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Lecture 11. 13. Exchange Rates. Exchange Rates. Nominal Exchange Rate The rate at which two currencies can be traded for each other. Exchange Rates. Nominal Exchange Rates The exchange rate between British and Canadian currencies 0.4889 British pounds = \$1 U.S.

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### Lecture 11

13

Exchange Rates

• Nominal Exchange Rate

• The rate at which two currencies can be traded for each other

• Nominal Exchange Rates

• The exchange rate between British and Canadian currencies

• 0.4889 British pounds = \$1 U.S.

• 1.009 Canadian \$s = \$1 U.S.

• 0.4889 British pounds = 1.009 Canadian \$s

• 0.4889/1.009 = 0.4845 pounds = 1 Canadian \$

• Economic Naturalist

• Should China change the way it manages its exchange rate?

11.4% Decline

in value

• Appreciation

• An increase in the value of a currency relative to other currencies

• Depreciation

• A decrease in the value of a currency relative to other currencies

• Some Definitions

• e = nominal exchange rate

• e = the number of units of foreign currency that the domestic currency will buy

• If e increases, it is an appreciation of the domestic (base) currency.

• If e decreases, it is a depreciation of the domestic (base) currency.

• Flexible Exchange Rate

• Fixed Exchange Rates

The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded

Supply of dollars

e*

Demand for dollars

The Supply and Demand for Dollars in the Yen-Dollar Market

Yen/dollar exchange rate

• Changes in the Supply of Dollars

• Factors that increase the supply of dollars

• An increase in the preference for Japanese goods

• An increase in U.S. real GDP

• An increase in the real interest rate on Japanese assets

S

S’

E

e*

F

e*’

D

An Increase in the Supply of Dollars Lowers the Value of the Dollar

• Increase in demand for Japanese video games

Yen/dollar exchange rate

• Changes in the Demand for Dollars

• Factors that increase the demand for dollars

• Increased preference for U.S. goods

• Increase in real GDP abroad

• An increase in the real interest rate on U.S. assets

• Thus a decrease in rates, decreases demand for dollars

S'

S

F

e*'

• The increased demand for U.S. assets by American Savers decreases the supply of dollars

• Exchange rate appreciates from e* to e*’

E

e*

D'

D

A Tightening of Monetary Policy Strengthens the Dollar

Yen/dollar exchange rate

S rate(sales to foreigners)

Excess supplyof pounds

Excess demandfor pounds

e

D(purchases from foreigners)

Foreign Exchange Market

Equilibrium (example)

• The dollar price of the English pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds in exchange for dollars.

Dollar price of foreign exchange(for pounds)

• The demand and supply of pounds are in equilibrium at the exchange rate of \$1.50 = 1 English pound.

• At this price, quantity demanded equals quantity supplied.

\$1.80

• A higher price of pounds (like \$1.80 = 1 pound), would lead to an excess supply of pounds ...

\$1.50

\$1.20

causing the dollar price of the pound to fall (depreciate).

• A lower price of pounds (like \$1.20 = 1 pound), would lead to an excess demand for pounds …

Quantity of

foreign exchange (pounds)

Q

causing the dollar price of the pound to rise (appreciate).

b rate

D2

Foreign Exchange Market Equilibrium

Dollar price of foreign exchange(for pounds)

• Other things constant, if incomes increase in the United States, U.S. imports of foreign goods and services will grow.

S(sales to foreigners)

• The increase in imports will increase the demand for pounds (in the foreign exchange market)

\$1.80

causing the dollar price of the pound to rise from \$1.50 to \$1.80.

\$1.50

a

D1

Quantity of

foreign exchange (pounds)

Q1

Q2

S rate2

b

D2

Inflation with Flexible Exchange Rates

Dollar price of foreign exchange(for pounds)

• If prices were stable in England while the price level in the U.S. increased by 50 percent …

S1

the U.S. demand for British goods (and pounds) would increase …

\$2.25

as U.S. exports to Britain would be relatively more expensive they would decline and thereby cause the supply of pounds to fall.

\$1.50

a

• These forces would cause the dollar to depreciaterelative to the pound.

D1

Quantity of

foreign exchange (pounds)

Q1

• How to Fix an Exchange Rate

• The government will peg its currency to a major currency or to a “basket” of currencies.

• The government may have to devalue or revalue its currency.

