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Exchange Rates and Macroeconomic Policy © 2003 South-Western/Thomson Learning Foreign Exchange Markets and Exchange Rates Foreign Exchange Market The market in which one country’s currency is traded for another country’s currency Exchange Rate •The amount of one country’s currency that is traded for one unit of another country’s currency •The price of foreign currency in dollars The Demand for British Pounds •The Demand for Pounds Curve •Shifts in the Demand for Pounds Curve The Demand for British Pounds In our model of the market for pounds, we assume that American households and businesses are the only buyers. The Demand for British Pounds Why do Americans want to buy pounds? • To buy goods/services from British firms • To buy British assets The Demand for Pounds Curve Demand Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that Americans will want to buy, during a given period, at each different exchange rate The Demand for Pounds Curve (a) (b) Dollars per Pound $2.25 Dollars per Pound A Fall in price of pound moves us rightward along demand for pounds curve Demand for pounds curve shifts rightward when: • U.S. real GDP • U.S. relative price level • U.S. tastes shift towards British goods • U.S. interest rate • Pound is expected to appreciate E 1.50 £ £ D 200 300 Millions of British Pounds £ D2 D1 Millions of British Pounds The Demand for Pounds Curve Price of pounds British goods cheaper to Americans Americans buy more British goods Quantity of pounds demanded Shifts in the Demand for Pounds Curve Variables That Shift the Demand for Pounds Curve • • • • • U.S. Real GDP Relative Price Levels Americans’ Tastes for British Goods Relative Interest Rates Expected Changes in the Exchange Rate The Supply of British Pounds • The Supply of Pounds Curve • Shifts in the Supply of Pounds Curve The Supply of Pounds Curve Supply Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that will be supplied, during a given period, at each different exchange rate The Supply of Pounds Curve (a) (b) Dollars per Pound Dollars per Pound S F $2.25 1.50 £ £ S1 £ S2 Rise in price of pound moves us rightward along supply of pounds curve E 300 Supply of pounds curve shifts rightward if: • British real GDP • U.S. relative price level • British tastes shift towards U.S. goods • U.S. interest rate • Pound is expected to depreciate 400 Millions of British Pounds Millions of British Pounds The Supply of Pounds Curve Price of pounds U.S. goods goods cheaper to British British buy more U.S. goods British need more dollars Quantity of pounds supplied Shifts in the Supply of Pounds Curve Variables That Shift the Supply of Pounds Curve • • • • • Real GDP in Britain Relative Price Levels British Tastes for U.S. Goods Relative Interest Rates Expected Changes in the Exchange Rate The Equilibrium Exchange Rate Floating Exchange Rate An exchange rate that is freely determined by the forces of supply and demand. The Equilibrium Exchange Rate Dollars per Pound £ S Dollars per Pound Equilibrium in the market for pounds $1.50 E £ S $2.00 C E 1.50 £ D2 £ D 300 Millions of British Pounds Higher U.S. real GDP leads to a higher price per pound 300 £ D1 Millions of British Pounds The Equilibrium Exchange Rate When the exchange rate floats - that is, when the government does not intervene in the foreign currency market - the equilibrium exchange rate is determined at the intersection of the demand curve and the supply curve. What Happens When Things Change? • How Exchange Rates Change over Time • The Very Short Run: “Hot Money” • The Short Run: Macroeconomic Fluctuations • The Long Run: Purchasing Power Parity What Happens When Things Change? Appreciation An increase in the price of a currency in a floating-rate system Depreciation A decrease in the price of a currency in a floating-rate system What Happens When Things Change? When a floating exchange rate changes, one country’s currency will appreciate (rise in price) and the other country’s currency will depreciate (fall in price). How Exchange Rates Change Over Time Dollars per Pound B A E C Years The Very Short Run •Relative interest rates and expectations of future exchange rates are the dominant forces moving exchange rates in the very short run. •“Hot money” consists of funds that can be moved from one type of investment to another on very short notice. Hot Money in the Very Short Run Dollars per Pound £ S1 £ S2 $1.50 1.00 E G £ D1 £ D2 Q1 Q2 Millions of British Pounds per Month The Short Run: Macroeconomic Fluctuations In the short run, movements in exchange rates are caused largely by economic fluctuations. • All else equal, a country whose GDP rises relatively rapidly will experience a depreciation of its currency. • A country whose GDP falls more rapidly will experience an appreciation of its currency. Exchange Rates In The Short Run (a) Dollars per Pound (b) Dollars per Pound £ S £ S1 £ S2 B $1.80 1.50 $1.80 A 1.50 B C £ £ D2 £ D1 Millions of British Pounds per Month D2 £ D1 Millions of British Pounds per Month The Long Run: Purchasing Power Parity Purchasing Power Parity (PPP) Theory The idea that the exchange rate will adjust in the long run so that the average price of goods in two countries will be roughly the same Purchasing Power Parity Some Important Caveats • Some Goods Are Difficult to Trade • High