitute price indices for domestic
and foreign price levels
Some Terminology
Depreciation and Appreciation

14-10
Depreciation is a decrease in the value of a
currency relative to another currency.

A depreciated currency is less valuable (less
expensive) and therefore can be exchanged for
(can buy) a smaller amount of foreign currency.

$1/€ → $1.20/€ means that the dollar has
depreciated relative to the euro. It now takes
$1.20 to buy one euro, so that the dollar is less
valuable.

The euro has appreciated relative to the dollar:
it is now more valuable.
Depreciation and Appreciation
(cont.)

14-11
Appreciation is an increase in the value of a
currency relative to another currency.

An appreciated currency is more valuable (more
expensive) and therefore can be exchanged for
(can buy) a larger amount of foreign currency.

$1/€ → $0.90/€ means that the dollar has
appreciated relative to the euro. It now takes
only $0.90 to buy one euro, so that the dollar is
more valuable.

The euro has depreciated relative to the dollar:
it is now less valuable.
Depreciation and Appreciation
(cont.)

A depreciated currency is less valuable, and therefore it
can buy fewer foreign produced goods that are
denominated in foreign currency.

A Nissan costs ¥2,500,000 = $25,000 at $0.010/¥

becomes more expensive $27,962.50 at $0.011185/¥

A depreciated currency means that imports are more
expensive and domestically produced goods and exports
are less expensive.

A depreciated currency lowers the price of exports
relative to the price of imports.
14-12
Depreciation and Appreciation
(cont.)

An appreciated currency is more valuable, and therefore
it can buy more foreign produced goods that are
denominated in foreign currency.


A Nissan costs ¥2,500,000 = $27,962.50 at $0.011185/¥
becomes less expensive $25,000 at $0.010/¥

An appreciated currency means that imports are less
expensive and domestically produced goods and exports
are more expensive.

An appreciated currency raises the price of exports
relative to the price of imports.
14-13
Purchasing Power Parity
The Price of a Big Mac



According to PPP, the price of a good should be the
same in all countries after adjusting for exchange
rates.
Your textbook reports Big Mac Prices, showing
recent prices ranging from $1.20 to $4.52 in different
countries.
So purchasing power parity does not hold (since all
countries do not produce the same mix of goods,
and since Big Macs are not easily shipped across
borders, this should not be a surprise).
Relative Purchasing Power
Parity
The Real Exchange Rate and
Net Exports


Our macro model is being modified by including net
exports as a component of spending.
Net Exports should depend on the real exchange
rate



The real exchange rate is the price of domestic goods (in
terms of foreign goods).
If Cadillacs become more expensive relative to Mercedes,
then sales of Cadillacs fall and those of Mercedes rise.
We expect an inverse relationship between the real
exchange rate and net exports
Determinants of the Real or
Nominal Exchange Rate
Determinants of Net Exports

We know that net exports depends on the
real exchange rate, but it also depends on
other things listed on the next slide
Determinants of Net Exports
Deriving the Open-Economy IS
Curve


We are now ready to return to the derivation
of the IS curve for the open economy model
Recall the equilibrium condition for the
goods market, which suggests a diagram to
follow:
S d  I d  NX
S d  I d  NX
Goods Market Equilibrium
Deriving IS


As in the closed economy case, an increase
in Y causes desired saving to rise, with no
direct effect on desired investment. So the S-I
curve shifts to the right.
An increase in Y decreases net exports,
shifting the NX curve to the left.
Derivation of the IS curve in an
open economy
NX Shocks


If the net exports curve shifts, this also shifts IS.
Suppose that a exogenous event (something
outside of our model) makes U.S. goods more
attractive


This shifts the net exports curve to the right.
For any level of income, the S-I curve intersects the
net exports curve at a higher interest rate, implying
that IS shifts up (to the right).
Shifting IS
International Shocks

The following foreign variables (considered
exogenous to the U.S.) will affect the home
(U.S.) IS curve:



Yfor up: IS shifts right
rfor up: IS shifts right
A change in tastes favoring U.S. goods: IS shifts
right
Domestic Shocks

We can also ask how domestic shocks,
including policy shifts, affect both domestic
and international economies in an open
economy setting
An Increase in Government
Spending


Suppose government spending increases
(temporarily)
We already know how to use our model to
make inferences about the income and the
interest rate


The home country IS curve shifts to the right.
In the classical view, the FE curve would also shift
right because of a negative wealth effect (but
probably not in a Keynesian view)
An Increase in Government
Spending: Diagram
What Happens to the
Exchange Rate? and NX?




