Download Ch 12 International finance

Chapter 12
International Finance I --Exchange Rate
© Pilot Publishing Company Ltd. 2005
Contents:
• Definitions
• Relation between domestic price and foreign
price
• Exchange rate system
• Changes in the demand for and supply of foreign
currency
• Determinants of the equilibrium exchange rate
• Automatic adjustment for BOP deficits under
different exchange rate systems
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Contents:
• Government policies on eliminating BOP
deficit under a fixed exchange rate system
• Comparison between flexible and fixed
exchange rate systems
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Definitions
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Definitions
Foreign exchange (fe) refers to
 foreign currency
 or claims on foreign currency
such as cheques drawn in the currency
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Exchange rate or exchange value of a foreign currency (e)
is the price of the currency (in terms of another currency).
Without specification of the currency, it is the amount of
domestic currency required to exchange for a unit of
foreign currency.
Note: When e , exchange value of foreign currency rises
while that of domestic currency drops.
Effective exchange rate index is the price index of
exchange rates of the domestic currency.
Note: When the index , the exchange value of the
domestic currency rises.
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Relation between Domestic Price
and Foreign Price
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Relation between domestic price and foreign price
Domestic price of a good is its price in domestic
currency (Pd).
Foreign price of a good is its price in foreign
currency (Pf).
Pd = e  Pf
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or
Pf = Pd /e
The slopes of the demand curve for and
the supply curve of foreign currency
 The demand curve for foreign
currency is downward sloping.
Imports: When e rises,
Pd (  e   P f )   Qm  Qd (  Qm   P f ) 
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The slope of the supply curve (S) of foreign currency
depends on the price elasticity of foreign demand for
the country’s exports (E).
Exports:
Pd
when e rises Pf (  e  ) 
 Qx  Qs( Qx  Pf )
1. If E is elastic  S is upward sloping
2. If E is unitarily elastic  S is vertical
3. If E is inelastic  S is downward sloping
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Exchange Rate System
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Exchange rate systems
Exchange between currencies
An economic agent who
demands foreign currency on the one hand
supplies domestic currency on the other hand
and vice versa.
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Demand for and supply of foreign currency
Price of foreign currency
in domestic currency
(or exchange rate)
S
Equilibrium
exchange rate
D
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Quantity of
foreign currency
Demand for and supply of domestic currency
Price of domestic currency
in foreign currency
S
Equilibrium
exchange rate
D
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Quantity of
domestic currency
Types of exchange rate systems
Flexible / Floating exchange rate system
Demand for & supply of foreign currency

determines the market exchange rate
Fixed exchange rate system
The monetary authority

fixes the official exchange rate
(at a pre-announced value)
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Balance of payments under different
exchange rate systems
Flexible exchange
rate system
Price of foreign currency in
domestic currency (e)
S
e*
The equilibrium e*
will finally be reached
at which Qd = Qs
Equilibrium
exchange rate
D
0
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As Qd = Qs, the
market BOP must
always be balanced.
Quantity of foreign
currency
Price of foreign currency in domestic
currency (or exchange rate )
Fixed exchange
rate system
S
At the pre-announced e,
Qd may not equal Qs.
e*
Equilibrium exchange rate
e1
Foreign
currency is
under-valued
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At e1, excess demand for
foreign currency exists (the
country suffers BOP deficit)
D
Quantity of foreign
currency
Fixed exchange rate system
At e1,
 Excess demand for foreign currency

Central Bank / Monetary Authority has to
sell foreign currency for domestic currency
( reserve assets & domestic money supply )

Exchange rate maintained at e1
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Price of domestic currency in
foreign currency
An alternative expression
Excess supply of
domestic currency
Fixed exchange
S rate system
e1^
e*
Domestic
currency is
over-valued
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
Equilibrium exchange rate
D
Quantity of domestic
currency
Terms describing changes in exchange rate
Under a flexible exchange rate system, a rise in the price of
a foreign currency is described as an appreciation of the
foreign currency or a depreciation of the domestic currency
(as more units of domestic currency are needed to exchange
for a unit of foreign currency).
Under a fixed exchange rate system, a rise in the price of a
foreign currency is described as a revaluation of the foreign
currency or a devaluation of the domestic currency.
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Changes in the Demand for and
Supply of Foreign Currency
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Demand for foreign currency increases
Exchange
rate
S
If e is flexible, e rises
e’
If e is fixed, Qd > Qs,
i.e., BOP deficit results
e
D’
0
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D
Quantity of
foreign currency
Supply of foreign currency decreases
Exchange
rate
e’
S’
S
If e is flexible, e rises
e
If e is fixed, Qd > Qs,
i.e., BOP deficit results
D
0
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Quantity of
foreign currency
Conclusion
Demand for foreign currency 
or supply of foreign currency 

The equilibrium exchange rate 

Flexible e system

Fixed e system

dc depreciates

BOP deficit
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Demand for foreign currency decreases
Exchange
rate
If e is fixed, Qs > Qd,
i.e., BOP surplus results
S
e
e’
If e is flexible, e falls
D
D’
0
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Quantity of
foreign currency
Supply of foreign currency increases
Exchange
rate
If e is fixed, Qs > Qd,
i.e., BOP surplus results
e
e’
0
If e is flexible, e falls
S
S’
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D
Quantity of
foreign currency
Conclusion
Demand for foreign currency 
or supply of foreign currency 

The equilibrium exchange rate 

Flexible e system

dc appreciates
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
Fixed e system

BOP surplus
Determinants of the
Equilibrium Exchange Rate
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Spending on imports 
Protectionist measures

