How Exchange Rates Are Determined

1
Chapter 10

• How Exchange Rates Are Determined

There are three main causes that dispose men to
madness Love, ambition, and the study of
foreign exchange. - Walter Leaf, 1926
2
Does the exchange affect us?

• How do changes in the international value of the
  dollar affect job opportunities?
• How are domestic interest rates linked with
  interest rates in the rest of the world?
• How are domestic prices affected by foreign
  prices?
• How are these questions/answers related?

3
Defining Exchange Rates

• Amount of foreign money that be acquired with one
  unit of domestic money
• Purchasing power of dollar in another country
• If 1 100 yen, later 1 150 yen,
• How has the dollar changed relative to the yen?
  Has it appreciated? Depreciated?
• How has the yen changed relative to the dollar?
  Has it appreciated? Depreciated?

4
Impact of Changing Exchange Rates

• As dollar appreciates
• Price of foreign currencies fall
• U.S. imports increase
• U.S. exports decrease
• Net job decrease
• As dollar depreciates
• Price of foreign currencies rise
• U.S. imports decrease
• U.S. exports increase
• Net job increase

5
The Exchange Rate Since 1980
Trade-Weighted Dollar (1980-September 28, 2001)
1985
1990
1995
2000
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Determining the Exchange Rates

• Supply and demand in foreign exchange market
  between two currencies
• Demand for dollars function of foreign demand for
  U.S. goods, services, securities
• Supply of dollars function of U.S. demand for
  foreign goods, services, securities

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The Foreign Exchange Market
U.S. Purchases (Demand) Foreign Goods, Services,
and Securities
Foreigners Purchase (Demand) U.S. Goods,
Services, and Securities
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The Market for Dollars
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Focusing on goods

• Foreign (yen) price of U.S. goods
• dollar price of U.S. goods
• x exchange rate
• If computer costs 1,500 in U.S. and the exchange
  rate is 100 yen/dollar
• Then computer will cost 150,000 yen in Japan
• What happens when dollar appreciates or
  depreciates?

10
Transitivity among currencies

• 1 11.523 pesos
• 1 0.787 euros
• Therefore, 1 euro should 14.64 pesos
• Does it? (14.685)

11
Impact of Changes in Supply of Money on Exchange
Rates

• Changes in U.S. real income
• Positive relationship between real income and
  changes in supply of dollars
• As income increases, more money to spend/save
• Demand increases for both domestic and foreign
  goods/services/securities
• Increases supply of dollars into market

12
Impact of Changes in Supply of Money on Exchange
Rates

• Changes in dollar price of U.S. goods relative to
  dollar price of foreign goods
• If prices of U.S. goods rise relative to foreign
  goods (c.p.) U.S. demand for foreign goods will
  increase
• Increases supply of dollars into market

13
Impact of Changes in Supply of Money on Exchange
Rates

• Changes in foreign interest rates relative to
  U.S. interest rates
• As foreign interest rates increase (c.p.),
  foreign securities more attractive
• U.S. will buy more foreign securities
• Supply of dollars increases

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Changes in the Exchange Rate The Role of Changes
in Supply
15
Impact of Changes in Demand for Money on Exchange
Rates

• Changes in foreign real income
• Positive relationship between real income and
  changes in demand for dollars
• Foreigners will have more to spend/save as income
  rises
• Increase in demand for dollars to buy U.S.
  goods/services/securities

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Impact of Changes in Demand for Money on Exchange
Rates

• Changes in foreign price of foreign goods
  relative to the foreign price of U.S. goods
• Increase in foreign price of foreign goods
  relative to U.S. goods, increases demand for U.S.
  goods
• Demand for dollars increases

17
Impact of Changes in Demand for Money on Exchange
Rates

• Changes in U.S. interest rates relative to
  foreign interest rates
• As U.S. interest rates increase (decrease),
  demand for dollars increases (decreases)

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Changes in the Exchange Rate The Role of Changes
in Demand
Yen/Dollar Exchange Rate
Supply of Dollars
A
100
Demand for Dollars
B
50
Demand for Dollars after Rise in U.S. Prices
Quantity of Dollars/Month
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What happens when China increases its interest
rate?

