1 / 42

CHAPTER 18

CHAPTER 18. THE WORLD OF INTERNATIONAL FINANCE. $. EXCHANGE RATE. The rate at which we can exchange one currency for another

germane-craft
Download Presentation

CHAPTER 18

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. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. CHAPTER 18 THE WORLD OF INTERNATIONAL FINANCE $

  2. EXCHANGE RATE • The rate at which we can exchange one currency for another • Since international trade occurs between nations with different currencies, the exchange rate, the price at which currency trades, is an important determinant of the trade in both goods and assets

  3. APPRECIATION • An increase in the value of currency DEPRECIATION • A reduction in the value of currency

  4. DEMAND AND SUPPLY OF DOLLARS Exchange Rate Supply Supply of dollars in exchange for marks. The supply curve is drawn under the assumption that as marks become cheaper,total spending on German goods and assets will increase. Therefore, the supply curve is upward sloping. Dollars

  5. DEMAND AND SUPPLY OF DOLLARS Exchange Rate The demand curve represents the quantity demanded of dollars in exchange for marks. As the exchange rate falls, dollars become relatively cheaper in terms of marks, This makes U.S. goods and assets less expensive for German residents. As these goods and assets become cheaper, we assume that more German residents will want to trade marks for dollars. Therefore, the demand curve is downward sloping. Demand Dollars

  6. DEMAND AND SUPPLY OF DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Demand Dollars Market equilibrium occurs where demand equals supply. At this price, the desire to trade dollars for marks just matches the desire to trade marks for dollars. The foreign exchange market is in balance.

  7. FACTORS THAT WILL SHIFT THE DEMAND CURVE FOR DOLLARS • Higher U.S. interest rates will lead to an increased demand for dollars -- With higher returns in U.S. markets, investors throughout the world will want to buy dollars to invest in U.S. assets • Lower U.S. prices will also lead to an increased demand for dollars

  8. SHIFTS IN DEMAND FOR DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Demand Dollars

  9. SHIFTS IN DEMAND FOR DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Increased Demand Demand Dollars An increase in demand for dollars will increase (appreciate) the exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.

  10. TWO FACTORS THAT WILL SHIFT THE SUPPLY CURVE OF DOLLARS RIGHT • Higher German interest rates will lead U.S. investors to purchase German bonds or other assets -- This will require the U.S. investors to supply dollars for marks, which will drive down the exchange rate for dollars • Lower German prices will also lead to an increase in the supply of dollars for marks

  11. SHIFTS IN DEMAND FOR DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Demand Dollars

  12. SHIFTS IN DEMAND FOR DOLLARS Exchange Rate Supply 2.5 marks / dollar Increased Supply 2 marks / dollar 1.5 marks / dollar Demand Dollars An increase in the supply of dollars will decrease (depreciate) the exchange rate. Higher German interest rates or lower German prices will increase the supply of dollars.

  13. REAL EXCHANGE RATE • A concept that adjusts the market exchange rates for changes in price • The price of all U.S. goods and services relative to all foreign goods and services, expressed in a common currency • It is measured by expressing U.S. prices for goods and services in foreign currency and comparing them to foreign prices REALITY PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value

  14. REAL EXCHANGE RATE EXAMPLE Real exchange rate x price of U.S. cars Exchange Rate= -------------------------------------------- For Cars price of German cars in marks (2 marks/dollar) x ($15,000 for U.S car) = -------------------------------------------------------- 30,000 marks for a German car 30,000 = --------------------------- 30,000 Real Exchange Rate For Cars = 1

  15. REAL EXCHANGE RATE • Instead of just using the price level of cars in both countries, the real exchange rate is determined by using the overall level of prices in both countries: • Real Exchange Rate x U.S. Price Level Exchange = --------------------------------------------Rate German Price Level • The real exchange rate is the ratio of the price of all U.S. goods and services compared to the price of German goods and services, using the exchange rate to express them in a common currency

  16. REAL EXCHANGE RATE CONTROLS FOR CHANGES IN A COUNTRY’S PRICES • Suppose country A had an inflation rate of 20%, while country B had no inflation • The exchange rate of country A fell or depreciated 20% against country B • There would be no change in real exchange rate between the two countries • Although prices in country A would have increased by 20%, its currency is 20% cheaper • From the point of view of residents of country B, nothing has changed • It would still cost the same to buy the goods in country A