• Devaluation

• A reduction in the official value of a currency (in a fixed-exchange-rate system)

• Revaluation

• An increase in the official value of a currency (in a fixed-exchange-rate system)

• Overvalued Exchange Rate

• An exchange rate that has an officially fixed value greater than its fundamental value

• Undervalued Exchange Rate

• An exchange rate that has an officially fixed value less than its fundamental value

• To maintain the value, the government must purchase a quantity of pesos (A-B)

Supply of pesos

A

B

0.125 dollar/

peso

Official value

Market equilibrium value

0.10 dollar/

peso

Demand for pesos

An Overvalued Exchange Rate

Dollar/peso exchange rate

Fixed Exchange Rates value; the peso is overvalued

• How to Fix an Exchange Rate

• Responses to an overvalued currency

• Devalue the currency

• Purchase the currency

• To purchase its own currency, a country must hold international reserves. International Reserves

• Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market.

Fixed Exchange Rates value; the peso is overvalued

• Speculative Attack

• A massive selling of domestic currency assets by financial investors

• Peso overvalued at 0.125 value; the peso is overvalued

• Investors launch a speculative attack -- sell peso dominated assets

S

S’

A

B

C

0.125 dollar/

peso

Official value

0.10 dollar/

peso

• Supply of pesos increases

• Central bank must purchase more pesos

D

A Speculative Attack on the Peso

Dollar/peso exchange rate

Fixed Exchange Rates value; the peso is overvalued

• Balance-of-Payments Deficit

• The net decline in a country's stock of international reserves over a year

Fixed Exchange Rates value; the peso is overvalued

• Balance-of-Payment Surplus

• The net increase in a country's stock of international reserves over a year

Fixed Exchange Rates value; the peso is overvalued

• Example

• Latinia’s balance-of-payments deficit

• Demand = 25,000 - 50,000e

• Supply = 17,600 - 24,000e

• Official value of the peso = 0.125 dollars

Fixed Exchange Rates value; the peso is overvalued

• Example

• Latinia’s balance-of-payments deficit

• Fundamental value

• 25,000 - 50,000e = 17,600 + 24,000e

• Solving for e:

• 7,400 = 74,000e

• e = 0.10

Fixed Exchange Rates value; the peso is overvalued

• Example

• As the official rate -- 0.125

• D = 25,000 - 50,000(0.125) = 18,750

• S = 17,600 - 24,000 (0.125) = 20,600

• Excess supply = 1,850 pesos

• Balance of payments deficit = 1,850 pesos

• 1,850 x 0.125 = \$231.25

• Tightening monetary policy increases D to D’ and the supply will fall S to S'.

• Official value = fundamental value

S'

S

F

0.125 dollar/

peso

Official value

E

0.10 dollar/

peso

D'

D

A Tightening of Monetary Policy Eliminates an Overvaluation

Dollar/peso exchange rate

Fixed Exchange Rates value; the peso is overvalued

• Observation

• If monetary policy is used to set the fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy.

Fixed Exchange Rates value; the peso is overvalued

• Observation

• The conflict monetary policymakers face, between stabilizing the exchange rate and stabilizing the domestic economy, is most severe when the exchange rate is under a speculative attack.

Should Exchange Rates Be Fixed or Flexible? value; the peso is overvalued

• Monetary Policy

• Flexible exchange rates can strengthen the impact of monetary policy.

• Fixed exchange rates prevent the use of monetary policy to stabilize the economy.

Should Exchange Rates Be Fixed or Flexible? value; the peso is overvalued

• Fixed exchange rate proponents argue that fixed rates promote international trade.

• The risk of a speculative attack may make the country less attractive to investors and trade.

Fixed Rate, Unified Currency Regime value; the peso is overvalued

• Some examples of fixed rate,unified currencysystems:

• the U.S., Panama, Ecuador, El Salvador, and Hong Kong all of which use currencies that are unified with the U.S. dollar

• the 12 countries of the European Monetary Union, all of which use the euro, which is managed by the European Central Bank

• Countries such as El Salvador & Hong Kong, that link their currency to the dollar at a fixed rate, are no longer in a position to conduct monetary policy. They merely accept the monetary policy of the Federal Reserve.

• The same can be said for the 12 countries of the European Monetary Union that accept the monetary policy of the European Central Bank.

Pegged Exchange Rate Regimes value; the peso is overvalued

• Pegged exchange rate system:a system where the country commits to using monetary and fiscal policy to maintain the exchange-rate value of the domestic currency at a fixed rate or within a narrow band relative to another currency (or bundle of currencies).

• Unlike the case of a currency board, however, countries with a pegged exchange rate continue to conduct monetary policy.

