Exchange Rates and The Open Economy Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

Exchange Rates and The Open Economy

Exchange Rates and The Open Economy

Principles of Macroeconomics

Dr. Gabriel X. Martinez

Ave Maria University

Chapter 29: Exchange Rates and Chapter 29: Exchange Rates and the Open Economythe Open Economy

22Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

IntroductionIntroduction

Have you visited any foreign countries?Have you visited any foreign countries?

What currency did they use there?What currency did they use there?

What was the exchange rate of that What was the exchange rate of that currency with the dollar?currency with the dollar?



Exchange RatesExchange Rates

To make a transaction with a foreign To make a transaction with a foreign country, first you need to get that country’s country, first you need to get that country’s currency.currency.

€ $

Pickle Co., in the US, sends him $36 worth of pickles.

Pierre takes his €30 to the foreign exchange market and gets $36.

Pierre wants American pickles. He has €30.



Exchange Rate PolicyExchange Rate Policy The choice of an exchange rate policy is The choice of an exchange rate policy is

tremendously important.tremendously important. A A flexibleflexible exchange rate exchange rate

– allows fluctuations in the value of a currency. It allows fluctuations in the value of a currency. It generates some uncertainty but it leaves generates some uncertainty but it leaves monetary policy free to pursue national monetary policy free to pursue national objectives.objectives.

A A fixedfixed exchange rate exchange rate– generates more certainty, but it ties monetary generates more certainty, but it ties monetary

policy to this single overriding goal, and it is policy to this single overriding goal, and it is open to speculative attacks.open to speculative attacks.



Sources of InformationSources of Information Exchange rates from the real world are available at a number of on-line Exchange rates from the real world are available at a number of on-line

sites.sites. The St. Louis Federal Reserve (The St. Louis Federal Reserve (

http://research.stlouisfed.org/fred2/categories/13http://research.stlouisfed.org/fred2/categories/13) offers tables as well ) offers tables as well as graphs for a limited number of countries. The graphs show the as graphs for a limited number of countries. The graphs show the number of units of foreign currency that can be purchased for one US number of units of foreign currency that can be purchased for one US dollar for a five (or more) year period. dollar for a five (or more) year period.

The New York Federal Reserve provides daily reports of current rates The New York Federal Reserve provides daily reports of current rates for many countries. The exchange rate is reported as units of foreign for many countries. The exchange rate is reported as units of foreign currency per US dollar. Go to (currency per US dollar. Go to (http://http://www.ny.frb.orgwww.ny.frb.org) link to “markets” ) link to “markets” and then to “Foreign Exchange.”and then to “Foreign Exchange.”

You will also find an “Exchange Rate Calculator” or “Currency You will also find an “Exchange Rate Calculator” or “Currency Converter” at Converter” at http://http://www.oandnda.comwww.oandnda.com/convert/classic/convert/classic. This converter . This converter has a database that includes 164 currencies and can provide historical has a database that includes 164 currencies and can provide historical data (back as far as three decades in some cases) in tabular or data (back as far as three decades in some cases) in tabular or graphic form.graphic form.

http://research.stlouisfed.org/fred2/categories/13

http://www.ny.frb.org/markets/fxrates/noonAm.cfm

http://www.ny.frb.org/markets/fxrates/noonAm.cfm

http://www.oandnda.com/convert/classic





ImagineImagine Imagine a business trip to Montreal, Canada. The Imagine a business trip to Montreal, Canada. The

trip is to be made May 10-14, 2006 and the trip is to be made May 10-14, 2006 and the meetings are to be held in the Hilton Montreal meetings are to be held in the Hilton Montreal Bonaventure Hotel – one of the premium hotels Bonaventure Hotel – one of the premium hotels near the city center.near the city center.

Like most major hotels in Canadian cities, the Like most major hotels in Canadian cities, the Montreal Bonaventure will accept either Canadian Montreal Bonaventure will accept either Canadian currency ($CAN) or U.S. currency ($US).currency ($CAN) or U.S. currency ($US).

The following nightly rates have been given to you:The following nightly rates have been given to you:

$225.00CAN per night$225.00CAN per night

$171.40US per night$171.40US per night



ImagineImagine The exchange rate at the time of the trip is The exchange rate at the time of the trip is

quoted as 1.3876 indicating that $1US will quoted as 1.3876 indicating that $1US will exchange for $1.3876 CAN.exchange for $1.3876 CAN.

Should you pay using Canadian or U.S. Should you pay using Canadian or U.S. currency?currency?

If you choose U.S. currency, you will pay the If you choose U.S. currency, you will pay the $171.40, but if you exchange the $171.40 $171.40, but if you exchange the $171.40 for Canadian currency, you will receive for Canadian currency, you will receive $1.3876 CAN for $1.3876 CAN for eacheach U.S. dollar for a total U.S. dollar for a total of of



ImagineImagine $171.40 US X $1.3876CAN/1$US = $237.83 CAN$171.40 US X $1.3876CAN/1$US = $237.83 CAN After exchanging the currency, you can pay in US After exchanging the currency, you can pay in US

dollars and pay the equivalent of $237.83 CAN.dollars and pay the equivalent of $237.83 CAN. Or you can pay the hotel its $225CAN per night Or you can pay the hotel its $225CAN per night

and keep the $12.83CAN + as a surplus that you and keep the $12.83CAN + as a surplus that you earned as a result of being aware of exchange earned as a result of being aware of exchange rates.rates.

This kind of calculation and transaction is very This kind of calculation and transaction is very familiar and almost continuous among travelers familiar and almost continuous among travelers who cross from one country (currency) to another.who cross from one country (currency) to another.



Imagine AgainImagine Again

You are a business person. Your firm is an You are a business person. Your firm is an importer-exporter.importer-exporter.

You buy de Beers diamonds from South You buy de Beers diamonds from South Africa, French wines, Japanese Africa, French wines, Japanese automobiles, Indian cashews, and sell automobiles, Indian cashews, and sell American DVDs and computer software.American DVDs and computer software.

If you don’t know If you don’t know everythingeverything about about exchange rates, you’ll go broke in two exchange rates, you’ll go broke in two months.months.