Higher income causes domestic residents to
increase imports, which also creates demand for the
foreign currency, lowering the exchange rate
However, the resulting interest rate increase causes
the exchange rate to rise.
So we are left with an ambiguous overall implication
for the exchange rate
NX declines because of the rise in the interest rate
and the rise in income

The ambiguity in the exchange rate might appear to make
the effect on NX, ambiguous but this is not the case.
A Monetary Contraction


A decrease in the (home) money supply
shifts LM to the left.
In the Keynesian model, income falls and the
real interest rate rises.
What Happens to the
Exchange Rate?



Falling income means falling demand for
imports, and falling demand for the foreign
currency. The home currency would
appreciate.
A higher interest rate means foreign funds
seek to invest in financial assets in the U.S.,
increasing demand for dollars. Again, the
home currency would appreciate.
So both falling income and a rising interest
rate cause an appreciation of the dollar.
What happens to NX?



The fall in income lowers demand for imports,
causing an increase in net exports
The increase in the exchange rate causes an
increase in the real exchange rate, which
means that U.S. goods are more expensive.
This decreases net exports
So the overall impact on NX is ambiguous
What about the J-Curve?



The evidence on the J-curve tells us that the
change in the terms of trade can have
different effects over time
U.S. goods have become more expensive, so
that net exports should eventually fall, but the
immediate impact could have the opposite
sign
This suggests that the likely short-term effect
will be that the NX will increase
Long-Run Effects of a
Monetary Contraction




In the closed economy model, money neutrality
prevailed in the long run.
The same should be true in the open economy
context.
The monetary contraction shifted LM and AD left. In
the long run, the leftward shift of AD puts downward
pressure on the price level. But this shifts LM back
to its original location.
With LM back to its starting point, Y and r will also
return to their original values. The real exchange
rate is unchanged, so trade patterns (NX) are
unchanged.
The Nominal Exchange Rate?


The price level has fallen, so the nominal
exchange rate has risen in equal proportion.
Recall:
enom P
e
Pfor
Fixed Exchange Rates



We have been analyzing the open economy under a
flexible exchange rate regime, where the exchange
rate is determined by demand and supply forces.
Under a fixed exchange rate regime, a country (or
both countries) officially set a rate of exchange
between currencies.
How can this be done?

A country’s central bank does ultimately control the supply
of the currency. The official rate will be compatible with the
market equilibrium rate so long as the central bank sets the
money supply appropriately.
What if Official and Equilibrium
Market Rates Diverge?


The next slide plots demand and supply
curves for dollars (as a function of the
nominal exchange rate).
But suppose that the official rate exceeds the
market equilibrium rate? What happens?
An overvalued exchange rate
Speculative Runs and
Exchange Rate Crises


Suppose that investors believe that an
overvalued currency will soon be devalued
Abel-Bernanke conclude: “If the exchange rate
is overvalued, the country must either devalue
its currency or make some policy changes to
raise the fundamental value of the exchange
rate.”
Exchange Rate Crisis: Hong
Kong



WSJ Oct. 23 1997 Hong Kong
… the odds are that the authorities won't give up the
peg with the U.S. dollar, say market participants.
The Hong Kong Monetary Authority pushed
overnight interest rates up to 300% in a desperate
attempt to maintain the Hong Kong dollar's link with
the U.S. dollar.
Does this make sense? (Yes, if a depreciation of a
fixed rate is expected, an extremely high rate of
interest on the home currency may be needed if
people are to be discouraged from fleeing the home
currency).
What about an Undervalued
Exchange Rate?


If a country has an undervalued exchange
rate, it accumulates international reserves.
This doesn’t lead to the same problems of
unsustainability as an overvalued rate, but it
can make trading partners uncomfortable,
and it may be of questionable rationality (you
accumulate currencies that are presumably
worth less than you paid for them).
How to Make Fundamentals
Coincide with an Official Rate


Suppose that the currency is overvalued (the
official rate exceeds the fundamental value).
To raise the fundamental value of the currency,
a monetary contraction is required
Under Fixed Exchange Rates
Monetary Policy is Constrained


Under fixed exchange rates, the money
supply must be set to insure that the value of
the currency stays at the official rate.
This means that the money supply cannot be
varied for other purposes, like countercyclical
stabilization policy.
Fixed vs. Flexible Exchange
Rates



