Download Exchange Rates - San Ramon Valley High School

Exchange Rates
• Balance of payments deficit/surplus +
adjustments depend on system of
exchange
• 1) flexible/floating: demand + supply
• 2) fixed/pegged: gov’t determines rates +
adjusts as necessary to maintain
• Currency demand down sloping: currency less
expensive goods less expensive to
foreigners higher demand for goods higher
quantity demand for currency
• Currency supply up sloping: as more expensive
(dollar price of pounds rises/pound price of
dollar falls) foreigners purchase more goods
greater supply foreign currency (exchanging
foreign currency for domestic)
British Pounds S+D
Dollar
price of
1
pound
S
2
D
Q1
Q of
pounds
Depreciation
• Dollar price of pounds increases dollar
depreciation relative to the pound (more
dollars to get single unit of pounds)
Dollar
price of
1
pound
British Pounds S+D
S
Dollar
depreciates $3
(pounds
appreciates)
$2
D2
D
Q1
Q2
Q of
pounds
Appreciation
• Dollar price of pounds decreases dollar
appreciation relative to the pound (fewer
dollars to get one unit of pounds)
British Pounds S+D
Dollar
price of
1
pound
S
$2
Dollar
$1
appreciates
(pounds
depreciates)
D
D2
Q2
Q1
Q of
pounds
Generalizations
• 1) Currency demand increases (ceteris
paribus) appreciation
• 2) Currency supply increases
depreciation
• 3) If US currency depreciates/appreciates
some foreign currency
appreciates/depreciates relative to it
Determinants
• 1) Tastes: changing demand products
• 2) Relative income: relative fast income
growth depreciation: income up more
consumption domestic + imports greater
relative demand foreign currency
• 3) Relative price-level: purchasing power
parity theory: exchange rates equate
purchasing power of currencies (dollar gets
same amount of stuff)
– However: exchange rates differ from PPP even over
long periods, BUT relative price levels a determinant
(attempt to get relatively cheaper goods)
• 4) Relative interest rates greater
demand financial investments greater
demand currency
• 5) Speculation: attempt to profit from rate
changes (often self-fulfilling)
Flexible Rates and Balance of
Payments
• Rates automatically adjust to eventually
eliminate balance of payment
deficits/surpluses
• At equilibrium no need to draw down/build
up official reserves to balance payments
• Suppose D for pounds increases
Dollar
price of
1
pound
British Pounds S+D
c
S
$3
$2
a
b
D2
D
Q1
Q2
Q of
pounds
• If exchange rate stays at $2 = £1, balance
of payments deficit of ab
US demand b pounds, Brits only supply a
quantity shortage pounds
Competitive market new exchange rate (say
$3 = £1) + dollar depreciates
Dollar
price of
1
pound
S
Dollar
depreciates $3
(pounds
appreciates)
$2
c
a
b
D2
D
Q1
Q2
Q of
pounds
Exchange rates links all domestic
and foreign prices
• Dollar price foreign good= foreign price x
exchange rate
£ 9,000 car at $2 = £1 $18,000
• At $3 = £1 $27,000 car decline US
imports B goods decrease quantity
demanded pounds (movement point b to
point c)
Dollar
price of
1
pound
British Pounds S+D
S
Dollar
depreciates $3
(pounds
appreciates)
$2
c
a
b
D2
D
Q1
Q2
Q of
pounds
• US goods relatively cheaper B imports
more (US exports more) increase
quantity supply pounds movement a to c
• Combination equilibrium S and D at new
exchange rate
Dollar
price of
1
pound
British Pounds S+D
S
Dollar
depreciates $3
(pounds
appreciates)
$2
c
a
b
D2
D
Q1
Q2
Q of
pounds
Fixed Exchange Rates
• G must intervene to maintain set
exchange rate:
• 1) Use of reserves: central bank buys/sells
currency in open-market
Reserves acquired: a) diff circumstances in past
(surplus/deficit), b) gold as “international
money”
• If deficit persistent + sizable, may be
unable to maintain peg bad news
2) Trade policies
• Discourage imports: Tariffs or import
quotas, special taxes
• Encourage exports: subsidies
•  loss of efficiency, retaliation
3) Exchange Controls + Rationing
• EC: require all pounds acquired through
trade sold to Fed ration only this amount
• 1) Distorted trade: comparative advantage
distorted
• 2) Favoritism
• 3) Restricted choice
• 4) Black markets
Domestic Macroeconomic
Adjustments
• Contractionary policy (tax hikes, reduce G,
increase interest rates) lower income
fewer imports + increased foreign
investment (if higher relative rates)
decrease D pounds + increase S
pounds new exchange rate
• Price of exchange-rate stability =
recession