Exchange Rates: DefinitionsExchange Rates: Definitions




Nominal Exchange RateNominal Exchange Rate– The rate at which two currencies can be traded The rate at which two currencies can be traded

for each otherfor each other

€

€ €

€ $

$ $

$

€1

$

€

€ €

€

$$ $ $€0.5

$ $$ $ $




Nominal Exchange RateNominal Exchange Rate– The rate at which two currencies can be traded The rate at which two currencies can be traded

for each otherfor each other

€

€ €

€ $

$ $

$

$1

€

€

€ €

€

$$ $ $$2

€ $$ $ $




Nominal Exchange RatesNominal Exchange Rates– The exchange rate between British and The exchange rate between British and

Canadian currenciesCanadian currencies 0.6393 British pounds = $1 U.S.0.6393 British pounds = $1 U.S. 1.5674 Canadian $s = $1 U.S.1.5674 Canadian $s = $1 U.S. 0.6393 British pounds = 1.5674 Canadian $s0.6393 British pounds = 1.5674 Canadian $s 0.6393/1.5674 = 0.4079 pounds = 1 Canadian $0.6393/1.5674 = 0.4079 pounds = 1 Canadian $ British/Canadian exchange 0.4079 pounds per British/Canadian exchange 0.4079 pounds per

Canadian dollarCanadian dollar



Country Foreign currency/dollar Dollar/foreign currency

Nominal Exchange RatesNominal Exchange Ratesfor the U.S. Dollarfor the U.S. Dollar

Nov 28, 2005

The dollar has weakened since 2002 (except against the peso)

United Kingdom (pound) 0.5810.581 1.72211.7221

Canada (Canadian dollar) 1.16561.1656 0.85790.8579

Mexico (peso) 10.571510.5715 0.094590.09459

Japan (yen) 119.25119.25 0.008390.00839

Switzerland (Swiss franc) 1.3111.311 0.762780.76278

South Korea (won) 1039.41039.4 0.0009620.000962

Euro 0.84310.8431 1.186031.18603




You are a business person. Your firm is an You are a business person. Your firm is an importer-exporter.importer-exporter.– You buy de Beers diamonds from South Africa, You buy de Beers diamonds from South Africa,

French wines, Japanese automobiles, Indian French wines, Japanese automobiles, Indian cashews, and sell American DVDs and cashews, and sell American DVDs and computer software.computer software.

Every time you carry out one of these Every time you carry out one of these transactions, you must exchange one transactions, you must exchange one currency for another, at the nominal currency for another, at the nominal exchange rate.exchange rate.



The U.S. NominalThe U.S. NominalExchange Rate, 1973-2002Exchange Rate, 1973-2002

Trade Weighted Exchange Index: Major CurrenciesNominal Exchange Rate

0

20

40

60

80

100

120

140

160




AppreciationAppreciation– An increase in the value of a currency An increase in the value of a currency

relative to other currenciesrelative to other currencies

DepreciationDepreciation– A decrease in the value of a currency A decrease in the value of a currency

relative to other currenciesrelative to other currencies



Visiting AustriaVisiting Austria

Suppose you are going to Austria next Suppose you are going to Austria next semester.semester.

You’ve saved up $2,000 for traveling. At an You’ve saved up $2,000 for traveling. At an exchange rate of $1.18/€, that means exchange rate of $1.18/€, that means €1,695.€1,695.– That’s about 90 meals.That’s about 90 meals.

But then, alas! The Euro appreciates to But then, alas! The Euro appreciates to $1.92/€. Now you only have €1,041.$1.92/€. Now you only have €1,041.– That’s about 54 meals.That’s about 54 meals.




Some DefinitionsSome Definitions– e = e = nominal exchange ratenominal exchange rate– e = e = the number of units of foreign currency the number of units of foreign currency

that the domestic currency will buythat the domestic currency will buy

e = e = the number of units the number of units of foreign currency that of foreign currency that 1 unit of domestic 1 unit of domestic currency will buycurrency will buy




When When ee increases, the domestic increases, the domestic currency appreciatescurrency appreciates

When When ee decreases, the domestic decreases, the domestic currency depreciatescurrency depreciates







If the Dollar If the Dollar appreciatesappreciates, US goods become , US goods become more expensive and harder to sell to foreign more expensive and harder to sell to foreign lands; foreign goods become cheaper and lands; foreign goods become cheaper and more attractive.more attractive.




Flexible Exchange RateFlexible Exchange Rate– An exchange rate whose value is not An exchange rate whose value is not

officially fixed but varies according to the officially fixed but varies according to the supply and demand for the currency in supply and demand for the currency in the foreign exchange marketthe foreign exchange market..

Foreign Exchange MarketForeign Exchange Market– The market on which currencies of various The market on which currencies of various

nations are traded for one anothernations are traded for one another




Fixed Exchange RateFixed Exchange Rate– An exchange rate whose value is set by An exchange rate whose value is set by

official government policyofficial government policy




The Real Exchange RateThe Real Exchange Rate– Nominal exchange rateNominal exchange rate

The number of units of foreign currency that the The number of units of foreign currency that the domestic currency will buydomestic currency will buy




The Real Exchange RateThe Real Exchange Rate– Real exchange rateReal exchange rate

The number of units of foreign GDP that 1 unit of The number of units of foreign GDP that 1 unit of domestic GDP can buy.domestic GDP can buy.

The price of the average domestic good or The price of the average domestic good or service relative to the price of the average service relative to the price of the average foreign good or service, when the prices are foreign good or service, when the prices are expressed in terms of a common currency. expressed in terms of a common currency.

How many loaves of French bread are needed How many loaves of French bread are needed to buy an American loaf of sliced bread? to buy an American loaf of sliced bread?




The Real Exchange RateThe Real Exchange Rate– Real exchange rateReal exchange rate

While knowing the magnitude of the real While knowing the magnitude of the real exchange rate is likely of little interest to an exchange rate is likely of little interest to an individual traveler making a one-week trip to individual traveler making a one-week trip to Iceland,Iceland,it is important and useful to importers and it is important and useful to importers and exporters who need information regarding the exporters who need information regarding the general relationship between two currencies and general relationship between two currencies and two economies. two economies.






What you are really interested in, ultimately, What you are really interested in, ultimately, is how many DVDs you have to sell to get is how many DVDs you have to sell to get so many bottles of wine.so many bottles of wine.



Exchange RatesExchange Rates ExampleExample

– You are the Director of Purchases for You are the Director of Purchases for Consumer Services, Inc.Consumer Services, Inc.

– You are considering whether to buy You are considering whether to buy 1,000,000 computers. Should you buy 1,000,000 computers. Should you buy Japanese or American computers?Japanese or American computers? Price in yenPrice in yen

= price in dollars x (yen-dollar exchange rate)= price in dollars x (yen-dollar exchange rate) Price in dollarsPrice in dollars

= price in yen / (yen-dollar exchange rate)= price in yen / (yen-dollar exchange rate)

e = e = the number of units of foreign currency that 1 unit of the number of units of foreign currency that 1 unit of domestic currency will buydomestic currency will buy



Price in the Price in the original original countrycountry

Currency Currency ConversionConversion

Price in the Price in the other other countrycountry

US US computercomputer $2,400$2,400

$2,400 *$2,400 *

110 yen/dollar110 yen/dollar¥264,000¥264,000

JapaneseJapanese

ComputerComputer ¥¥242,000242,000 ¥¥242,000 / 242,000 / 110 yen/dollar110 yen/dollar $2,200$2,200

e = e = 110 yen/dollar110 yen/dollar = = the number of units of foreign the number of units of foreign currency that 1 unit of domestic currency will buycurrency that 1 unit of domestic currency will buy




ExampleExample– Should you buy Japanese or American Should you buy Japanese or American

computers for your company?computers for your company? Japanese computers are cheaper.Japanese computers are cheaper.

