Exchange Rates

1
Lecture 11
13

• Exchange Rates

2
Exchange Rates

• Nominal Exchange Rate
• The rate at which two currencies can be traded
  for each other

3
Exchange Rates

• Nominal Exchange Rates
• The exchange rate between British and Canadian
  currencies
• 0.4889 British pounds 1 U.S.
• 1.009 Canadian s 1 U.S.
• 0.4889 British pounds 1.009 Canadian s
• 0.4889/1.009 0.4845 pounds 1 Canadian
• British/Canadian exchange 0.4845 pounds per
  Canadian dollar

4
Nominal Exchange Rates for the U.S. Dollar
Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates Major Currency Cross Rates
Currency Currency U.S. en Euro Can U.K. AU Swiss Franc
Last Trade Last Trade N/A 846am ET 846am ET 846am ET 846am ET 846am ET 846am ET
 1 U.S. 1.000 111.690 0.680 1.006 0.489 1.136 1.125
 1 en 0.009 1.000 0.006 0.009 0.004 0.010 0.010
 1 Euro 1.472 164.380 1.000 1.481 0.720 1.672 1.656
 1 Can 0.994 111.018 0.675 1.000 0.486 1.130 1.118
 1 U.K. 2.045 228.423 1.390 2.058 1.000 2.324 2.301
 1 AU 0.880 98.293 0.598 0.885 0.430 1.000 0.990
 1 Swiss Franc 0.889 99.280 0.604 0.894 0.435 1.010 1.000
5
Fixed Exchange Rates

• Economic Naturalist
• Should China change the way it manages its
  exchange rate?

6
U.S. Dollar to Chinese Yuan
11.4 Decline in value
7
Exchange Rates

• Appreciation
• An increase in the value of a currency relative
  to other currencies
• Depreciation
• A decrease in the value of a currency relative to
  other currencies

8
Exchange Rates

• Some Definitions
• e nominal exchange rate
• e the number of units of foreign currency that
  the domestic currency will buy
• If e increases, it is an appreciation of the
  domestic (base) currency.
• If e decreases, it is a depreciation of the
  domestic (base) currency.

9
Exchange Rates

• Flexible Exchange Rate
• Fixed Exchange Rates

10
The Supply and Demand for Dollars in the
Yen-Dollar Market
Yen/dollar exchange rate
Quantity of dollars traded
11
The Determination of the Exchange Rate in the
Short Run

• Changes in the Supply of Dollars
• Factors that increase the supply of dollars
• An increase in the preference for Japanese goods
• An increase in U.S. real GDP
• An increase in the real interest rate on Japanese
  assets

12
An Increase in the Supply of Dollars Lowers the
Value of the Dollar

• Increase in demand for Japanese video games

Yen/dollar exchange rate
Quantity of dollars traded
13
The Determination of the Exchange Rate in the
Short Run

• Changes in the Demand for Dollars
• Factors that increase the demand for dollars
• Increased preference for U.S. goods
• Increase in real GDP abroad
• An increase in the real interest rate on U.S.
  assets
• Thus a decrease in rates, decreases demand for
  dollars

14
A Tightening of Monetary Policy Strengthens the
Dollar
Yen/dollar exchange rate
Quantity of dollars traded
15
Foreign Exchange Market Equilibrium (example)

• The dollar price of the English pound is
  measured on the vertical axis. The horizontal
  axis indicates the flow of pounds in exchange
  for dollars.

Dollar price of foreign exchange(for pounds)

• The demand and supply of pounds are in
  equilibrium at the exchange rate of 1.50 1
  English pound.

• At this price, quantity demanded equals
  quantity supplied.

1.80

• A higher price of pounds (like 1.80 1
  pound), would lead to an excess supply of
  pounds ...

1.50
1.20
causing the dollar price of the pound to
fall (depreciate).

• A lower price of pounds (like 1.20 1
  pound), would lead to an excess demand for
  pounds

Quantity of foreign exchange (pounds)
Q
causing the dollar price of the pound to
rise (appreciate).
16
Foreign Exchange Market Equilibrium
Dollar price of foreign exchange(for pounds)

• Other things constant, if incomes increase
  in the United States, U.S. imports of foreign
  goods and services will grow.

S(sales to foreigners)

• The increase in imports will increase the
  demand for pounds (in the foreign exchange
  market)

1.80
causing the dollar price of the pound to
rise from 1.50 to 1.80.
1.50
a
D1
Quantity of foreign exchange (pounds)
Q1
Q2
17
Inflation with Flexible Exchange Rates
Dollar price of foreign exchange(for pounds)

• If prices were stable in England while the
  price level in the U.S. increased by 50 percent
  

S1
the
U.S. demand for British goods (and
pounds) would increase
2.25

as U.S. exports to Britain would be
relatively more expensive they would decline
and thereby cause the supply of pounds to
fall.
1.50
a

• These forces would cause the dollar to
  depreciate relative to the pound.