  17. A COUNTRY’S NET EXPORTS DECREASE WHEN ITS REAL EXCHANGE RATE INCREASES • If the U.S. real exchange rate increases, the price of U.S. goods will increase relative to foreign goods • U.S. exports will reduce because U.S. goods have become more expensive • U.S. imports will increase because foreign goods have become relatively cheaper • As a result of the decrease in U.S. exports and increase in U.S. imports, net exports will decline

  18. Net Exports Index for real exchange rate Net Exports Index for real exchange rate Source: Date from International Financial Statistics, International Monetary Fund and Economic Report of the President, (Washington, DC: U.S. Government Printing Office, yearly

  19. MULTILATERAL REAL EXCHANGE RATE • An index based on an average of real exchange rates with all U.S. treading partners • Notice from the preceding figure, that when the multilateral real exchange rate increased, U.S. net exports fell

  20. THE LAW OF ONE PRICE • The tendency for goods that are easily tradable to sell at the same price when expressed in common currency • Metals, agricultural commodities, computer chips and other tradable goods follow the law of one price • If all goods were tradable and the law of one price held exactly, exchange rates would reflect no more than the differences in the way the price levels are expressed in the two countries

  21. PURCHASING POWER PARITY • A theory which states that market exchange rates simply reflect differences in the overall price levels between countries • Research has shown that purchasing power parity does not hold precisely

  22. THE BIG MAC AROUND THE WORLD Country Price of Price of Predicted Actual Big Mac Big Mac Purchasing Exchange in local Expressed Power Rate Currency in dollars Exchange Rate (foreign currency / $) United States $2.32 $2.32 Belgium 109 francs $3.84 47 28.4 Hong Kong 9.50 HK dollars $1.23 4.09 7.73 Israel 8.90 shekels $3.01 3.84 2.95 Mexico 10.9 pesos $1.71 4.70 6.37 Singapore 2.95 S dollars $2.10 1.27 1.40 Japan 391 yen $4.65 169 84.2 Source: Data from The Economist, April 15, 1995, p.74

  23. CURRENT ACCOUNT • The sum of net exports (exports minus imports), net income received from investments abroad, and net transfer payments from abroad • If a country has a positive current account, its current account is in surplus • If it has a negative current account, its current account is in deficit • If income from investments abroad and net transfer payments is negligible, the current account is equivalent to a country’s net exports • U.S. current account surplus = U.S. exports - U.S. imports + net income from foreign investments + net transfers from abroad

  24. CAPITAL ACCOUNT • The purchase of a foreign asset by a U.S. resident gives rise to a deficit (negative) item on the capital account because it requires a demand for foreign currency • The purchase of a foreign asset can be thought of as “importing” capital • A purchase of a U.S. asset by a foreign resident leads to a supply of foreign currency in terms of dollars and a surplus (positive) item on the current account • This can be thought of as exporting capital U.S. capital account surplus = foreign purchases of U.S. assets - U.S. purchase of foreign assets

  25. CURRENT ACCOUNT-CAPITAL ACCOUNT LINK Current account + capital account = 0 • Any excess demand for foreign currency that arises from transactions in goods and services (the current account) must be met by an excess supply of foreign currency arising from asset transactions (the capital account).

  26. CURRENT ACCOUNT-CAPITAL ACCOUNT HISTORY IN THE U.S. SINCE THE 1980’s • Since 1982, the United States has run a current account deficit (equal capital account surplus) every year • The United States has, on net, reduced its holdings of foreign assets • In 1986, the U.S. Department of Commerce estimated that the U.S. had a net international investment position of $136 billion (U.S. holdings of foreign assets exceeded foreign holdings of U.S. assets by $136 billion) • By 1984, it was -$584billion • The U.S. was a net debtor -- Its net international investment position was negative

  27. U.S. CURRENT ACCOUNT AND CAPITAL ACCOUNT, 1994 (BILLIONS) Current account Merchandise account -166 Service account 59 Net investment income -9 Net unilateral transfers -35 Total on current account -151 Capital account Increase in U.S. holdings abroad -126 Increase in foreign holdings in the U.S. 291 Total on capital account 165 Statistical discrepancy -14 Sum of current account, capital account and 0 statistical discrepancy

  28. FOREIGN EXCHANGE MARKET INTERVENTION • To prevent the value of the currency from changing, governments can enter the foreign exchange market try to influence the price of foreign exchange • In the United States, the Treasury Department has the official responsibility for foreign exchange intervention, although it conducts its activities in conjunction with the Federal Reserve

  29. INTERVENTION TO RAISE THE PRICE OF DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Initial Demand Dollars

  30. INTERVENTION TO RAISE THE PRICE OF DOLLARS Exchange Rate Supply 2.5 marks / dollar 2 marks / dollar 1.5 marks / dollar Demand After Intervention Initial Demand Dollars To Increase the price of dollars, the U.S. government sells marks in exchange for dollars. This shifts the demand curve for dollars to the right.