Price of U.S. computer = Price of U.S. computer = $2,400$2,400 Price in of Japanese computer in dollars =Price in of Japanese computer in dollars =

242,000 yen/110 = 242,000 yen/110 = $2,200$2,200 Real exchange rate = $2,400/$2,200 = 1.09Real exchange rate = $2,400/$2,200 = 1.09





Real Exchange RateReal Exchange Rate

)( dollars in good, foreign of Price

)( gooddomestic of Price Rate Exchange Real

fP

P

/e Rate Exchange Real

fP

P

fP

eP RER

P$

P€=P

$ /e




The Computer Example, revisitedThe Computer Example, revisited– EE = 110/$1 = 110/$1– P =P = $2,400 $2,400– PPff = 242,000 yen = 242,000 yen

yen242,000

$2,400 x yen/$1)(110 Rate Exchange Real

1.09 yen242,000

yen264,000 Rate Exchange Real





The Real Exchange RateThe Real Exchange Rate– A high real exchange rate makes it difficult for A high real exchange rate makes it difficult for

domestic producers to export to other countries: domestic producers to export to other countries: domestic goods are too expensive.domestic goods are too expensive.

– A high (appreciated) real exchange rate attracts A high (appreciated) real exchange rate attracts imports.imports.

e = e = the number of units the number of units of foreign currency that of foreign currency that 1 unit of domestic 1 unit of domestic currency will buycurrency will buyThis is an important topic of

International Monetary Economics, ECO 421



Austria, RevisitedAustria, Revisited

You’d saved up $2,000. If e = $1.18/€, that You’d saved up $2,000. If e = $1.18/€, that means €1,695, about 90 meals.means €1,695, about 90 meals.

But the dollar depreciates to $1.92/€, you But the dollar depreciates to $1.92/€, you only have €1,041, about 54 meals.only have €1,041, about 54 meals.

The dollar depreciation made the Euro The dollar depreciation made the Euro appreciateappreciate..

This made European meals more expensive This made European meals more expensive and less attractive.and less attractive.




The Real Exchange RateThe Real Exchange Rate– NXNX will tend to be low when the real exchange will tend to be low when the real exchange

rate is high.rate is high.– Real and nominal exchange rates tend to Real and nominal exchange rates tend to

move in the same directionmove in the same direction





Economic NaturalistEconomic Naturalist– Does a strong currency imply a strong Does a strong currency imply a strong

economy?economy? A currency will get strong if there is a high A currency will get strong if there is a high

demand for the country’s goods (and therefore demand for the country’s goods (and therefore its currency).its currency).

But if an economy has a big trade deficit But if an economy has a big trade deficit (Imports > Exports), a devaluation of the (Imports > Exports), a devaluation of the currency will solve the problem: it makes currency will solve the problem: it makes domestic goods more competitive.domestic goods more competitive.



Real Exchange Rates,Real Exchange Rates,US/CAN, US/MEXUS/CAN, US/MEX

0

2

4

6

8

10

12

14

16

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

Mexico Canada

Determination of Exchange Determination of Exchange RatesRates

Purchasing Power ParityPurchasing Power Parity

This is an important topic ofInternational Monetary Economics, ECO 421



A blank DVD is a blank DVD, right? So it A blank DVD is a blank DVD, right? So it should cost the same everywhere.should cost the same everywhere.

Law of One PriceLaw of One Price– If transportation costs are relatively small, the If transportation costs are relatively small, the

price of an internationally traded commodity price of an internationally traded commodity must be the same in all locations.must be the same in all locations.

The Determination of the Exchange The Determination of the Exchange RateRate




Your firm is an importer-exporter.Your firm is an importer-exporter. Suppose you could get the exact same Suppose you could get the exact same

diamond from South Africa and also from diamond from South Africa and also from Australia.Australia.

After taking into account the nominal After taking into account the nominal exchange rate, eitherexchange rate, either1.1. prices are exactly the same, so you’re prices are exactly the same, so you’re

indifferent orindifferent or2.2. prices are different, and you’d buy from the prices are different, and you’d buy from the

cheapest until prices came cheapest until prices came to equalityto equality..



Purchasing Power Parity (Purchasing Power Parity (PPPPPP))– ““Nominal exchange rates move so that the law Nominal exchange rates move so that the law

of one price can hold.”of one price can hold.”


P$

P€=P

$ /e=



Purchasing Power Parity (Purchasing Power Parity (PPPPPP))

The Real Exchange rate = e P / Pf

PPP implies Pe = Pf and e=Pf/P

This way, if I have domestic blank DVD, I This way, if I have domestic blank DVD, I can sell it, get home currency, change it into can sell it, get home currency, change it into foreign currency, and a foreign blank DVD.foreign currency, and a foreign blank DVD.


:PPP implies

e=Pf/PIt also implies e=Pf – P

Currency depreciates if P > Pf



Purchasing Power Parity (Purchasing Power Parity (PPPPPP))– In the long run, the currencies of countries that In the long run, the currencies of countries that

experience significant inflation will tend to experience significant inflation will tend to depreciate.depreciate.




ExampleExample– How many Indian rupees equal to one How many Indian rupees equal to one

Australian dollar?Australian dollar? A Bushel of grain is the same bushel of grain in India A Bushel of grain is the same bushel of grain in India

or in Australia.or in Australia. A bushel of grain costs 5 Australian dollars or 150 A bushel of grain costs 5 Australian dollars or 150

rupeesrupees 5 Australian dollars = 150 rupees5 Australian dollars = 150 rupees Nominal exchange should equal 30 rupees/Australian Nominal exchange should equal 30 rupees/Australian

dollardollar




ExampleExample– How many Indian rupees equal one Australian How many Indian rupees equal one Australian

dollar?dollar? Suppose the Price of grain in India increases from Suppose the Price of grain in India increases from

150 to 300 rupees150 to 300 rupees But Price of Indian grain in Australia stays equal to 5 But Price of Indian grain in Australia stays equal to 5

Australian dollarsAustralian dollars




ExampleExample– Now, how many Indian rupees equal one Now, how many Indian rupees equal one

Australian dollar?Australian dollar? 5 Australian dollars = 300 rupees5 Australian dollars = 300 rupees 1 Australian dollar = 60 rupees1 Australian dollar = 60 rupees Nominal exchange rate increased from 30 to 60 Nominal exchange rate increased from 30 to 60

rupees/Australian dollarrupees/Australian dollar Indian currency depreciatedIndian currency depreciated Australian currency appreciatedAustralian currency appreciated




ExampleExample– Shortcomings of the PPP TheoryShortcomings of the PPP Theory

The theory hasThe theory hasbeen successfulbeen successfulin the in the long runlong runbut not thebut not theshort run.short run.