Flexible exchange rates permit a country to
control its own monetary policy
However, exchange rate swings lead to trade
fluctuations that make trade sensitive sectors
risky
Fixed exchange rates can reduce the large
exchange rate induced trade fluctuations, but
they are subject to crises and they limit a
countries ability to determine its own
monetary policy
Foreign Exchange Markets

The set of markets where foreign currencies
and other assets are exchanged for domestic
ones


The daily volume of foreign exchange
transactions was $4.0 trillion in April 2010


14-47
Institutions buy and sell deposits of currencies or
other assets for investment purposes.
up from $500 billion in 1989.
Most transactions (85% in April 2010)
exchange foreign currencies for U.S. dollars.
Foreign Exchange Markets
The participants:
1.
Commercial banks and other depository institutions:
transactions involve buying/selling of deposits in different
currencies for investment purposes.
2.
Non-bank financial institutions (mutual funds, hedge
funds, securities firms, insurance companies, pension
funds) may buy/sell foreign assets for investment.
3.
Non-financial businesses conduct foreign currency
transactions to buy/sell goods, services and assets.
4.
Central banks: conduct official international
reserves transactions.
14-48
Foreign Exchange Markets
(cont.)

14-49
Buying and selling in the foreign exchange
market are dominated by commercial and
investment banks.

Inter-bank transactions of deposits in foreign
currencies occur in amounts $1 million or more
per transaction.

Central banks sometimes intervene, but the direct
effects of their transactions are small and
transitory in many countries.
Foreign Exchange Markets
(cont.)


Computer and telecommunications technology
transmit information rapidly and have
integrated markets.
The integration of financial markets implies that
there can be no significant differences in
exchange rates across locations.


14-50
Arbitrage: buy at low price and sell at higher price
for a profit.
If the euro were to sell for $1.1 in New York and
$1.2 in London, could buy euros in New York
(where cheaper) and sell them in London at a profit.
Spot Rates and Forward Rates

Spot rates are exchange rates for currency
exchanges “on the spot,” or when trading is
executed in the present.

Forward rates are exchange rates for
currency exchanges that will occur at a future
(“forward”) date.
14-51

Forward dates are typically 30, 90, 180, or 360
days in the future.

Rates are negotiated between two parties in the
present, but the exchange occurs in the future.
Fig. 14-1: Dollar/Pound Spot and Forward
Exchange Rates, 1983–2011
Source: Datastream. Rates shown are 90-day forward exchange rates and spot exchange
rates, at end of month.
14-52
Other Methods of Currency Exchange

14-53
Foreign exchange swaps: a combination of a spot sale
with a forward repurchase.

Swaps allow parties to meet each other’s needs for a temporary
amount of time and often cost less in fees than separate
transactions.

For example, suppose Toyota receives $1 million from American
sales, plans to use it to pay its California suppliers in three
months, but wants to invest the money in euro bonds in the
meantime.
Other Methods of Currency Exchange
(cont.)

Futures contracts: a contract designed by a third party
for a standard amount of foreign currency
delivered/received on a standard date.

14-54
Contracts can be bought and sold in markets, and only the
current owner is obliged to fulfill the contract.
Other Methods of Currency Exchange
(cont.)

14-55
Options contracts: a contract designed by a third party
for a standard amount of foreign currency
delivered/received on or before a standard date.

Contracts can be bought and sold in markets.

A contract gives the owner the option, but not obligation, of
buying or selling currency if the need arises.
The Demand of Currency
Deposits

What influences the demand of (willingness to buy)
deposits denominated in domestic or foreign currency?

Factors that influence the return on assets determine the
demand of those assets.
14-56
The Demand of Currency Deposits (cont.)

Rate of return: the percentage change in value that an
asset offers during a time period.


The annual return for $100 savings deposit with an interest rate of
2% is $100 x 1.02 = $102, so that the rate of return = ($102 –
$100)/$100 = 2%.
Real rate of return: inflation-adjusted rate of return,

which represents the additional amount of goods & services that
can be purchased with earnings from the asset.

The real rate of return for the above savings deposit when inflation
is 1.5% is 2% – 1.5% = 0.5%. After accounting for the rise in the
prices of goods and services, the asset can purchase 0.5% more
goods and services after 1 year.
14-57
The Demand of Currency Deposits (cont.)

If prices are fixed, the inflation rate is 0% and (nominal)
rates of return = real rates of return.