  31. TO RAISE THE PRICE OF DOLLARS • The governments need to increase the demand for dollars • To do this, either the government can go into the market for foreign exchange and sell marks in exchange for dollars • This shifts the demand curve right until the price of dollars has risen to the desired level

  32. IF THE DESIRED EXCHANGE RATE IS 2 MARKS PER DOLLAR And the free market price exceeded 2 marks per dollar • The governments would have to buy marks in exchange for dollars • By selling dollars in exchange for marks, they would make the demand for dollars decrease and the exchange rate would fall • To lower the price of dollars (raise the value of the mark), the U.S. government has to buy marks in exchange for dollars • The government acquires marks anytime it tries to raise the price of marks

  33. FIXED EXCHANGE RATE SYSTEMS • Currency systems in which governments try to keep constant the values of their currencies against one another • In a typical fixed exchange rate system, one country stands at the center and other countries fix or peg their exchange rates to the currency of this center country • They must intervene in the foreign exchange market, if necessary, to keep the exchange rate constant

  34. BALANCE OF PAYMENTS DEFICIT • When there is an excess supply of a country’s currency at the fixed exchange rate • A balance of payments deficit will occur whenever there is a deficit on the current account that is not matched by net sales of assets to foreigners by the private sector • With an excess supply of a country’s currency in the market, the currency would fall in value without any intervention • To prevent the currency from depreciating in value and maintain the fixed exchange rate, the government must sell foreign exchange (foreign currency) and buy its own currency

  35. BALANCE OF PAYMENTS SURPLUS • When there is an excess demand for a country’s currency at the fixed exchange rate • Arises when there is a current account surplus that is not matched by net purchases of foreign assets by the private sector • With an excess demand of a country’s currency in the market, the currency would rise in value without any intervention • To prevent the currency from appreciating in value and maintain the fixed exchange rate, the government must buy foreign exchange (foreign currency) and sell its own

  36. DEVALUATION AND REVALUATION Devaluation A country facing a balance of payments deficit can lower the value at which the currency is pegged Revaluation A country facing a balance of payments surplus can increase the value at which its currency is pegged and reduce its net exports

  37. FLEXIBLE EXCHANGE RATE SYSTEM • Free markets primarily determine exchange rates • The exchange rate of a currency is determined by the supply and demand for it

  38. U.S. EXPERIENCE WITH FIXED AND FLEXIBLE EXCHANGE RATES • After World War II, the countries of the world operated under a fixed exchange system known as Bretton Woods • The United States operated at the center of the system • All countries fixed or pegged their currencies against the U.S. dollar • The Bretton Woods system lasted until the 1970s when the world abandoned it and went to the current flexible exchange rate system

  39. ABANDONMENT OF BRETTON WOODS • In the late 1960s, inflation in the United States began to exceed inflation in other countries and a U.S. balance of payments deficit emerged • In 1971 President Nixon devalued the dollar against all other currencies of the world • The U.S. devaluation did not stop the U.S. balance of payments deficit • Germany bought U.S. dollars from its citizens to keep the mark from appreciating • This increased the amount of marks in circulation in Germany and increased inflation in Germany • Speculators bet Germany would revalue the mark

  40. ABANDONMENT OF BRETTON WOODS • Speculators bought massive amounts of German assets, trading dollars for marks to purchase them • Their actions forced the German government to buy even more dollars • The flow of financial capital into Germany was so massive that eventually the German government gave up all attempts to keep its exchange rate fixed to the dollar • It let its exchange rate be determined in the free market

  41. EXCHANGE RATE MECHANISM • Within Europe, a number of countries -- including Germany and France --maintain exchange rates with one another within narrow bands called target zones • The United Kingdom participated in this arrangement for awhile but did not want to keep its interest rates in line with those of other countries

  42. CONVERGENCE CONDITIONS • As a precondition for adopting a single currency, the European countries, under the Maastricht treaty, set strict conditions for inflation, deficits, and debt • The rationale for these conditions is that to sustain a common currency, countries must have similar underlying economic fundamentals

More Related