ExampleExample– Limits to the PPP TheoryLimits to the PPP Theory

Not all goods and services are traded internationally.Not all goods and services are traded internationally.– The greater the share of non-traded goods, the less precise The greater the share of non-traded goods, the less precise

the PPP theorythe PPP theory

Not all internationally traded goods and services are Not all internationally traded goods and services are perfectly standardized commodities.perfectly standardized commodities.




The Big Mac IndexThe Big Mac Index

The Economist'sThe Economist's Big Mac index seeks to Big Mac index seeks to make exchange-rate theory more digestible. make exchange-rate theory more digestible.

It is arguably the world's most accurate It is arguably the world's most accurate financial indicator to be based on a fast-food financial indicator to be based on a fast-food item.item.




The Big Mac index, which The Economist The Big Mac index, which The Economist has compiled since 1986, is based on the has compiled since 1986, is based on the notion that a currency's price should reflect notion that a currency's price should reflect its purchasing power.its purchasing power.

In other words, a unit of currency should buy In other words, a unit of currency should buy the same amount of burger anywhere.the same amount of burger anywhere.




Their index shows that burger prices can Their index shows that burger prices can certainly fall out of line with each other.certainly fall out of line with each other.

If he could keep the burgers fresh, an If he could keep the burgers fresh, an ingenious arbitrageur could buy Big Macs ingenious arbitrageur could buy Big Macs for the equivalent of $1.27 in China, whose for the equivalent of $1.27 in China, whose yuan is the most undervalued currency in yuan is the most undervalued currency in our table, and sell them for $5.05 in our table, and sell them for $5.05 in Switzerland, whose franc is the most Switzerland, whose franc is the most overvalued currency.overvalued currency.




The impracticality of such a trade highlights The impracticality of such a trade highlights some of the flaws in the PPP idea. Trade some of the flaws in the PPP idea. Trade barriers, transport costs and differences in barriers, transport costs and differences in taxes drive a wedge between prices in taxes drive a wedge between prices in different countries.different countries.




More important, the $5.05 charged for a More important, the $5.05 charged for a Swiss Big Mac helps to pay for the retail Swiss Big Mac helps to pay for the retail space in which it is served, and for the labor space in which it is served, and for the labor that serves it. Neither of these two crucial that serves it. Neither of these two crucial ingredients can be easily traded across ingredients can be easily traded across borders. borders.







Determination of Exchange Determination of Exchange RatesRates

Supply and Demand AnalysisSupply and Demand Analysis





Every time you buy some Indian cashews, Every time you buy some Indian cashews, you must buy Indian rupees (their currency), you must buy Indian rupees (their currency), that is, demand rupees.that is, demand rupees.

Every time you sell some American DVDs to Every time you sell some American DVDs to an Indian firm, it must sell rupees to buy an Indian firm, it must sell rupees to buy dollars, that is, supply rupees.dollars, that is, supply rupees.



Supplying A CurrencySupplying A Currency

A recent newspaper account indicates that Wal-A recent newspaper account indicates that Wal-Mart sells approximately 10 percent of all Chinese-Mart sells approximately 10 percent of all Chinese-made items sold in the United States economy.made items sold in the United States economy.

Since Wal-Mart does not earn large amounts of Since Wal-Mart does not earn large amounts of yuan in China, the retail giant must go to the yuan in China, the retail giant must go to the currency market to currency market to getget the yuan with which to buy the yuan with which to buy Chinese goods.Chinese goods.

Wal-Mart must selling a lot of dollars to buy the Wal-Mart must selling a lot of dollars to buy the Chinese currency.Chinese currency.

Wal-Mart is a supplier of dollars.Wal-Mart is a supplier of dollars.



Demanding A CurrencyDemanding A Currency

The People’s Bank of China buys billions of The People’s Bank of China buys billions of dollars worth of U.S. assets (government dollars worth of U.S. assets (government securities) and in that way it finances a large securities) and in that way it finances a large part of the US current account deficit.part of the US current account deficit.

Since the PBoC does not print dollars, it Since the PBoC does not print dollars, it must buy them in the market for currency. must buy them in the market for currency.

The bank then becomes a demander of The bank then becomes a demander of dollars.dollars.



Demand and Supply for CurrencyDemand and Supply for Currency

The Demand for Dollars in the Forex MarketThe Demand for Dollars in the Forex Market– Happens in the foreign exchange marketHappens in the foreign exchange market– Someone wants to get rid of some currency to Someone wants to get rid of some currency to

buy dollars.buy dollars.– Is distinct from “money demand”, which is the Is distinct from “money demand”, which is the

allocation of wealth.allocation of wealth.



Demand and Supply for CurrencyDemand and Supply for Currency

The Supply of Dollars in the Forex MarketThe Supply of Dollars in the Forex Market– Happens in the foreign exchange marketHappens in the foreign exchange market– Someone wants to buy another currency with Someone wants to buy another currency with

some dollars, and so sells the dollars.some dollars, and so sells the dollars.– Is distinct from “money supply”, set by the CB.Is distinct from “money supply”, set by the CB.



Quantity of dollars traded

Yen

/do

llar

exch

ang

e ra

te

Demand for dollars

Supply of dollars

e*

The equilibrium exchange rate (e*) or fundamental exchange rate makes the quantities of dollars supplied and demanded equal

The Supply and Demand for The Supply and Demand for Dollars In The Yen-Dollar MarketDollars In The Yen-Dollar Market



Changes in the Supply of DollarsChanges in the Supply of Dollars– Factors that increase the supply of dollarsFactors that increase the supply of dollars

An increase in the preference for Japanese goodsAn increase in the preference for Japanese goods An increase in U.S. real GDPAn increase in U.S. real GDP An increase in the real interest rate on Japanese An increase in the real interest rate on Japanese

assetsassets




Changes in the Supply of DollarsChanges in the Supply of Dollars– Factors that increase the supply of dollarsFactors that increase the supply of dollars

An increase in the preference for Japanese goodsAn increase in the preference for Japanese goods An increase in U.S. real GDPAn increase in U.S. real GDP An increase in the real interest rate on Japanese An increase in the real interest rate on Japanese

assetsassets


¥

$

A Toyota goes to US




Yen

/do

llar

exch

ang

e ra

te

D

S

e*E

•Increase in demand for Japanese video games

e*’

S’

F

•Supply of dollars increases from S to S’•The value of the dollar in terms of yen falls•e* falls to e*’

