Ch 10 the exchange rate and the balance of payments
Download
1 / 48

Ch. 10: The Exchange Rate and the Balance of Payments. - PowerPoint PPT Presentation


  • 326 Views
  • Uploaded on

Ch. 10: The Exchange Rate and the Balance of Payments. Exchange rates Definition Determinants Short run Long run Purchasing power parity Interest rate parity Balance of payments accounts Causes of an international deficit Alternative exchange rate policies and their long-run effects.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Ch. 10: The Exchange Rate and the Balance of Payments.' - Jeffrey


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Ch 10 the exchange rate and the balance of payments l.jpg
Ch. 10: The Exchange Rate and the Balance of Payments.

  • Exchange rates

    • Definition

    • Determinants

      • Short run

      • Long run

        • Purchasing power parity

        • Interest rate parity

  • Balance of payments accounts

  • Causes of an international deficit

  • Alternative exchange rate policies and their long-run effects


Currencies and exchange rates l.jpg
Currencies and Exchange Rates

  • U.S. Citizens sell dollars in the foreign exchange market in order to purchase foreign currency to

    • purchase imports

    • purchase foreign assets (stocks, bonds, real estate, etc.)

  • Foreign citizens buy dollars in the foreign exchange market with foreign currency in order to

    • Purchase U.S. exports

    • Purchase U.S. assets.


Currencies and exchange rates3 l.jpg
Currencies and Exchange Rates

  • Foreign Exchange Rates

    • The price at which one currency exchanges for another is.

  • Currency depreciation

    • A fall in the value of one currency in terms of another currency

    • Makes country’s imports more expensive

    • Makes country’s exports more affordable to trading partners

  • Currency appreciation

    • A rise in value of one currency in terms of another currency.

    • Opposite effect of depreciation on imports/exports.


Slide4 l.jpg

Suppose that the exchange rate is 7 pesos per dollar. If you are in Mexico and must pay 120 pesos for a round of golf, it will cost you $_____ (give your answer to nearest dollar, no dollar sign – e.g. 37)

30


Slide5 l.jpg

If the exchange changes from 8 yuan per dollar to 10 yuan per dollar, relative to the yuan, the dollar has _____ and the cost of U.S. imports from China _____.

  • Appreciated; increased

  • Depreciated; increased

  • Appreciated; decreased.

  • Depreciated; decreased.

30


Slide6 l.jpg

Current exchange rates: per dollar, relative to the yuan, the dollar has _____ and the cost of U.S. imports from China _____.http://finance.yahoo.com/currency-investing



Slide8 l.jpg

The the Mexican peso.trade-weighted index is the average exchange rate of the U.S. dollar against other currencies, with individual currencies weighted by their importance in U.S. international trade.


The foreign exchange market l.jpg
The Foreign Exchange Market the Mexican peso.

  • The Demand for One Money Is the Supply of Another Money

    • When people who are holding one money want to exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money.

    • Factors that influence the demand for U.S. dollars also influence the supply of foreign currencies.

    • Factors that influence the demand for another country’s currency also influence the supply of U.S. dollars.


The foreign exchange market10 l.jpg
The Foreign Exchange Market the Mexican peso.

  • The Law of Demand for Foreign Exchange

    • The demand for dollars is a derived demand.

    • People buy U.S. dollars so that they can buy U.S.-produced goods and services or U.S. assets.

    • Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market.


The foreign exchange market11 l.jpg
The Foreign Exchange Market the Mexican peso.

  • The exchange rate influences the quantity of U.S. dollars demanded for two reasons:

  • Exports effect

    • As P of $ drops, foreign citizens wish to purchase more U.S. exports and more $.

  • Expected profit effect

    • The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying U.S. assets and the greater is the quantity of $ demanded today


The foreign exchange market12 l.jpg
The Foreign Exchange Market the Mexican peso.

  • Supply of $ in the Foreign Exchange Market

    • The quantity $ supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.


The foreign exchange market13 l.jpg
The Foreign Exchange Market the Mexican peso.

  • The Law of Supply of Foreign Exchange

    • Other things remaining the same, the higher the exchange rate, the greater is the quantity of $ supplied in the foreign exchange market.

    • Imports effect

      • As P of $ rises, U.S. citizens increase imports and sell more $ to purchase more imports.

    • Expected profit effect

      • As P of $ rises, U.S. citizens see greater potential for profits in foreign assets and sell more $ to purchase more foreign assets.


The foreign exchange market15 l.jpg
The Foreign Exchange Market the Mexican peso.

