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

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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