An Increase In The Supply of An Increase In The Supply of Dollars Lowers The Value of The DollarDollars Lowers The Value of The Dollar



Changes in the Demand for DollarsChanges in the Demand for Dollars– Factors that increase the demand for dollarsFactors that increase the demand for dollars

Increased preference for U.S. goodsIncreased preference for U.S. goods Increase in real GDP abroadIncrease in real GDP abroad An increase in the real interest rate on U.S. assetsAn increase in the real interest rate on U.S. assets




Changes in the Demand for DollarsChanges in the Demand for Dollars– Factors that increase the demand for dollarsFactors that increase the demand for dollars

Increased preference for U.S. goodsIncreased preference for U.S. goods Increase in real GDP abroadIncrease in real GDP abroad An increase in the real interest rate on U.S. assetsAn increase in the real interest rate on U.S. assets


¥$

The Bank of Japan buys a US bond




Yen

/do

llar

exch

ang

e ra

te

D

S

e*E

• Tighter monetary policy raises the domestic real interest rate

• Foreign demand for U.S. assets increase

e*’ F

D’

• The demand for dollars rises• Exchange rate appreciates from

e* to e*’

A Tightening of Monetary A Tightening of Monetary Policy Strengthens the DollarPolicy Strengthens the Dollar



Demand and Supply of CurrencyDemand and Supply of Currency

The The equilibrium exchange rate equilibrium exchange rate (e*) or (e*) or fundamental exchange rate fundamental exchange rate makes the makes the quantities of dollars supplied and demanded quantities of dollars supplied and demanded equal.equal.



Economic NaturalistEconomic Naturalist– Why do people think the dollar will Why do people think the dollar will

depreciate brutally in the next few months?depreciate brutally in the next few months? Right now, there’s a tremendous demand for US Right now, there’s a tremendous demand for US

dollars by foreigners to pay for the $700 billion dollars by foreigners to pay for the $700 billion current account annual deficit.current account annual deficit.

If they chose not to buy dollars, the demand for If they chose not to buy dollars, the demand for the dollar (and its foreign-exchange value) would the dollar (and its foreign-exchange value) would collapse.collapse.

Monetary Policy andMonetary Policy andthe Exchange Ratethe Exchange Rate





The Exchange Rate as a Tool of The Exchange Rate as a Tool of Monetary PolicyMonetary Policy– When the exchange rate is flexible:When the exchange rate is flexible:

Tighter monetary policy reduces net exports.Tighter monetary policy reduces net exports.– By raising the interest rate, the exchange rate By raising the interest rate, the exchange rate

appreciates.appreciates.

Easier monetary policy stimulates net exports.Easier monetary policy stimulates net exports.– By lowering the interest rate, the exchange rate By lowering the interest rate, the exchange rate

depreciates.depreciates.

Monetary policy is more effective in an open Monetary policy is more effective in an open economy with flexible exchange rates.economy with flexible exchange rates.




The Exchange Rate is a Tool of Monetary The Exchange Rate is a Tool of Monetary PolicyPolicy– When the exchange rate is flexible:When the exchange rate is flexible:

Tighter monetary policy reduces net exports.Tighter monetary policy reduces net exports.– A higher interest rate makes purchasing domestic A higher interest rate makes purchasing domestic

assets (such as bonds) bonds more attractive.assets (such as bonds) bonds more attractive.– As people buy domestic assets, the exchange rate As people buy domestic assets, the exchange rate

appreciates.appreciates.– As As ee appreciates, imports become cheaper. appreciates, imports become cheaper.– As As ee appreciates, exports become more expensive. appreciates, exports become more expensive.


M ↓

i ↑

e ↑

NX ↓

Y ↓



The Exchange Rate is a Tool of Monetary PolicyThe Exchange Rate is a Tool of Monetary Policy Tighter monetary policy reduces net exports.Tighter monetary policy reduces net exports.

– As As ee appreciates, imports become cheaper. appreciates, imports become cheaper.– As As ee appreciates, exports become more expensive. appreciates, exports become more expensive.– Ex: suppose Ex: suppose ee = = €€1/$.1/$.– French wine costs French wine costs €30. Notice €30 / €€30. Notice €30 / €1/$ = 1/$ = $$3030..– Californian wine costs $30. Notice $30 x €Californian wine costs $30. Notice $30 x €1/$ = 1/$ = €€3030..

– Suppose e = €Suppose e = €2/$, so the dollar is worth more euros2/$, so the dollar is worth more euros..– French wine costs French wine costs €30. Now €30 / €€30. Now €30 / €2/$ = 2/$ = $$1515..– Californian wine costs $30. Now $30 x €Californian wine costs $30. Now $30 x €2/$ = 2/$ = €€6060..




The Exchange Rate as a Tool of Monetary The Exchange Rate as a Tool of Monetary PolicyPolicy

Easier monetary policy stimulates net exports.Easier monetary policy stimulates net exports.– By lowering the interest rate, the exchange rate By lowering the interest rate, the exchange rate

depreciates.depreciates.– As As ee depreciates, imports become more expensive. depreciates, imports become more expensive.– As As ee depreciates, exports become cheaper. depreciates, exports become cheaper.

– Suppose e = €Suppose e = €0.5/$, so the dollar is worth fewer 0.5/$, so the dollar is worth fewer euroseuros..

– French wine costs French wine costs €30. Now €30 / €€30. Now €30 / €0.5/$ = 0.5/$ = $$6060..– Californian wine costs $30. Now $30 x €Californian wine costs $30. Now $30 x €0.5/$ = 0.5/$ = €15.€15.


M ↑

i ↓

e ↓

NX ↑

Y ↑





If the Fed lowers interest rates, the dollar If the Fed lowers interest rates, the dollar will be pressured downward.will be pressured downward.

Your import business will suffer (foreign Your import business will suffer (foreign goods will become more expensive) but goods will become more expensive) but your export business will benefit (US goods your export business will benefit (US goods will become cheaper).will become cheaper).

Fixed Exchange RatesFixed Exchange Rates





Suppose you are an importer-exporter.Suppose you are an importer-exporter.– You buy de Beers diamonds from South Africa, You buy de Beers diamonds from South Africa,


Wouldn’t you like to know that the value of Wouldn’t you like to know that the value of the US Dollar will stay constant relative to the US Dollar will stay constant relative to these currencies for the foreseeable future?these currencies for the foreseeable future?




For many, many years, the US fixed the For many, many years, the US fixed the value of the dollar to Goldvalue of the dollar to Gold– Right now, many countries still fix the value of Right now, many countries still fix the value of

their currencies to the dollar or other currencies their currencies to the dollar or other currencies (they “peg” their currency to the dollar, Euro, etc.).(they “peg” their currency to the dollar, Euro, etc.).