  • Market Equilibrium

If $ is “too strong”, surplus of $

If $ is “too weak”, shortage of $


Exchange rate fluctuations l.jpg
Exchange Rate Fluctuations the Mexican peso.

  • Changes in the Demand for U.S. Dollars

    • Changes in exchange rate cause movement along the demand curve, NOT a change in demand.

  • Changes in Demand for $ caused by:

    • World demand for U.S. exports

    • U.S. interest rate relative to the foreign interest rate

    • Expected profits on U.S. assets relative to profits on foreign assets

    • The expected future exchange rate


Exchange rate fluctuations17 l.jpg
Exchange Rate Fluctuations the Mexican peso.

  • Changes in the Supply of Dollars

    • Changes in the exchange rate cause a movement along the supply curve, NOT a change in supply

  • Changes in the supply of dollar are caused by:

    • U.S. demand for imports

    • U.S. interest rates relative to the foreign interest rate

    • Expected profits on U.S. assets relative to profits on foreign assets

    • The expected future exchange rate


Slide18 l.jpg

If U.S. demand for Chinese imports falls as a result of our recession, we should expect the dollar to _____ relative to the yuan because the ____ dollars will fall.

  • Appreciate; demand for

  • Appreciate; supply of

  • Depreciate; demand for

  • Appreciate; supply of

30


Slide19 l.jpg

If the Chinese become less willing to buy U.S. bonds because of concerns about default, the dollar will ______ because the _______ dollars will decrease.

  • Appreciate; demand for

  • Depreciate; demand for

  • Appreciate; supply

  • Depreciate; supply of

30


Slide20 l.jpg
If everyone begins to believe that the dollar will strengthen over the next several months, this should cause:

  • An increase in the demand for $

  • An increase in the supply of $

  • A decrease in the supply of $

  • Both A and B

  • Both A and C

30


Exchange rate fluctuations21 l.jpg
Exchange Rate Fluctuations strengthen over the next several months, this should cause:

  • Exchange Rate Expectations

    • The exchange rate changes when it is expected to change.

    • But expectations about the exchange rate are driven by deeper forces. Two such forces are

    • Interest rate parity

    • Purchasing power parity


Interest rate parity l.jpg
Interest Rate Parity strengthen over the next several months, this should cause:

  • Expected $ return on investment in foreign currency =

    interest rate on foreign currency +

    expected change in value of foreign currency

  • Interest rate parity exists when interest rates are such that expected returns on currencies are equal across countries.

  • Market forces achieve interest rate parity very quickly.

  • Example:

    • U.S. interest rate=5%; German interest rate=8%

      • What’s required for interest rate parity?


Interest rate parity23 l.jpg
Interest Rate Parity strengthen over the next several months, this should cause:

  • Example: U.S. pays 5% interest; Japan pays 4% interest; Value of $ expected to appreciate by 3% over next year.

  • Where will U.S. citizens buy bonds?

  • Japanese buy bonds?

  • Effect on interest rates in U.S. and Japan


Slide24 l.jpg

U.S. pays 5% interest; Japan pays 8% interest; Value of $ expected to depreciate by 5% over next year. People should buy their bonds from:

  • U.S.

  • Japan

30


Slide25 l.jpg

U.S. pays 5% interest; Japan pays 8% interest; Value of $ expected to depreciate by 5% over next year. Given the observed buying pattern in prior problem, we should expect interest rates to ___ in U.S. and ___ in Japan.

  • Rise; fall

  • Rise; rise

  • Fall; fall

  • Fall; rise

30


Purchasing power parity l.jpg
Purchasing Power Parity expected to

  • Exists when the exchange rate is such that a currency has the same “purchasing power” in all countries.

  • If PPP did not exist, one could take advantage of “arbitrage” opportunities:

  • buy item at low price and sell at high price

  • drives up price in low price country and drives down price in high price country.


Purchasing power parity27 l.jpg
Purchasing Power Parity expected to

  • Suppose $1 = 2 francs, price of gold=$500 in U.S. and 800 francs in France.

  • What’s the arbitrage opportunity?

  • What will happen to price of gold in

  • U.S.

  • France

  • What will happen to price of $?


Purchasing power parity28 l.jpg
Purchasing Power Parity expected to

  • In the long run, because of PPP:

  • Exchange rate between foreign currency and dollar =

  • price in foreign country / price in U.S.