Because trading of deposits in different currencies
occurs on a daily basis, we often assume that prices do
not change from day to day.

14-58
A good assumption to make for the short run.
The Demand of Currency Deposits (cont.)

Risk of holding assets also influences decisions about
whether to buy them.

Liquidity of an asset, or ease of using the asset to buy
goods and services, also influences the willingness to
buy assets.
14-59
The Demand of Currency Deposits (cont.)

14-60
But we assume that risk and liquidity of currency
deposits in foreign exchange markets are essentially the
same, regardless of their currency denomination.

Risk and liquidity are only of secondary importance when
deciding to buy or sell currency deposits.

Importers and exporters may be concerned about risk and
liquidity, but they make up a small fraction of the market.
The Demand of Currency Deposits (cont.)

We therefore say that investors are primarily concerned
about the rates of return on currency deposits.

Rates of return that investors expect to earn are
determined by
14-61

interest rates that the assets will earn

expectations about appreciation or depreciation
The Demand of Currency Deposits (cont.)

A currency deposit’s interest rate is the amount of a
currency that an individual or institution can earn by
lending a unit of the currency for a year.

The rate of return for a deposit in domestic currency is
the interest rate that the deposit earns.

To compare the rate of return on a deposit in domestic
currency with one in foreign currency, consider


14-62
the interest rate for the foreign currency deposit
the expected rate of appreciation or depreciation of the foreign
currency relative to the domestic currency.
Fig. 14-2: Interest Rates on Dollar and Yen
Deposits, 1978–2011
Source: Datastream. Three-month interest rates are shown.
14-63
The Demand of Currency Deposits (cont.)

Suppose the interest rate on a dollar deposit is 2%.

Suppose the interest rate on a euro deposit is 4%.

Does a euro deposit yield a higher expected rate
of return?
14-64

Suppose today the exchange rate is $1/€1, and the expected rate
one year in the future is $0.97/€1.

$100 can be exchanged today for €100.

These €100 will yield €104 after one year.

These €104 are expected to be worth $0.97/€1 x €104 = $100.88
in one year.
The Demand of Currency Deposits (cont.)

The rate of return in terms of dollars from investing in
euro deposits is
($100.88 – $100)/$100 = 0.88%.

Let’s compare this rate of return with the rate of return
from a dollar deposit.



14-65
The rate of return is simply the interest rate.
After 1 year the $100 is expected to yield $102:
($102 – $100)/$100 = 2%
The euro deposit has a lower expected rate of return:
thus, all investors should be willing to dollar deposits and
none should be willing to hold euro deposits.
The Demand of Currency Deposits (cont.)

Note that the expected rate of appreciation of the euro
was ($0.97 – $1)/$1 = –0.03 = –3%.

We simplify the analysis by saying that the dollar rate of
return on euro deposits approximately equals

the interest rate on euro deposits
plus the expected rate of appreciation of euro deposits
4% + –3% = 1% ≈ 0.88%

R€ + (Ee$/€ – E$/€)/E$/€


14-66
The Demand of Currency Deposits (cont.)

The difference in the rate of return on dollar deposits and
euro deposits is
R$ – (R€ + (Ee$/€ – E$/€)/E$/€ ) =
R$
expected rate
of return =
interest rate
on dollar
deposits
–R€ –(Ee$/€ – E$/€)/E$/€
interest rate
on euro
deposits
expected
exchange rate
current
exchange rate
expected rate of
appreciation of the euro
expected rate of return on euro deposits
14-67
Table 14-3: Comparing Dollar Rates of
Return on Dollar and Euro Deposits
14-68
Model of Foreign Exchange
Markets

We use the


demand of (rate of return on) dollar denominated deposits
and the demand of (rate of return on) foreign currency
denominated deposits
to construct a model of foreign exchange markets.

This model is in equilibrium when deposits of all
currencies offer the same expected rate of return:
interest parity.


14-69
Interest parity implies that deposits in all currencies are equally
desirable assets.
Interest parity implies that arbitrage in the foreign exchange
market is not possible.
Model of Foreign Exchange Markets (cont.)


Interest parity says:
R$ = R€ + (Ee$/€ – E$/€)/E$/€
Why should this condition hold? Suppose it didn’t.




