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EXCHANGE RATES
GT01003
Macroeconomics
THE INTERNATIONAL ECONOMY Every day, news draws our attention to the
global economy The US sub-prime mortgage crisis of 2007 –
2008 quickly became a worldwide event because of the trade in mortgage securities
Since the mid 1980s, international trade has grown faster than GDP
Changing trading patterns have reduced the sensitivity of foreign economies to the events in the US
Innovations in transportation and communication can make events abroad an immediate issue worldwide
LEARNING OBJECTIVES1. Define the nominal exchange rate
Use the terms appreciation and depreciation to describe movements in exchange rates
2. Use supply and demand to analyze how the nominal exchange rate is determined in the short run
3. Distinguish between flexible and fixed exchange rates
IMPORTANCE OF EXCHANGE RATES Domestic purchases are made with local
currency Purchases of goods abroad requires converting
your local currency to their local currency The exchange rate is the price for that transaction
Exchange rates are set in the foreign exchange market, with a small number of exceptions Rates are determined by supply and demand Affect the value of imported goods and the
costs of foreign investment Changes in exchange rates can have a significant
effect on most economies
NOMINAL EXCHANGE RATES The nominal exchange rate is the
rate at which two currencies can be traded for each other
Rates for March 20, 2008
Foreign Currency /
Dollar
Dollar / Foreign Currency
UK (£) 0.5442 1.9823
Canada (Canadian $) 1.0265 0.9742
Mexico (peso) 10.7230 0.0933
Japan (¥) 98.79 0.0101
Switzerland (SFr) 1.0107 0.9894
South Korea (won) 1,009.15 0.0010
European Union (€) 0.6486 1.5417
Consider 3 currencies: $, C$, and £One dollar buys £ 0.5045 or C$ 1.0265The exchange rate between UK pounds and
Canadian dollars can be calculated from this information
£ 0.5045 = C$ 1.0265£ 1 = C$ 1.0265 / 0.5045
£ 1 = C$ 2.035
ORC$ 1 = £ 0.5045 / 1.0265
C$ 1 = £ 0.4915
NOMINAL EXCHANGE RATES
US NOMINAL EXCHANGE RATE, 1973-2007
CHANGES IN EXCHANGE RATES Appreciation is an increase in the
value of a currency relative to other currenciesExample: US dollar appreciates when it
goes from $1 = £ 0.5 to $1 = £ 0.6 A dollar buys more of the foreign currency
Depreciation is a decrease in the value of a currency relative to other currenciesExample: the Canadian dollar depreciates
when it goes from C$ 1 = ¥ 96 to C$ 1 = ¥ 95 A Canadian dollar buys fewer yen
EXCHANGE RATES Definition
e = the number of units of foreign currency that the domestic currency will buy Example, e is the number of Swiss francs you
can buy with $1 e is the nominal exchange rate
Domestic currency appreciates if e increases
Domestic currency depreciates if e decreases
HOW THE NOMINAL EXCHANGE RATE IS DETERMINED IN THE SHORT RUN??
EXCHANGE RATE STRATEGIES: FLEXIBLE VS FIXED EXCHANGE RATES
Foreign exchange market is the market on which currencies of various nations are traded
Flexible exchange rate is a system that sets the exchange rate according to demand and supply of a country's currency
Fixed exchange rate is an exchange rate set by official government policyCan be set independently or by agreement
with a number of other governmentsFixed rates can be set relative to the dollar,
the euro, or even gold
FLEXIBLE EXCHANGE RATE IN THE SHORT RUN Countries that have flexible exchange rates
see the values of their currencies change continually.
