Foreign Exchange Markets & Exchange Rates Foreign exchange market The market in which one country’s currency is traded for another country’s currency Exchange

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Foreign Exchange Markets & Exchange Rates

• Foreign exchange market• The market in which one country’s currency is

traded for another country’s currency• Exchange rate

• The amount of one country’s currency that is traded for one unit of another country’s currency

• The price of foreign currency in dollars

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Table 1: Foreign Exchange Rates, September 10, 2009


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• The demand for British pounds• Assume that American households and

businesses are the only buyers• To buy goods and services from British firms• To buy British assets


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• Demand curve for foreign currency • Quantity of a specific foreign currency• That Americans will want to buy

• During a given period• At each different exchange rate

• Downward-sloping


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• As we move rightward along the demand for pounds curve:


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• Shifts in the demand for pounds curve - determined by changes in:• U.S. real GDP• Relative price levels• Americans’ Tastes for British Goods• Relative Interest Rates• Expected Changes in the Exchange Rate


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Figure 1: The Demand for British Pounds


DollarsPer Pound

Millions of British Pounds

(b)DollarsPer Pound

Millions ofBritish Pounds

(a)

$2.25

1.50

200 300

D£

A

E

A drop in the price of the pound moves us rightward along the demand for pounds curve.

D1£

D2£

Demand for pounds curve shifts rightward when:• U.S. real GDP ↑• U.S. relative price level ↑ • U.S. tastes shift toward British goods• U.S. interest rate ↓• Pound is expected to appreciate

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• The supply of British pounds• Assumption: British households and firms are

the only sellers• To buy goods and services from American firms• To buy American assets


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• Supply curve for foreign currency• Quantity of a specific foreign currency • That will be supplied

• During a given period• At each different exchange rate

• Upward-sloping


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• As we move rightward along the supply of pounds curve:


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• Shifts in the supply for pounds curve - determined by changes in:• Real GDP in Britain• Relative price levels• British tastes for U.S. Goods• Relative interest rates• Expected change in the exchange rate


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Figure 2: The Supply of British Pounds


DollarsPer Pound


(b)DollarsPer Pound


(a)

$2.25

1.50

300 400

A rise in the price of the pound moves us rightward along the supply of pounds curve.

S1£

The supply of pounds curve shifts rightward if:• British real GDP ↑• U.S. relative price level ↓• British tastes shift toward U.S. goods• U.S. interest rate ↑• Pound is expected to depreciate

S2£

S£

E

F

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• Floating exchange rate• Exchange rate that is freely determined by the

forces of supply and demand• When the exchange rate floats

• When the government does not intervene in the foreign currency market

• The equilibrium exchange rate• Determined at the intersection of the demand

curve and the supply curve


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Figure 3: The Equilibrium Exchange Rate


DollarsPer Pound


(b)DollarsPer Pound


(a)

1.50

300

Equilibrium in the market for pounds

S£

Higher U.S. real GDP leads to a higher price per pound

S£

D£ D1£

D2£

E

C

E1.50

300

$2.25

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What Happens When Things Change?

• Appreciation • An increase in the price of a currency in a

floating-rate system• Depreciation

• A decrease in the price of a currency in a floating-rate system


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• When a floating exchange rate changes• One country’s currency will appreciate• The other country’s currency will depreciate

• How exchange rates change over time• Very short-run: sharp up-and-down spikes• Short run movements• Long-run trend


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Figure 4: Hypothetical Exchange Rate Data over Time


These hypothetical data show typical patterns of exchange rate fluctuations. Over the course of a few minutes, days, or weeks, the exchange rate can experience sharp up-and-down spikes. Over several months or a year or two, the exchange rate may rise or fall, as in the appreciation of the foreign currency from points A to B and the depreciation from B to C. Over the long run, there may be a general upward or downward trend, like the depreciation of the foreign currency illustrated by the dashed line connecting points A and E.