– Countries believe that fixing the exchange rate Countries believe that fixing the exchange rate generates more stability and predictability.generates more stability and predictability.




Fixed Exchange RatesFixed Exchange Rates– The government will The government will pegpeg its currency to a major its currency to a major

currencycurrency or to a “basket” of currencies.or to a “basket” of currencies.

– The Central Bank declares that it will buy and The Central Bank declares that it will buy and sell unlimited amounts of domestic currency at sell unlimited amounts of domestic currency at that particular price.that particular price.

– For example, the Thai baht may be pegged to For example, the Thai baht may be pegged to the US dollar.the US dollar.




Fixed Exchange RatesFixed Exchange Rates– Suppose the exchange rate is fixed, but some Suppose the exchange rate is fixed, but some

event requires a change in the parityevent requires a change in the parity (parity: the number, the precise value of (parity: the number, the precise value of ee at which at which

the exchange rate is fixed)the exchange rate is fixed)

– The government may have to The government may have to devalue devalue or or revaluerevalue its currency. its currency.




DevaluationDevaluation– A reduction in the official value of a currency (in A reduction in the official value of a currency (in

a fixed-exchange-rate system)a fixed-exchange-rate system)

RevaluationRevaluation– An increase in the official value of a currency (in An increase in the official value of a currency (in

a fixed-exchange-rate system)a fixed-exchange-rate system)




Overvalued Exchange RateOvervalued Exchange Rate– An exchange rate that has an An exchange rate that has an officiallyofficially fixed fixed

value greater than its value greater than its fundamentalfundamental value value

Undervalued Exchange RateUndervalued Exchange Rate– An exchange rate that has an An exchange rate that has an officiallyofficially fixed fixed

value less than its value less than its fundamentalfundamental value value



An Overvalued Exchange An Overvalued Exchange RateRate

Quantity of pesos traded

Do

llar/

pes

o e

xch

ang

e ra

te

Demand for pesos

Supply of pesos

Official value

Fundamental value0.10 dollar/peso

0.125 dollar/peso

• The peso’s official value is greater than the fundamental value; the peso is overvalued

A B

• To maintain the value, the government must purchase a quantity of pesos (A-B)



Imagine AgainImagine Again You are an importer.You are an importer.

– If the dollar is overvalued vis-à-vis the Euro, you If the dollar is overvalued vis-à-vis the Euro, you will lobby the Treasury to keep it overvalued, will lobby the Treasury to keep it overvalued, because your dollars will buy more European because your dollars will buy more European goods.goods.

You are an exporter (or you compete with You are an exporter (or you compete with imports).imports).– If the dollar is overvalued vis-à-vis the Chinese If the dollar is overvalued vis-à-vis the Chinese

yuan, you will pressure the Treasury to make yuan, you will pressure the Treasury to make the Chinese revalue their currency, which will the Chinese revalue their currency, which will make Chinese goods more expensive and make Chinese goods more expensive and yours relatively cheaper.yours relatively cheaper.


How to Fix an Exchange RateHow to Fix an Exchange Rate



How to Fix an Exchange RateHow to Fix an Exchange Rate Suppose you’ve fixed your exchange rate at Suppose you’ve fixed your exchange rate at

0.125 dollar/peso = 8 pesos/dollar.0.125 dollar/peso = 8 pesos/dollar. But the fundamental value is 0.1 dollar/pesoBut the fundamental value is 0.1 dollar/peso

= 10 pesos/dollar= 10 pesos/dollar– This is the value at which quantity demanded This is the value at which quantity demanded

and quantity supplied are equal.and quantity supplied are equal.

The Dollar is undervaluedThe Dollar is undervalued The peso is overvalued.The peso is overvalued.



How to Fix an Exchange RateHow to Fix an Exchange Rate Suppose the peg was at 0.08 dollar/pesoSuppose the peg was at 0.08 dollar/peso

(= 12.5 pesos/dollar).(= 12.5 pesos/dollar). because the fundamental value is 0.1 because the fundamental value is 0.1

dollar/peso = 10 pesos/dollar.dollar/peso = 10 pesos/dollar.– This is the value at which quantity demanded This is the value at which quantity demanded

and quantity supplied are equal.and quantity supplied are equal.

The Dollar is overvalued (it should be worth The Dollar is overvalued (it should be worth less).less).

The peso is undervalued.The peso is undervalued.



How to Fix an Exchange RateHow to Fix an Exchange Rate Responses to an Responses to an overovervalued currencyvalued currency

– Devalue the currency: adjust the official Devalue the currency: adjust the official value of the currency to equal the value of the currency to equal the fundamental value.fundamental value.




– Impose trade barriers: prevent people Impose trade barriers: prevent people from trading, either goods and services, or from trading, either goods and services, or the currency (this last is called capital the currency (this last is called capital controls).controls). This reduces the supply of currency and This reduces the supply of currency and

ameliorates the excess supply. Hence, the ameliorates the excess supply. Hence, the price of currency (the exch. rate) doesn’t get price of currency (the exch. rate) doesn’t get pushed in any way.pushed in any way.




– The Central Bank can buy large amounts The Central Bank can buy large amounts of the currency : increase the demand for of the currency : increase the demand for domestic currency so the fundamental domestic currency so the fundamental value rises to equal the official value.value rises to equal the official value. To purchase your own currency (to keep its To purchase your own currency (to keep its

value high) you must sell value high) you must sell other country’s other country’s currenciescurrencies, that is, your , that is, your international international reservesreserves..




International ReservesInternational Reserves– Foreign currency assets held by a government Foreign currency assets held by a government

for the purpose of purchasing the domestic for the purpose of purchasing the domestic currency in the foreign exchange market.currency in the foreign exchange market.

– To purchase its own currency, a country must To purchase its own currency, a country must hold international reserves.hold international reserves.



How to Fix an Exchange RateHow to Fix an Exchange Rate An overvalued currency leads to a An overvalued currency leads to a balance balance

of payments deficitof payments deficit– Leads to a net decline in international reserves Leads to a net decline in international reserves

over a year if exchange rates are fixed.over a year if exchange rates are fixed.– IM = 500 and X = 400.IM = 500 and X = 400.

NX = NX = – 1– 100.00.

– Suppose it has KI = 80. Where does it get the Suppose it has KI = 80. Where does it get the extra 20 to pay for the extra imports?extra 20 to pay for the extra imports? NX + KI = NX + KI = –– 100 + 80 = 100 + 80 = –– 20 = BOP < 0. 20 = BOP < 0. This 20 is called a BOP deficitThis 20 is called a BOP deficit



How to Fix an Exchange RateHow to Fix an Exchange Rate An overvalued currency leads to a An overvalued currency leads to a balance balance

of payments deficitof payments deficit– If exchange rates are flexible, If exchange rates are flexible, ee depreciates: depreciates:

imports fall and exports rise. This makes imports fall and exports rise. This makes BOP=0.BOP=0.