Exchange rates are set by supply and demand in the foreign exchange market
US supplies dollars to buy foreign exchange in order to buy foreign goods or foreign assets Not the same as the money supply controlled
by the Fed Supply of dollars in the foreign exchange
market is the number of dollars offered for sale for a given foreign currency
SUPPLY OF DOLLARS IN FOREIGN EXCHANGE MARKET Anyone who holds dollars is a potential
supplierUS households and firms are the most common
suppliers Supply curve has a positive slope
The more foreign currency per dollar, the larger the quantity of dollars supplied This makes foreign goods cheaper
When $1 = ¥ 100, a ¥ 5,000 item costs $50 If $1 = ¥ 200, that same ¥ 5,000 item costs $25When the dollar appreciates, quantity of dollars
supplied increases
DEMAND FOR DOLLARS IN FOREIGN EXCHANGE MARKET Anyone who holds yen can demand
dollars Japanese households and firms are the most
common demanders Demand curve has a negative slope
The more foreign currency per dollar, the smaller the quantity of dollars demanded This makes US goods more expensive
When $1 = ¥ 100, a $30 item costs ¥ 3,000 If $1 = ¥ 200, that same $30 item costs ¥
6,000When the dollar appreciates, quantity of
dollars demanded decreases
THE DOLLAR – YEN MARKET Market equilibrium
equates the number of dollars supplied and the number demanded at an exchange rate, e*
Dollar appreciates if the exchange rate exceeds e*
Dollar depreciates if the exchange rate is less than e*
Market for Dollars
Quantity of dollars
Ye
n/d
olla
r ex
cha
nge
ra
te
Demand for dollars
Supply of dollars
e*
Q*D
olla
r ap
pre
ciate
s
SUPPLY OF DOLLARS IN FOREIGN EXCHANGE MARKET Supply of dollars for Japanese yen is
determined by The preference for Japanese goods
The stronger the preference, the greater the supply of dollars
US real GDP The higher GDP, the greater the supply of dollars
Real interest rate on Japanese assets and the real interest rate on US assets Supply of dollars will be greater if
Real interest rate on Japanese assets are higher
Real interest rate on US assets is lower
AN INCREASE IN THE SUPPLY OF DOLLARS Initial equilibrium at E Suppose consumers prefer
the new video game system made in Japan Shift in preferences
Increase in the supply of dollars shifts dollar supply curve to the rightNew equilibrium at F
Dollar depreciates to e*' Quantity of dollars traded increases to Q*'
Quantity of dollars
Yen
/ d
olla
r ex
chan
ge r
ate
D
S
e*E
F
S'
Q*
e*'
Q*'
DEMAND FOR DOLLARS IN FOREIGN EXCHANGE MARKET Demand for dollars by holders of yen is
determined by The preference for US goods
The stronger the preference, the greater the demand for dollars
Real GDP in Japan The higher GDP, the greater the demand for
dollarsReal interest rate on Japanese assets and
real interest rate on US assets Supply of dollars will be greater if
Real interest rate on Japanese assets are lowerReal interest rate on US assets is higher
DOES A STRONG CURRENCY IMPLY A STRONG ECONOMY? At the G8 Summit in Japan, July, 2008,
President Bush stated his support for a strong dollar A strong currency means its value is high in
terms of other countries A strong currency is unrelated to a strong
economy Dollar was strong in 1973, a time of recession The dollar was weak in 2007 but the domestic
economy was strong Strong currencies reduce net exports
Japanese goods look cheap, so NX goes down NX affects spending and aggregate demand
THE EXCHANGE RATE AS A TOOL OF MONETARY POLICY
MONETARY POLICY AND THE EXCHANGE RATE Monetary policy affects interest rates
which affect the exchange rateTighter US monetary policy, leading to a
higher real interest rateHigher interest rates make US assets more
attractive than foreign assets Demand for the dollar increases by foreigners
Demand curve shifts to the right Supply of dollars by US decreases
Supply curve shifts to the leftDollar appreciates
TIGHTER OF MONETARY POLICY
Higher real interest rates in US increase demand for dollars and decrease supply
Dollar appreciates Change in quantity of
dollars traded depends on Size of shifts in
demand and supplySlopes of supply
and demand Quantity of dollars
Yen
/ d
olla
r ex
chan
ge r
ate
e*'
F S
D
e*
E
S'
D'
MONETARY POLICY RESULTS Monetary policy was the main cause of
recent changes in the dollar exchange rateDollar appreciation in the early 1980s
Real interest rate rose from negative values in 1979 and 1980 to 7% in 1983 and 1984
Dollar depreciation 2002 - 2005 US economy grew faster than our trading
partners' economiesForeign exchange demand for imports
increased Fed funds rate went from 6% in 2001 to 1% in
2003Demand for US assets decreased
MONETARY POLICY AND THE EXCHANGE RATE Flexible exchange rates make monetary
policy more effectiveWhen the Fed tightens money, it sets off a
chain of domestic events
And a chain of international events
Monetary policy is more effective in an open economy with flexible exchange rates
r C, IP PAE Y
r e* NX PAE Y
SHOULD EXCHANGE RATES BE FIXED OR FLEXIBLE?
FIXED EXCHANGE RATES Most large industrial countries use a
flexible exchange rateSmall and developing countries may use
fixed exchange rate Fixed rate system was set up after World
War IIBegan to break down in the 1960sAbandoned by 1976
FIXED EXCHANGE RATES To establish a fixed exchange rate system,
the government states the value of its currency in terms of a major currency May use an average of the currencies of its
major trading partners Government attempts to maintain fixed
exchange rate at its existing level The government may change the value of
its currency in response to market eventsDevaluation is a reduction in the official valueRevaluation is an increase in the official value Analogous to depreciation and appreciation
FIXED EXCHANGE RATES A flexible exchange rate actually strengthen
the impact of monetary policy on aggregate demand.