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• The very short run: “hot money”• Funds that can be moved from one type of

investment to another at very short notice• Dominant forces moving exchange rates

• Relative interest rates• Expectations of future exchange rates


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Figure 5: Hot Money in the Very Short Run


DollarsPer Pound


$1.50

Q1

The market for pounds is initially in equilibrium at point E, with an exchange rate of $1.50 per pound. A rise in U.S. interest rate relative to British rate will make U.S. assets more attractive to Americans and Britons. Hot-money managers in both countries will shift funds from British to U.S. assets, causing a rightward shift of the supply of pounds curve. American investors will want to buy fewer British assets, causing a decrease in the demand for pounds. The net effect is a lower exchange rate—$1.00 per pound at point G.

D1£

D2£

S1£

S2£

E

G

Q2

1.00

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• Short run: macroeconomic fluctuations• Dominant forces moving exchange rates

• Economic fluctuations• A country whose GDP rises relatively rapidly

• Will experience a depreciation of its currency• A country whose GDP falls more rapidly

• Will experience an appreciation of its currency


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Figure 6: Exchange Rates in the Short Run


DollarsPer Pound

Millions of British Pounds per month

(b)DollarsPer Pound

Millions of British Pounds per month

(a)

1.50

Panel (a) shows a situation in which the United States recovers from a recession first. U.S. demand for foreign goods and services increases, shifting the demand for pounds curve to the right. The equilibrium moves from A to B —an appreciation of the pound. Panel (b) shows Britain’s subsequent recovery from its recession. As the British begin to buy more U.S. goods and services, the supply of pounds curve shifts rightward. The equilibrium moves from B to C causing the pound to depreciate.

S£

D1£

A

D2£

S2£

B$1.80

1.50

S1£

D1£

D2£

B$1.80

C

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• Long run: purchasing power parity• The currency of a country with a higher

inflation rate • Will depreciate against the currency of a country

whose inflation rate is lower

• Purchasing power parity (PPP) theory • The exchange rate will adjust in the long run • So that the average price of goods in two

countries will be roughly the same


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• Purchasing power parity – caveats• Some goods are difficult to trade• High transportation costs • Artificial barriers to trade


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Government Intervention in Foreign Exchange Markets

• Governments sometime intervene in foreign exchange markets involving their currency: • If the value of a country’s currency rises

• To protect export-oriented industries• If the value of a country’s currency falls

• To protect import-oriented industries and consumers

• Too volatile exchange rate• Can make trading riskier


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• Managed float • A policy of frequent central bank intervention

to move the exchange rate • Under a managed float

• A country’s central bank actively manages its exchange rate• Buying its own currency to prevent depreciations• Selling its own currency to prevent appreciations


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• Fixed exchange rate • Government-declared exchange rate

• Maintained by central bank intervention in the foreign exchange market

• If fixed below the equilibrium value• Excess demand for the country’s currency

• Central bank must sell its own currency

• If fixed above the equilibrium value• Excess supply of the country’s currency

• Central bank must buy its own currency


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Figure 7: A Fixed Exchange Rate for the Baht


DollarsPer Baht

Millions of Bahtper month

(b)DollarsPer Baht

Millions of Bahtper month

(a)Sbaht

Dbaht

$0.06

Sbaht

Dbaht

0.02

0.04 $0.04ExcessDemand

ExcessSupply

100 400 100 4001. In both panels, Thailand fixes the exchange rate at $0.04 per baht.

2. Here the supply and demand curves show the equilibrium exchange rate is $0.06 per baht.

3. The Thai Central Bank must sell 300 million baht to keep the baht from appreciating

4. With these supply and demand curves, the equilibrium exchange rate is $0.02 per baht

5. The Thai Central Bank must buy 300 million baht to keep the baht from depreciating

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• Devaluation • A change in the exchange rate from a higher

fixed rate to a lower fixed rate• Foreign currency crisis

• A loss of faith that a country can prevent a drop in its exchange rate, leading to a rapid depletion of its foreign currency (e.g., dollar) reserves


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• International Monetary Fund (IMF)• An international organization founded in 1945

to help stabilize the world monetary system.• Moral hazard

• When decision makers• Expecting assistance in the event of an

unfavorable outcome• Change their behavior so that the unfavorable

outcome is more likely


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Figure 8: A Foreign Currency Crisis


DollarsPer Baht

Millions of Baht per Month

D2baht

S1baht

0.02

Initially, the baht is fixed at the equilibrium rate of $0.04. When the supply and demand curves shift to D2 and S2, the equilibrium exchange rate falls to $0.02. If Thailand continues to fix the rate at $0.04, it will have to buy up the excess supply of 300 million baht per month, using dollars. As its dollar reserves dwindle, traders will anticipate a drop in the value of the baht, shifting the curves out further, as indicated by the arrows.