– If exchange rates are fixed and BOP<0, the If exchange rates are fixed and BOP<0, the currency is overvalued and the CB sells currency is overvalued and the CB sells international reserves to defend the exchange international reserves to defend the exchange rate.rate. The currency is overvalued because if it were The currency is overvalued because if it were

allowed to lose value, X would become more allowed to lose value, X would become more competitive and rise, increasing NX and BOP.competitive and rise, increasing NX and BOP.




An undervalued currency leads to a An undervalued currency leads to a balance balance of payments surplusof payments surplus– When a balance-of-payments surplus occurs, a When a balance-of-payments surplus occurs, a

country has a net increase in international country has a net increase in international reserves over a year.reserves over a year. Suppose X – IM = 100 and capital outflows = -50.Suppose X – IM = 100 and capital outflows = -50. NX + KI = 100 – 50 = 50 = BOP > 0.NX + KI = 100 – 50 = 50 = BOP > 0.




ExampleExample– Latinia’s balance-of-payments deficitLatinia’s balance-of-payments deficit

Official value of the peso = 0.125 dollarsOfficial value of the peso = 0.125 dollars

Demand = 25,000 - 50,000Demand = 25,000 - 50,000ee Supply = 17,600 + 24,000Supply = 17,600 + 24,000ee




ExampleExample– Latinia’s balance-of-payments deficitLatinia’s balance-of-payments deficit

Official value of the peso = 0.125 dollarsOfficial value of the peso = 0.125 dollars

Demand = 25,000 - 50,000Demand = 25,000 - 50,000ee Supply = 17,600 + 24,000Supply = 17,600 + 24,000ee Fundamental valueFundamental value

– 25,000 - 50,00025,000 - 50,000e = e = 17,600 + 24,00017,600 + 24,000ee

Solving for Solving for e:e: – 7,400 = 74,0007,400 = 74,000ee– ee = 0.10 = 0.10




ExampleExample– At the official rate -- 0.125, the demand for At the official rate -- 0.125, the demand for

currency is…currency is…– DD = 25,000 - 50,000(0.125) = 18,750 = 25,000 - 50,000(0.125) = 18,750– And the supply of currency is …And the supply of currency is …– SS = 17,600 - 24,000 (0.125) = 20,600 = 17,600 - 24,000 (0.125) = 20,600– Excess supply = 1,850 pesosExcess supply = 1,850 pesos– Balance of payments deficit = 1,850 pesosBalance of payments deficit = 1,850 pesos




Latinia is running a P 1,850 BOP deficit Latinia is running a P 1,850 BOP deficit because there’s an excess supply of pesos.because there’s an excess supply of pesos.– People are getting rid of pesos to buy imports People are getting rid of pesos to buy imports

and foreigners are not buying enough pesos and foreigners are not buying enough pesos back to buy exports.back to buy exports.

The explanation for the excess supply is that The explanation for the excess supply is that the currency is the currency is overvaluedovervalued: the fixed : the fixed ee is too is too high compared to the equilibrium value.high compared to the equilibrium value.




Latinia has an overvalued currency which Latinia has an overvalued currency which generates an excess supply of pesos.generates an excess supply of pesos.

Its Central Bank will have to increase the Its Central Bank will have to increase the demand for pesos until Qdemand for pesos until QDD = Q = QSS..

It will buy pesos and It will buy pesos and sell dollarssell dollars.. Buying pesos will reduce the money supply Buying pesos will reduce the money supply

and raise interest rates.and raise interest rates.– Selling dollarsSelling dollars will reduce the bank’s will reduce the bank’s

international reserves.international reserves.


Speculative AttacksSpeculative Attacks




Suppose a currency is overvaluedSuppose a currency is overvalued– That is, the fundamental value is below the That is, the fundamental value is below the

official value.official value.– There’s an excess supply of pesos, so the CB There’s an excess supply of pesos, so the CB

buys up the pesos (demand) by selling dollars buys up the pesos (demand) by selling dollars (i.e., international reserves).(i.e., international reserves).

– In other words, the CB defends the exchange In other words, the CB defends the exchange rate peg by selling international reserves, but rate peg by selling international reserves, but financial investors know that the CB doesn’t financial investors know that the CB doesn’t have an infinite amount of int’l reserves.have an infinite amount of int’l reserves.




Suppose a currency is overvaluedSuppose a currency is overvalued– That is, the fundamental value is below the That is, the fundamental value is below the

official value.official value.– The CB defends the exchange rate peg by The CB defends the exchange rate peg by

selling international reserves, but financial selling international reserves, but financial investors know that int’l reserves will run out.investors know that int’l reserves will run out.

Speculative AttackSpeculative Attack– A massive selling of domestic currency assets A massive selling of domestic currency assets

by financial investorsby financial investors



A Speculative AttackA Speculative Attackon the Pesoon the Peso


Do

llar/

pes

o e

xch

ang

e ra

te

A B

D

S

Official value0.125 dollar/peso

• Peso overvalued at 0.125• Central bank buys pesos• Investors launch a speculative attack -- sell

peso dominated assets

0.10 dollar/peso

S’

C

• Supply of pesos increases• Central bank must purchase

more pesos




Speculative AttackSpeculative Attack– It generates a large excess supply of currency It generates a large excess supply of currency

at the fixed exchange rate.at the fixed exchange rate.– This excess supply has to be covered by selling This excess supply has to be covered by selling

international reserves.international reserves.– If the excess supply is large enough, and is If the excess supply is large enough, and is

maintained for long enough, the country maintained for long enough, the country runs runs out of international reservesout of international reserves and has to and has to abandon the peg!abandon the peg!




Economic NaturalistEconomic Naturalist– Can a speculative attack occur under flexible Can a speculative attack occur under flexible

exchange rates?exchange rates? Not in the sense of investors forcing the CB to sell all Not in the sense of investors forcing the CB to sell all

of its reserves, because, by definition, the CB is not of its reserves, because, by definition, the CB is not selling any reserves.selling any reserves.

Yes, in the sense that they can come to believe that Yes, in the sense that they can come to believe that the exchange rate will depreciate in the near future, the exchange rate will depreciate in the near future, and so they sell massive amounts of the currency, and so they sell massive amounts of the currency, shifting the Supply curve to the right.shifting the Supply curve to the right.




What is the alternative to selling reserves What is the alternative to selling reserves (and risking a speculative attack)?(and risking a speculative attack)?

To defend an exchange rate peg,To defend an exchange rate peg,– Impose capital controls or tariffsImpose capital controls or tariffs– Change monetary policyChange monetary policy

To defend an overvalued currency, tighten and raise To defend an overvalued currency, tighten and raise interest rates.interest rates.