However, a fixed exchange rate prevent policymakers from using monetary policy to stabilize the economy because they must use monetary policy to ensure that the fundamental value of the exchange rate equals to the official value. In this case, monetary policy is no longer available
for stabilizing the domestic economy Limiting monetary policy as a stabilization tool
is a strong argument against fixed exchange rates
THE EFFECT OF FIXED EXCHANGE RATES ON TRADE AND INTEGRATION Fixed exchange rates have benefits
Predictability and stability in foreign transactions
Certainty of future value of the currencies However, fixed rates are not fixed
foreverSudden and unforeseen large changes are
possible. In 1997, the baht depreciated by over 67% in just two weeks.
Predicting exchange rates over the long term is difficult under either fixed or flexible rates
THE EURO The potential instability of fixed exchange rates
has led to the adoption of a common currency. European Common Market was formed in 1957
Free trade between member countries Fixed exchange rate system stet up in the 1970s was
abandoned in 1992 European Union was created by the Maastricht
Treaty in 1991 Agreed to work toward adopting a common currency The euro was phased in
Began as an accounting unit Euro currency was phased in and local currency phased out
in 11 member countries
THE EURO Countries with a single currency must
have a common monetary policyThe European Central Bank became the
central bank for the euro countries Countries sacrifice some control to be
part of the euroEconomic conditions vary between
countries and the central bank cannot respond to each Slow growth in Germany and rapid growth in
Ireland
EXCHANGE RATE DETERMINATION IN THE LONG RUN
REAL EXCHANGE RATE – AN EXAMPLE Choose between a US computer and a
comparable Japanese computer, based on price US computer costs $2,400 Japanese computer costs ¥ 242,000 $1 = ¥ 110
The Japanese computer cost is ¥ 242,000 / (¥ 110/$1) or $2,200 The Japanese computer is cheaper
The relative price of the US computer to the Japanese computer is $2,400 / $2,200 = 1.09 US computer costs 9% more than the Japanese
one
REAL EXCHANGE RATES In the short run, domestic prices of goods
are fixed In the long run, this assumption is relaxed
Real exchange rate is the price of the average domestic good relative to the price of the average foreign good Prices are expressed in a common currency
The exchange rate, e, is the number of units of foreign currency per dollar To convert a foreign price, Pf, to the dollar
price, Pf$, divide Pf by e
Pf / e = ¥ 242,000 / (¥ 110/$1) = $2,200
REAL EXCHANGE RATESPrice of domestic good
Price of foreign good in $Real exchange rate =
Real exchange rate =P
Pf / e
Real exchange rate =(P) (e)
Pf
Real exchange rate =($2,400) (¥ 110 / $1)
¥242,000
Real exchange rate = 1.09
REAL EXCHANGE RATE In our example, the real exchange rate
of 1.09 meant the US computer is more expensive than the Japanese computer
In the general case, the real exchange rate uses an average price of all goods and services in both countries If the real exchange rate is high, domestic
goods are expensive relative to foreign goods Net exports will tend to be low when the real
exchange rate is high
An increase in e increases the real exchange rate if P and Pf are constant
LAW OF ONE PRICE The law of one price is that the price of
an internationally traded commodity must be the same in all locations Assumes transportation costs are relatively
small Suppose wheat in Sydney was half the
price of wheat in Mumbai Buy wheat in Sydney, increasing demand and
price Sell wheat in Mumbai, increasing supply and
decreasing the price The law of one price implies that real
exchange rates prevail in the long run
PURCHASING POWER PARITY (PPP) Purchasing power parity is the theory
that nominal exchange rates are determined as necessary for the law of one price to hold In the long run, the currencies of countries
that experience significant inflation will tend to depreciate
PPP – AN EXAMPLE A bushel of grain costs
A$ 5 in Sydney and Rs 150 in MumbaiFor the price of the bushel of grain to be the
same in both countries, the implied nominal exchange rate is A$ 1 = Rs 30
Suppose that India experiences inflation and the bushel of grain now costs Rs 300 in MumbaiThe Australian dollar appreciates to A$ 1 =
Rs 60Price of the wheat is the same in both
countries
INFLATION AND CURRENCY DEPRECIATIONIN SOUTH AMERICA, 1995-2004
45º line
SHORTCOMINGS OF THE PPP THEORY Shortcomings of the PPP Theory
The theory predicts well in the long run but not the short run
Limits to the PPP TheoryNot all goods and services are traded
internationally The greater the share of non-traded goods, the
less precise the PPP theoryFor example, the market for haircuts is very
localNot all internationally traded goods and
services are perfectly standardized commodities
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