D1
Quantity of foreign exchange (pounds)
Q1
18
Fixed Exchange Rates

• How to Fix an Exchange Rate
• The government will peg its currency to a major
  currency or to a basket of currencies.
• The government may have to devalue or revalue its
  currency.

19
Fixed Exchange Rates

• Devaluation
• A reduction in the official value of a currency
  (in a fixed-exchange-rate system)
• Revaluation
• An increase in the official value of a currency
  (in a fixed-exchange-rate system)

20
Fixed Exchange Rates

• Overvalued Exchange Rate
• An exchange rate that has an officially fixed
  value greater than its fundamental value
• Undervalued Exchange Rate
• An exchange rate that has an officially fixed
  value less than its fundamental value

21
An Overvalued Exchange Rate
Dollar/peso exchange rate
Quantity of pesos traded
22
Fixed Exchange Rates

• How to Fix an Exchange Rate
• Responses to an overvalued currency
• Devalue the currency
• Impose trade barriers
• Purchase the currency
• To purchase its own currency, a country must hold
  international reserves. International Reserves
• Foreign currency assets held by a government for
  the purpose of purchasing the domestic currency
  in the foreign exchange market.

23
Fixed Exchange Rates

• Speculative Attack
• A massive selling of domestic currency assets by
  financial investors

24
A Speculative Attack on the Peso
Dollar/peso exchange rate
Quantity of pesos traded
25
Fixed Exchange Rates

• Balance-of-Payments Deficit
• The net decline in a country's stock of
  international reserves over a year

26
Fixed Exchange Rates

• Balance-of-Payment Surplus
• The net increase in a country's stock of
  international reserves over a year

27
Fixed Exchange Rates

• Example
• Latinias balance-of-payments deficit
• Demand 25,000 - 50,000e
• Supply 17,600 - 24,000e
• Official value of the peso 0.125 dollars

28
Fixed Exchange Rates

• Example
• Latinias balance-of-payments deficit
• Fundamental value
• 25,000 - 50,000e 17,600 24,000e
• Solving for e
• 7,400 74,000e
• e 0.10

29
Fixed Exchange Rates

• Example
• As the official rate -- 0.125
• D 25,000 - 50,000(0.125) 18,750
• S 17,600 - 24,000 (0.125) 20,600
• Excess supply 1,850 pesos
• Balance of payments deficit 1,850 pesos
• 1,850 x 0.125 231.25

30
A Tightening of Monetary Policy Eliminates an
Overvaluation
Dollar/peso exchange rate
Quantity of pesos traded
31
Fixed Exchange Rates

• Observation
• If monetary policy is used to set the fundamental
  value of the exchange rate equal to the official
  value, it is no longer available for stabilizing
  the domestic economy.

32
Fixed Exchange Rates

• Observation
• The conflict monetary policymakers face, between
  stabilizing the exchange rate and stabilizing the
  domestic economy, is most severe when the
  exchange rate is under a speculative attack.

33
Should Exchange Rates Be Fixed or Flexible?

• Monetary Policy
• Flexible exchange rates can strengthen the impact
  of monetary policy.
• Fixed exchange rates prevent the use of monetary
  policy to stabilize the economy.

34
Should Exchange Rates Be Fixed or Flexible?

• Trade and Economic Integration
• Fixed exchange rate proponents argue that fixed
  rates promote international trade.
• The risk of a speculative attack may make the
  country less attractive to investors and trade.

35
Fixed Rate, Unified Currency Regime

• Some examples of fixed rate, unified currency
  systems
• the U.S., Panama, Ecuador, El Salvador, and Hong
  Kong all of which use currencies that are unified
  with the U.S. dollar
• the 12 countries of the European Monetary Union,
  all of which use the euro, which is managed by
  the European Central Bank
• Countries such as El Salvador Hong Kong, that
  link their currency to the dollar at a fixed
  rate, are no longer in a position to conduct
  monetary policy. They merely accept the monetary
  policy of the Federal Reserve.
• The same can be said for the 12 countries of the
  European Monetary Union that accept the monetary
  policy of the European Central Bank.

36
Pegged Exchange Rate Regimes

• Pegged exchange rate systema system where the
  country commits to using monetary and fiscal
  policy to maintain the exchange-rate value of the
  domestic currency at a fixed rate or within a
  narrow band relative to another currency (or
  bundle of currencies).
• Unlike the case of a currency board, however,
  countries with a pegged exchange rate continue to
  conduct monetary policy.

37
When Pegged Regimes Lead to Problems

• A nation can either
• follow an independent monetary policy, allowing
  its exchange rate to fluctuate, or,
• tie its monetary policy to the maintenance of the
  fixed exchange rate.
• It cannot, however
• maintain currency convertibility at a fixed
  exchange rate while following a monetary policy
  more expansionary than that of the country to
  which its currency is tied.