Transportation Costs • Artificial Barriers to Trade Interdependent Markets: The Role of Arbitrage Arbitrage Simultaneous buying and selling of a foreign currency in order to profit from a difference in exchange rates. Interdependent Markets: The Role of Arbitrage Bilateral Arbitrage Arbitrage involving one pair of currencies. Bilateral arbitrage ensures that the exchange rate between any two currencies is the same everywhere in the world. Bilateral Arbitrage (a) New York Dollars per Pound (b) London Dollars per Pound £ S £ S1 £ S2 $1.80 $1.50 E 1.50 E 1.20 £ £ D1 D2 Millions of British Pounds per Month £ D Millions of British Pounds per Month Interdependent Markets: The Role of Arbitrage Triangular Arbitrage Arbitrage involving trades among three (or more) currencies Triangular Arbitrage Triangular arbitrage ensures that the price of a foreign currency is the same whether it is purchased directly - in a single foreign exchange market - or indirectly, by buying and selling a third currency. Government Intervention in Foreign Exchange Markets •Managed Float •Fixed Exchange Rates •The Euro Managed Float A policy of frequent central bank intervention to move the exchange rate. Managed Float Under a managed float, a country’s central bank actively manages its exchange rate, buying its own currency to prevent depreciations and selling its own currency to prevent appreciations. Fixed Exchange Rate A government-declared exchange rate maintained by central bank intervention in the foreign exchange market. Fixed Exchange Rate (a) Dollars per Baht (b) Dollars per Baht baht S $0.06 $0.06 S Excess Demand 0.04 Excess Supply 0.04 D baht baht 0.02 0.02 D 100 400 Millions of Baht per Month 100 baht 400 Millions of Baht per Month Fixed Exchange Rate When a country fixes its exchange rate below the equilibrium value, the result is an excess demand for the country’s currency. To maintain the fixed rate, the country’s central bank must sell enough of its own currency to eliminate the excess demand. Fixed Exchange Rate When a country fixes its exchange rate above the equilibrium value, the result is an excess supply of the country’s currency. To maintain the fixed rate, the country’s central bank must buy enough of its own currency to eliminate the excess supply. Foreign Currency Crises, the IMF, and Moral Hazard Dollars per Baht baht S1 baht S2 A $0.04 0.02 B baht baht D1 D2 10 0 400 Millions of Baht per Month Foreign Currency Crises, the IMF, and Moral Hazard Devaluation A change in the exchange rate from a higher fixed rate to a lower fixed rate. Foreign Currency Crisis A foreign currency crisis arises when people no longer believe a country can maintain a fixed exchange rate above the equilibrium rate: –the supply of the currency increases, –demand for it decreases, and –the country must use up its reserves of dollars and other key currencies even faster in order to maintain the fixed rate. International Monetary Fund International Monetary Fund (IMF) International organization founded in 1945 to help stabilize the world monetary system Moral Hazard Occurs when a decision maker (firm, individual, government) expects to be rescued in the event of an unfavorable outcome, and then changes its behavior so that the unfavorable outcome is more likely. The Euro Advantages to the Euro: • Single currency means no commission on exchange of currency • Reduced risk of rate changing before accounts settled • Easier to sell stocks/bonds throughout Europe • Cross-country comparison shopping easier • High-inflation countries will benefit from lower inflation The Euro Disadvantages to the Euro: • Single monetary policy makes it impossible to adjust money supply/interest rates to problems of individual nations • Requires countries to maintain strict fiscal discipline that may prevent use of fiscal stimuli when needed – Economists question if Europe is an optimum currency area The Euro Optimum Currency Area A region whose economies perform better with a single currency than with separate national currencies Exchange Rates and the Macroeconomy •Exchange Rates and Spending Shocks •Exchange Rates and Monetary Policy Exchange Rates and Spending Shocks • A depreciation of the dollar causes net exports to rise - a positive spending shock that increases real GDP in the short run. • An appreciation of the dollar causes net exports to drop - a negative spending shock that decreases real GDP in the short run. Exchange Rates and Monetary Policy Monetary policy has a stronger effect when we include the impact on exchange rates and net exports, rather than just the impact on interest-sensitive consumption and investment spending. Exchange Rates and Monetary Policy Money supply Interest rate a and IP Real GDP U.S. assets less attractive Decreased supply and increased demand for foreign currency Dollar depreciates Net exports Net Effect: GDP by more when exchange rate’s effect on net exports is included Trade Deficit Trade deficit = imports – exports Trade surplus = exports – imports Trade Deficit Net Capital Inflow An inflow of funds equal to a nation’s trade deficit Trade Deficit Increase in desire of foreigners to invest in U.S. contributes to an appreciation of the dollar: • U.S. exports become more expensive to foreigners • U.S. exports decline • Imports become cheaper to Americans • Imports increase Result is a rise in trade deficit