400

S2baht

D1baht

A

B

$0.04

100

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Exchange Rates and the Macroeconomy

• A depreciation of the dollar• Causes net exports to rise

• A positive demand shock • Increases real GDP in the short run

• An appreciation of the dollar • Causes net exports to drop

• A negative demand shock • Decreases real GDP in the short run


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• Monetary policy:


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• Monetary policy: • Has a stronger effect when we include the

impact on • Exchange rates • And net exports

• Rather than just the impact on • Interest-sensitive consumption and investment

spending


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Exchange Rates and the Trade Deficit

• Trade deficit = Imports – Exports • The excess of a nation’s imports over its

exports during a given period• Trade surplus = Exports – Imports

• The excess of a nation’s exports over its imports during a given period


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• U.S. net financial inflow = U.S. trade deficit• = Foreign purchase of U.S. assets – U.S.

purchases of foreign assets • Trade deficit

• Results in a transfer of wealth from Americans to foreign residents

• Can arise because of forces that cause a financial inflow


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• U.S. trade deficit • Has been caused by the desire of foreigners to

invest in the United States• Result: massive financial inflow and trade

deficit that arose in the early 1980s


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Figure 9: Net financial flows into the U.S. as a percentage of GDP


Beginning in the early 1980s, and continuing today, a massive net financial inflow has led to a U.S. trade deficit. The inflow shrunk during the financial crisis of 2008, but it was still a significant fraction of GDP.

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• How a financial inflow causes a trade deficit• An increase in the desire of foreigners to

invest in the United States• Contributes to an appreciation of the dollar• U.S. exports - decline

• Become more expensive for foreigners

• Imports - increase• Become cheaper to Americans

• Result: a rise in the U.S. trade deficit


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Figure 10: How a U.S. Financial Inflow Creates a U.S. Trade Deficit


DollarsPer Yen

Billions of Yen per Month

S1¥

0.010

15,000

S2¥

D¥

A

B

$0.015

10,00012,000

C

Japanese purchasesof U.S. assets

Increase in Japan'sexports to U.S.

Decrease in Japan'simports from U.S.

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• Sources for the rise in the trade deficit during recent decades:• Relatively high interest rates in the 1980s• A long-held preference for American assets

• Grew stronger in the 1990• A growing demand for funds in the U.S. + high

saving in other countries • From the late 1990s until around 2006


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• Concerns about the trade deficit• It’s sustainability

• The soft-landing scenario• Gradually adjust to a slowdown in foreign purchases of

U.S. assets• Require structural changes in the U.S. economy

• The hard-landing scenario• Changes: much larger and more sudden• Very serious recession


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The U.S. trade deficit with China• Growing U.S. trade deficit with China

• Special trade agreements• Chinese trade policies that have• Encouraged exports and discouraged imports• China’s undervalued exchange rate


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Figure 11: The growing U.S. trade deficit with China (trade in goods only)


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The U.S. trade deficit with China• When a U.S. trading partner

• Fixes the dollar price of its currency below its equilibrium value

• U.S. exports decline• Become more expensive to foreigners

• U.S. imports increase• Become cheaper to Americans

• Result: a rise in the U.S. trade deficit


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Figure 12: How an undervalued Chinese Yuan can create a U.S. trade deficit


DollarsPer Yuan

Billions of Yuan per Month

SYuan

0.15

1,000

DYuan

A

B

$0.24

200

C

Equilibrium valueof Yuan

Decrease in China'simports from U.S.

Increase in China'sexports to U.S.

700

Fixed valueof Yuan

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Foreign Exchange Markets & Exchange Rates Foreign exchange market The market in which one country’s currency is traded for another country’s currency Exchange