38
When Pegged Regimes Lead to Problems

• Attempts to peg rates and follow a monetary
  policy that is too expansionary have led to
  several recent financial crisesa situation where
  falling foreign reserves eventually force the
  country to forego the pegged rate.
• The experiences of Mexico in 1989-1994 and of
  Brazil, Thailand, South Korea, Indonesia, and
  Malaysia in 1997-1998 illustrate this point very
  clearly.

39

• Balance of Payments
• Revisited

40
Balance of Payments

• Balance of payments accounts that summarize the
  transactions of a countrys citizens,
  businesses, and governments with foreigners

• Any transaction that creates a demand for foreign
  currency (and a supply of the domestic currency)
  in the foreign exchange market is recorded as a
  debit item.

• Transactions that create a supply of foreign
  currency (and demand for the domestic currency)
  on the foreign exchange market are recorded as a
  credit item.

41
Balance of Payments

• Under a pure flexible rate system, the foreign
  exchange market will bring the quantity demanded
  and the quantity supplied into balance, and as a
  result, it will also bring the total debits into
  balance with the total credits.

42
Balance of Payments

• Current account transactionsall payments (and
  gifts) related to the purchase or sale of goods
  and services and income flows during the current
  period
• Four categories of current account transactions
• Merchandise trade(import and export of goods)
• Service trade(import and export of services)
• Income from investments
• Unilateral transfers(gifts to and from
  foreigners)

43
Balance of Payments

• Capital account transactionstransactions that
  involve changes in the ownership of real and
  financial assets
• The capital account includes both
• direct investments by foreigners in the U.S. and
  by Americans abroad, and,
• loans to and from foreigners.
• Under a pure flexible-rate system, official
  reserve transactions are zero therefore
• a current-account deficit implies a
  capital-account surplus.
• a current-account surplus implies a
  capital-account deficit.

44
U.S. Balance of Payments, 2003
Balance
Debits
Credits
deficit (-) / surplus ()
Current account
713.1
1. U.S. merchandise exports
2. U.S. merchandise imports
- 1260.7

3. Balance of merchandise trade (1 2)
- 547.6
307.4
4. U.S. service exports
5. U.S. service imports
- 256.3
6. Balance on service trade (4 5)
51.1
7. Balance on goods and services (3 6)
- 496.5
8. Income receipts of Americans from abroad
294.4
9. Income receipts of foreigners in the U.S.
- 261.1
10. Net income receipts (8 9)
33.3
11. Net unilateral transfers
- 67.4
12. Balance on current account (7 10 11)
- 530.6
Source http//www.economagic.com/. Figures
are in Billions of Dollars
45
U.S. Balance of Payments, 2003
Balance
Debits
Credits
deficit (-) / surplus ()
Current account
12. Balance on current account (7 10 11)
- 530.6
Capital account
580.6
13. Foreign investment in the U.S. (capital
inflow)
14. U.S. investment abroad (capital outflow)
-297.1
15. Balance on capital account (13 14)
283.5
Official Reserve Transactions
16. U.S. official reserve assets
-1.5
17. Foreign official assets in the U.S.
248.6
247.1
18. Balance, Official Reserve Account (16 17)
17. Total (12 15 18)
0.0
Source http//www.economagic.com/. Figures
are in Billions of Dollars
46

• Capital Flows and
• the Current Account

47
Leading Trading Partners of the U.S.
2
0
- 2
- 4
1973
1978
1983
1988
1993
2003
1998
4
2
0
- 2
1973
1978
1983
1988
1993
2003
1998

• Under a flexible exchange rate system the inflow
  and outflow of capital will exert a major impact
  on the current account and trade balances.
• The figures for the U.S. (above) illustrate this
  linkage.

48
Are Trade Deficits Bad?

• An inflow of capital implies a trade (current
  account) deficit an outflow of capital implies a
  trade (current account) surplus.
• While the term deficit generally has negative
  connotations, this is not necessarily true for a
  trade deficit.
• If a nations investment environment is
  attractive, it is likely to result in a net
  inflow of capital, which will tend to cause a
  trade deficit.
• Similarly, rapid economic growth will tend to
  stimulate imports, which is likely to result in a
  trade deficit.

49
Trade Deficits Points to Ponder

• Although they often cause trade (and current
  account) deficits, both rapid growth and a
  healthy investment environment are signs of a
  strong economy, not a weak one.
• A trade deficit (or surplus) is an aggregate that
  reflects the voluntary choices of individuals and
  businesses. In contrast with a budget deficit,
  no legal entity is responsible for the trade
  deficit.
• The trade deficits of the U.S. during the 1980s
  and 90s were largely the result of rapid growth
  and a favorable investment climate.

50
Should Trade Between Countries Balance?

• Political leaders often imply that U.S. exports
  to a country, China or Japan for example, should
  be approximately equal to our imports from that
  country.
• This is a fallacious view.
• Under a flexible exchange rate system, overall
  purchases from foreigners will balance with
  overall sales to foreigners, but there is no
  reason why bilateral trade between any two
  countries will balance.