Demand for fc 
Exchange
rate
S
Flexible e system:
dc appreciates.
Fixed e system:
BOP surplus.
e
e’
D
D’
0
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Quantity of
foreign currency
More domestic
investment opportunities
Outflow of capital 
& inflow of capital 
Exchange rate
Demand for fc  &
supply of fc 
S
S’
e
Flexible e system:
dc appreciates.
Fixed e system:
BOP surplus.
e’
0
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D’
D
Quantity of
foreign currency
National income rises
National income 

Spending on imports 
Exchange
rate

Demand for fc 
S
e’
e
D’
D
0
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Flexible e system:
dc depreciates.
Fixed e system:
BOP deficit.
Quantity of
foreign currency
Interest rate rises
Outflow of capital 
& inflow of capital 
Exchange rate
Demand for fc  &
supply of fc 
S
S’
e
Flexible e system:
dc appreciates.
Fixed e system:
BOP surplus.
e’
0
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D’
D
Quantity of
foreign currency
Ms  LM shifts rightward
 r & Y
Money Supply rises
Exchange
rate
S’
S
e’
r  outflow of capital
& inflow of capital 
D&S
Y  Spending on
imports   D 
e
D
0
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Flexible e system:
D’
dc depreciates.
Fixed e system:
BOP deficit.
Quantity of foreign
currency
Inflation
Inflation rate of a country 
that of its trading partner
1. Competitiveness of import-competing products
 spending on imports

Demand for fc 
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2. Foreign prices of the
country’s exports 
If foreign demand for the
country’s exports is elastic
Exchange
rate
S’
e’
e
D
0
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Volume of exports &
receipts from exports 
S
Supply of fc 
D’
Flexible e system:
dc depreciates.
Fixed e system:
BOP deficit.
Quantity of foreign
currency
Speculation upon the value of a currency
A bullish speculation upon the domestic currency
Outflow of capital 
Exchange rate
& inflow of capital 
S
Demand for fc  &
supply of fc 
S’
e
Flexible e system:
dc appreciates.
e’
Fixed e system:
BOP surplus.
D
D’
Quantity of
0
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foreign currency
Automatic Adjustment for BOP
Deficits under Different
Exchange Rate Systems
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Automatic adjustment for BOP deficits under
different exchange rate systems
Under a flexible e system
BOP Deficit  excess D for fc  e
Imports:
Pd (  e   P f )   Qm
 Qd (  Qm  P f ) 
Exports:
Pd
Pf ( 
)
e
 Qx
 Qs( Qx  Pf )
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If foreign demand for the country’s exports is elastic
Exchange
rate
S
Depreciation can improve
the BOP deficit
e’
e
0
Excess Demand
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D
Quantity of
foreign currency
If the demand for exports is unitarily elastic
Exchange
rate
S
Depreciation can improve
the BOP deficit
e’
e
Excess Demand
0
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D
Quantity of
foreign currency
If the demand for exports is inelastic
and the M-L condition holds
Exchange
rate
Depreciation can improve
the BOP deficit
e’
e
Excess Demand
0
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S
D
Quantity of
foreign currency
Marshall-Lerner condition (M-L condition):

The sum of the price elasticities of
foreign demand for the country’s exports and
the country’s demand for foreign imports
is greater than one.
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If the demand for export is inelastic
but the M-L condition does not hold
Exchange rate
Depreciation cannot improve
the BOP deficit and e rises
persistently
e
Excess Demand
D
0
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S
Quantity of
foreign currency
Under a fixed exchange rate system
Facing a BOP deficit
Central bank sells
foreign currency for
domestic currency
r
LM’
LM
r’
r

Ms   Y & r
IS
0
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Y’
Y
Y
Y  spending on imports
 D
Exchange rate
S
r  outflow of capital 
& inflow of capital 
 D & S
S’
Fixed e

The process continues
until deficit  0
D
D’
0
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Quantity of
foreign currency
Government Policies on
Eliminating BOP Deficit under
a Fixed Exchange Rate System
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Protectionist policy
Spending on imports 
Exchange rate
S

Demand for fc 
Fixed e
D

External deficit 
D’
0
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Quantity of foreign
currency
An increase in interest rate
Outflow of capital 
& inflow of capital 
Exchange rate
S
S’
Demand for fc  &
supply of fc 

External deficit 
Fixed e
D
0
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D’
Quantity of
foreign currency
Contractionary policy -- Prices are rigid
Y  spending on
imports 
Exchange rate

Demand for fc 
S

External deficit 
Fixed e
D
D’
0
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Quantity of
foreign currency
Devaluation
Exchange rate
The Marshall-Lerner
condition is required.
S
New fixed e
Original
fixed e
D
0
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Quantity of
foreign currency
Comparison between
Flexible and Fixed
Exchange Rate Systems
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Advantages of flexible e system
(or disadvantages of fixed e system)
 Allocate resources efficiently
 No BOP problem
 No need to hold a large amount of reserve assets
 Government policies are free to achieve
domestic objectives
 Insulated from imported inflation
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Disadvantages of flexible e system
(or advantages of fixed e system)
 Bring uncertainty to businessmen
 Arouse speculation
 Enhance domestic inflation
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Correcting Misconceptions:
1. There is no BOP problem because
the payments must always be balanced.
2. Some economic transactions are favourable
to an economy but some are not.
3. The gain from trade is determined by
the balance of payments.
4. The supply curve of foreign currency must be
upward sloping.
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Correcting Misconceptions:
5. Depreciation or devaluation can resolve the
problem of payments deficit.
6. Without government intervention, a BOP deficit
will persist under a fixed exchange rate system.
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