To defend an undervalued currency, loosen and To defend an undervalued currency, loosen and lower interest rates.lower interest rates.




Do

llar/

pes

o e

xch

ang

e ra

te

D

S

Official value

E0.10 dollar/

peso

0.125 dollar/peso

•Pesos overvalued at 0.125

F

D’

•Tightening monetary policy increases D to D’•Official value = fundamental value

A Tightening of Monetary A Tightening of Monetary Policy Eliminates An OvervaluationPolicy Eliminates An Overvaluation




If monetary policy is used to set the If monetary policy is used to set the fundamental value of the exchange rate fundamental value of the exchange rate equal to the official value, it is no longer equal to the official value, it is no longer available for stabilizing the domestic available for stabilizing the domestic economy.economy.– The Central Bank loses control of monetary The Central Bank loses control of monetary

policy when it pegs the exchange rate.policy when it pegs the exchange rate.




The conflict monetary policymakers face, The conflict monetary policymakers face, between stabilizing the exchange rate and between stabilizing the exchange rate and stabilizing the domestic economy, is most stabilizing the domestic economy, is most severe when the exchange rate is under a severe when the exchange rate is under a speculative attack.speculative attack.– Suppose an economy is in bad shape, so Suppose an economy is in bad shape, so

financial investors dump the currency, creating financial investors dump the currency, creating a speculative attack. The CB responds by a speculative attack. The CB responds by raising the interest rate … which makes the raising the interest rate … which makes the economy worse!economy worse!



Monetary PolicyMonetary Policy– Flexible exchange rates can strengthen the Flexible exchange rates can strengthen the

impact of monetary policy.impact of monetary policy.– Fixed exchange rates prevent the use of Fixed exchange rates prevent the use of

monetary policy to stabilize the economy.monetary policy to stabilize the economy.

Should Exchange Rates Be Fixed or Should Exchange Rates Be Fixed or Flexible?Flexible?



Trade and Economic IntegrationTrade and Economic Integration– Fixed exchange rate proponents argue that Fixed exchange rate proponents argue that

fixed rates promote international trade.fixed rates promote international trade.– Stable nominal exchange rates are good for Stable nominal exchange rates are good for

predicting the future, for exporting and predicting the future, for exporting and importing.importing.

– The risk of a speculative attack may make the The risk of a speculative attack may make the country less attractive to investors and trade.country less attractive to investors and trade.


ExamplesExamples



What were the causes and consequences of the What were the causes and consequences of the East Asian crisis of 1997-1998?East Asian crisis of 1997-1998?– Over 1997, East Asian currencies lost half of their value.Over 1997, East Asian currencies lost half of their value.– To protect the pegs, central banks raised interest rates.To protect the pegs, central banks raised interest rates.– Exports should have boomed, but many debts were Exports should have boomed, but many debts were

denominated in dollars. Because banks were badly run, denominated in dollars. Because banks were badly run, their assets quickly became worthless.their assets quickly became worthless.

– The result was a sharp recession and the end of the The result was a sharp recession and the end of the Asian Miracle.Asian Miracle.




-40%

-20%

0%

20%

40%

60%

80%

100%

120%

South Korea Malaysia Thailand



How did policy mistakes contribute to the How did policy mistakes contribute to the Great Depression?Great Depression?– Among many other mistakes, the US kept the Among many other mistakes, the US kept the

dollar pegged to gold for too long.dollar pegged to gold for too long.– This meant that exports were too expensive and This meant that exports were too expensive and

imports pretty cheap, further depressing imports pretty cheap, further depressing economic activity.economic activity.




Why have 11 European countries adopted a Why have 11 European countries adopted a common currency?common currency?– Many Europeans believe that peace and prosperity can Many Europeans believe that peace and prosperity can

only happen if there is political union in Europe. This only happen if there is political union in Europe. This depends on economic union, which depends on trade.depends on economic union, which depends on trade.

– There is more trade if exchange rates are predictable … There is more trade if exchange rates are predictable … or if the partners have the same currency.or if the partners have the same currency.

– But that means that Ireland and Germany must have the But that means that Ireland and Germany must have the same monetary policy, which makes little sense.same monetary policy, which makes little sense. (Neither does it make sense for Florida and Louisiana to have (Neither does it make sense for Florida and Louisiana to have

the same monetary policy, though).the same monetary policy, though).




Should the Fed defend the dollar? Should Should the Fed defend the dollar? Should the European Central Bank prop it up?the European Central Bank prop it up?– I mentioned that the US Current Account deficit I mentioned that the US Current Account deficit

suggests a massive dollar depreciation.suggests a massive dollar depreciation.– If foreigners did not by US dollars, interest rates If foreigners did not by US dollars, interest rates

would have to rise.would have to rise.– This would mean a collapse of the housing This would mean a collapse of the housing

market. Should the Fed do anything about it?market. Should the Fed do anything about it?– If the dollar collapses, European goods will be If the dollar collapses, European goods will be

more expensive, deepening the recession there.more expensive, deepening the recession there.




What have we learned today?What have we learned today?

Nominal exchange rates:Nominal exchange rates:– The rate at which two currencies can be traded The rate at which two currencies can be traded

for each other.for each other.

Real exchange rateReal exchange rate– The price of the average domestic good or The price of the average domestic good or

service relative to the price of the average service relative to the price of the average foreign good or service, when the prices are foreign good or service, when the prices are expressed in terms of a common currency.expressed in terms of a common currency.

Appreciation versus depreciationAppreciation versus depreciation




In the long run, the nominal exchange rate is In the long run, the nominal exchange rate is determined by Purchasing Power Parity.determined by Purchasing Power Parity.

In the short run, the nominal exchange rate In the short run, the nominal exchange rate is determined by supply and demand for is determined by supply and demand for currency in the foreign exchange market.currency in the foreign exchange market.– The fundamental exchange rate is the The fundamental exchange rate is the

equilibrium exchange rate in the market.equilibrium exchange rate in the market.




Monetary policy is more effective in the Monetary policy is more effective in the open economy because it affects open economy because it affects expenditure through the exchange rate in expenditure through the exchange rate in addition to through the interest rate.addition to through the interest rate.– Higher interest rates appreciate the currency, Higher interest rates appreciate the currency,

which depresses net exports and output.which depresses net exports and output.




A Central Bank may fix the value of the A Central Bank may fix the value of the currency in terms of another currency.currency in terms of another currency.– If it does, it may have to raise or lower interest If it does, it may have to raise or lower interest

rates to defend the exchange rate rates to defend the exchange rate pegpeg, losing , losing control over monetary policy.control over monetary policy.

– Fixed exchange rates lead to balance of Fixed exchange rates lead to balance of payments deficits or surpluses.payments deficits or surpluses.

Documents

Exchange Rates and The Open Economy Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University