14-70
Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€
Then no investor would want to hold euro deposits, driving down the
demand and price of euros.
Then all investors would want to hold dollar deposits, driving up the
demand and price of dollars.
The dollar would appreciate and the euro would depreciate,
increasing the right side until equality was achieved:
R$ > R€ + (Ee$/€ – E$/€)/E$/€
Model of Foreign Exchange Markets (cont.)

14-71
How do changes in the current exchange rate affect the
expected rate of return of foreign currency deposits?
Model of Foreign Exchange Markets (cont.)

Depreciation of the domestic currency today lowers the
expected rate of return on foreign currency deposits.
Why?

14-72
When the domestic currency depreciates, the
initial cost of investing in foreign currency deposits
increases, thereby lowering the expected rate of
return of foreign currency deposits.
Model of Foreign Exchange Markets (cont.)

Appreciation of the domestic currency today raises the
expected return of deposits on foreign currency deposits.
Why?

14-73
When the domestic currency appreciates, the initial cost of
investing in foreign currency deposits decreases, thereby
lowering the expected rate of return of foreign currency deposits.
Table 14-4: Today’s Dollar/Euro Exchange Rate and the
Expected Dollar Return on Euro Deposits When Ee$/€ =
$1.05 per Euro
14-74
Fig. 14-3: The Relation Between the Current Dollar/Euro
Exchange Rate and the Expected Dollar Return on Euro
Deposits
14-75
Fig. 14-4: Determination of the Equilibrium
Dollar/Euro Exchange Rate
14-76
Model of Foreign Exchange
Markets

14-77
The effects of changing interest rates:

an increase in the interest rate paid on deposits
denominated in a particular currency will increase
the rate of return on those deposits.

This leads to an appreciation of the currency.

Higher interest rates on dollar-denominated
assets cause the dollar to appreciate.

Higher interest rates on euro-denominated assets
cause the dollar to depreciate.
Fig. 14-5: Effect of a Rise in the Dollar
Interest Rate
14-78
Fig. 14-6: Effect of a Rise in the Euro
Interest Rate
14-79
The Effect of an Expected Appreciation
of the Euro

If people expect the euro to appreciate in the future, then
euro-denominated assets will pay in valuable euros, so
that these future euros will be able to buy many dollars
and many dollar-denominated goods.



14-80
The expected rate of return on euros therefore increases.
An expected appreciation of a currency leads to an actual
appreciation (a self-fulfilling prophecy).
An expected depreciation of a currency leads to an actual
depreciation (a self-fulfilling prophecy).
Fig. 14-7: Cumulative Total Investment Return in
Australian Dollar Compared to Japanese Yen, 2003-2010
Source: Exchange rates and three-month treasury yields from Global Financial Data.
14-81
Covered Interest Parity

Covered interest parity relates interest rates across
countries and the rate of change between forward
exchange rates and the spot exchange rate:
R$ = R€ + (F$/€ – E$/€)/E$/€
where F$/€ is the forward exchange rate.

It says that rates of return on dollar deposits and
“covered” foreign currency deposits are the same.


14-82
How could you earn a risk-free return in the foreign exchange
markets if covered interest parity did not hold?
Covered positions using the forward rate involve little risk.
Summary
An exchange rate is the price of one country’s currency
in terms of another country’s currency.
1.
•
14-83
It enables us to translate different countries’ prices into
comparable terms.
Summary (cont.)
2.
Depreciation of a currency means that it becomes less
valuable and goods denominated in it are less
expensive: exports are cheaper and imports more
expensive.
3.
Appreciation of a currency means that it becomes
more valuable and goods denominated in it are more
expensive: exports are more expensive and imports
cheaper.
14-84
Summary (cont.)
Commercial and investment banks that invest in
deposits of different currencies dominate the foreign
exchange market.
4.

5.
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Expected rates of return are most important in determining the
willingness to hold these deposits.
Rates of return on currency deposits in the foreign
exchange market are influenced by interest rates and
expected exchange rates.
Summary (cont.)
6.
7.
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Equilibrium in the foreign exchange market occurs when
rates of returns on deposits in domestic currency and in
foreign currency are equal: interest rate parity.
An increase in the interest rate on a currency’s deposit
leads to an increase in its expected rate of return and to
an appreciation of the currency.
Summary (cont.)
8.
An expected appreciation of a currency leads to an
increase in the expected rate of return for that
currency, and leads to an actual appreciation.
9.
Covered interest parity says that rates of return on
domestic currency deposits and “covered” foreign
currency deposits using the forward exchange rate are
the same.
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The End