  • % ch in price of $ (exchange rate)=

  • % ch in foreign price - % ch in U.S. prices


Purchasing power parity29 l.jpg
Purchasing Power Parity expected to

  • Links for exercises below are on eco202 Website.

  • Gold prices and exchange rates

  • Big Mac Index


Slide30 l.jpg

Suppose exchange rate is .75 Euros per dollar. The price of gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Rise; rise

  • Rise; fall

  • Fall; fall

  • Fall; rise

30


Financing international trade l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Balance of Payments Accounts

    • Record a country’s international trading, borrowing, and lending.

    • Transactions leading to an inflow of currency into the U.S. create a + (credit) in a balance of payments account

    • Transactions leading to an outflow of currency from the U.S. create a – (debit) in a balance of payments account.


Financing international trade32 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

Three balance of payments accounts

  • Current account

    The current accounts balance equals the sum of exports minus imports, net interest income, and net transfers.

  • Capital account

    Foreign investment in the United States minus U.S. investment abroad.

  • Official settlements account

    • records the change in U.S. official reserves.

    • U.S. official reserves are the government’s holdings of foreign currency

    • If U.S. official reserves increase, the official settlements account is negative.

  • The sum of the three account balances is zero.


Financing international trade34 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Borrowers and Lenders

    • A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower.

    • A country that is lending more to the rest of the world than it is borrowing from it is called a net lender.

    • The United States is currently a net borrower but during the 1960s and 1970s, the United States was a net lender.


Financing international trade35 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Debtors and Creditors

    • A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it.

    • Since 1986, the United States has been a debtor nation.

    • A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.

    • The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.


Financing international trade36 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Being a net borrower does not reduce long term economic growth provided the borrowed funds are used to finance capital accumulation that increases income.

  • Being a net borrower can reduce economic growth if the borrowed funds are used to finance consumption.


Financing international trade37 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Current Account Balance

    • The current account balance (CAB) is

      CAB = NX + Net interest income + Net transfers

    • The main item in the current account balance is net exports (NX).

    • The other two items are much smaller and don’t fluctuate much.


Financing international trade38 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • The government sector surplus or deficit is equal to net taxes, T, minus government expenditures on goods and services G.

  • The private sector surplus or deficit is saving, S, minus investment, I.

  • Net exports is equal to the sum of government sector balance and private sector balance:

  • NX = (T – G) + (S – I)


Financing international trade39 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • For the United States in 2006,

  • Net exports is a deficit of $784 billion, which equals the sum of the government sector deficit of $313 billion and the private sector deficit of $471 billion.


Financing international trade40 l.jpg
Financing International Trade gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • The Three Sector Balances

    • The private sector balance and the government sector balance tend to move in opposite directions.

    • Net exports is the sum of the private sector and government sector balances.


Exchange rate policy l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Three possible exchange rate policies are

  • Flexible exchange rate

  • Fixed exchange rate

  • Crawling peg

  • Flexible Exchange Rate

  • A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.


Exchange rate policy42 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Fixed Exchange Rate

  • pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market.

  • A fixed exchange rate requires active intervention in the foreign exchange market.


Exchange rate policy43 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Suppose that the target is 100 yen per U.S. dollar.

  • If demand increases, the central bank sells U.S. dollars to increase supply.

  • Effect of “undervalued dollar” and subsequent intervention on1. U.S. money supply? 2. U.S. Inflation?


Exchange rate policy44 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • If demand decreases, the central bank buys U.S. dollars (with foreign reserves) to decrease supply.

  • Effect of “over-valued” dollar and subsequent intervention on:

  • U.S. money supply and reserves of foreign currency

  • U.S. inflation


Exchange rate policy45 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • Crawling Peg

  • selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path.

  • China is a country that operates a crawling peg.

  • Crawling peg works like a fixed exchange rate except that the target value changes.

  • Avoids wild swings in the exchange rate


Exchange rate policy46 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • People’s Bank of China in the Foreign exchange Market

  • China’s official foreign currency reserves are piling up.


Exchange rate policy47 l.jpg
Exchange Rate Policy gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone:

  • The People’s bank buys U.S. dollars to maintain the target exchange rate.

  • China’s official foreign reserves increase.

  • Based on diagram, is $ over- or under-valued relative to Chinese Yuan?


Slide48 l.jpg

If there is a fixed exchange rate system and the dollar is “undervalued”, the U.S. central bank will be forced to ___ dollars which will ___ the U.S. money supply

  • Buy ; increase

  • Buy; decrease

  • Sell ; increase

  • Sell; decrease

30


ad