• Increased by 0.27 (to 5.58) today first
  change in 9 years
• Potential impacts
• Increase demand for Chinese securities
• Increase supply of dollars
• Depreciate the dollar relative to yen
• Unclear market reaction today

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What happens when China increases its interest
rate?

• Other possible effects
• Slow down Chinese economy
• However, both lenders and borrowers owned by
  government
• Lessened demand for oil

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Pull It Together

• U.S. economy expanding at slow pace (real GDP
  growing at 1-2 annually)
• Fed undertakes expansive monetary policy to
  increase aggregate demand for goods and services
• Leads to lower interest rates
• What will be impact on dollar exchange rate with
  the yen?

22
Pull It Together

• Impact on exchange rate depreciation of dollar
• Fall in interest rates makes U.S. securities less
  attractive to foreign investors
• Less demand for dollars with less demand for U.S.
  securities
• More supply of dollars to move to Japanese
  investment

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Pull It Together

• Ultimate result?
• Output will expand
• Income will grow
• Demand for imports will rise
• Supply of money will increase
• Further depreciation of dollar

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Pull It Together

• Does the cycle continue?
• Depreciated dollar makes U.S. exports more
  attractive
• Increased demand for dollars
• Etc.

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Balance of Payments

• Receipts for U.S. (credit items)
• Foreign purchase of U.S. goods (U.S. merchandise
  exports)
• Foreign purchase of U.S. securities
• Expenditures by foreigners travelers in U.S.
• Payments by U.S. (debit items)
• U.S. purchases of foreign goods (U.S. merchandise
  imports)
• U.S. purchases of foreign securities
• Expenditures by U.S. travelers in other countries

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Balance of Payments

• Current Account
• Exports, imports, net transfer payments
• Trade Balance
• Difference between exports and imports
• Capital Account
• Financial flow of funds and securities between
  U.S. and rest of world

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Balance of Payments and Exchange Rate

• Balance of payments receipts demand for dollars
• Balance of payments payments supply of
  dollars
• Exchange rate is the equalizer

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A Hypothetical and Simplified Balance of Payments
for the U.S. Economy in the Year 2005 (in
Billions of Dollars)
Account Component Receipts Payments
Balance Use of Source of by
foreigners by foreigners Current (2) Merchandise
exports 400 (4) Balance of trade (3)
Merchandise imports -600 (2)
(3) -200 (5) Net exports of
services 50 (6) Balance of goods and
services (4) (5) -150 net
exports (7) Net unilateral transfers -30 (1)
Balance on current account (6)
(7) -180 Capital (9) Capital
inflows 280 (8) Balance on capital
account (10) Capital outflows -100 (9)
(10) 180 Balance of Total uses Total
sources Payments 730 -730 (1) (8) 0
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Exchange Rate Movements of 1980s

• Dollar reached record low 1980
• Then appreciated 60 by 1985
• Why?
• Fed policy to restrict money supply and lower
  inflation (interest rates increased)
• Large tax cut (increased earnings, returns)
• Larger budget deficit (increased interest rates)
• Increased foreign demand for U.S. securities,
  reduced U.S. demand for foreign securities

30
Exchange Rate Movements of 1980s

• Results
• Increase in account current deficit
• Appreciation raised prices of U.S. goods in
  foreign markets (less exports)
• Appreciation lowered prices of foreign goods in
  U.S. (more imports)
• Put drag on growth of output and employment
• G-5 intervened to lower value of dollar

31
Exchange Rate Movements since 1990

• Roller coaster ride
• Budget deficit of early 1990s
• Contractionary fiscal policy
• Easy monetary policy
• Economy weak, less fear of inflation
• Lower interest rates, depreciation of dollar
• 1993 trade deficit widened
• Recovery of U.S. economy relative to others
• Dollar depreciated
• 1995 interest rates increased, dollar
  appreciated
• 1997-1998, flight to quality, appreciating dollar
• 1998 Fed intervened to support yen
• 1998 Fed lowered interest rates, dollar
  depreciated
• 1999 booming economy, dollar appreciated
• 2000 dollar stronger than 1986
• 2001 economy slowed, interest rates fell, dollar
  depreciated