When Pegged Regimes value; the peso is overvalued

• A nation can either:

• follow an independent monetary policy, allowing its exchange rate to fluctuate, or,

• tie its monetary policy to the maintenance of the fixed exchange rate.

• It cannot, however:

• maintain currency convertibility at a fixed exchange rate while following a monetary policy more expansionary than that of the country to which its currency is tied.

When Pegged Regimes value; the peso is overvalued

• Attempts to peg rates and follow a monetary policy that is too expansionary have led to several recent financial crises—a situation where falling foreign reserves eventually force the country to forego the pegged rate.

• The experiences of Mexico in 1989-1994 and of Brazil, Thailand, South Korea, Indonesia, and Malaysia in 1997-1998 illustrate this point very clearly.

Balance of Payments value; the peso is overvalued

Revisited

Example: value; the peso is overvalued Imports

Example: Exports

Balance of Payments

• Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners

• Any transaction that creates a demand for foreign currency (and a supply of the domestic currency) in the foreign exchange market is recorded as a debit item.

• Transactions that create a supply of foreign currency (and demand for the domestic currency) on the foreign exchange market are recorded as a credit item.

Balance of Payments value; the peso is overvalued

• Under a pure flexible rate system, the foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits.

Balance of Payments value; the peso is overvalued

• Current account transactions:all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period

• Four categories of current account transactions:

• Merchandise trade(import and export of goods)

• Service trade(import and export of services)

• Income from investments

• Unilateral transfers(gifts to and from foreigners)

Balance of Payments value; the peso is overvalued

• Capital account transactions:transactions that involve changes in the ownership of real and financial assets

• The capital account includes both

• direct investments by foreigners in the U.S. and by Americans abroad, and,

• loans to and from foreigners.

• Under a pure flexible-rate system, official reserve transactions are zero; therefore:

• a current-account deficit implies a capital-account surplus.

• a current-account surplus implies a capital-account deficit.

Continued on next page … value; the peso is overvalued

U.S. Balance of Payments, 2003*

Balance

Debits

Credits

deficit (-) / surplus (+)

Current account:

+ 713.1

1. U.S. merchandise exports

2. U.S. merchandise imports

- 1260.7

3. Balance of merchandise trade (1 + 2)

- 547.6

+ 307.4

4. U.S. service exports

5. U.S. service imports

- 256.3

+ 51.1

6. Balance on service trade (4 + 5)

7. Balance on goods and services (3 + 6)

- 496.5

8. Income receipts of Americans from abroad

+ 294.4

9. Income receipts of foreigners in the U.S.

- 261.1

33.3

10. Net income receipts (8 + 9)

- 67.4

11. Net unilateral transfers

12. Balance on current account (7 + 10 + 11)

- 530.6

Source:http://www.economagic.com/. * Figures are in Billions of Dollars

U.S. Balance of Payments, 2003 value; the peso is overvalued*

Balance

Debits

Credits

deficit (-) / surplus (+)

Current account:

12. Balance on current account (7 + 10 + 11)

- 530.6

Capital account:

+ 580.6

13. Foreign investment in the U.S. (capital inflow)

-297.1

14. U.S. investment abroad (capital outflow)

15. Balance on capital account (13 + 14)

+ 283.5

Official Reserve Transactions:

16. U.S. official reserve assets

-1.5

17. Foreign official assets in the U.S.

+ 248.6

+ 247.1

18. Balance, Official Reserve Account (16 + 17)

0.0

17. Total (12 + 15 + 18)

Source:http://www.economagic.com/. * Figures are in Billions of Dollars

Capital Flows and value; the peso is overvalued

the Current Account

Current Account as % of GDP value; the peso is overvaluedsurplus (+) or deficit (-)

Net Foreign Investment as % of GDPsurplus (+) or deficit (-)

+ 2

0

- 2

- 4

1973

1978

1983

1988

1993

1998

2003

+ 4

+ 2

0

- 2

1973

1978

1983

1988

1993

1998

2003

• Under a flexible exchange rate system the inflow and outflow of capital will exert a major impact on the current account and trade balances.

• The figures for the U.S. (above) illustrate this linkage.

• An inflow of capital implies a trade (current account) deficit; an outflow of capital implies a trade (current account) surplus.

• While the term “deficit” generally has negative connotations, this is not necessarily true for a trade deficit.

• If a nation’s investment environment is attractive, it is likely to result in a net inflow of capital, which will tend to cause a trade deficit.

• Similarly, rapid economic growth will tend to stimulate imports, which is likely to result in a trade deficit.

Trade Deficits: Points to Ponder value; the peso is overvalued

• Although they often cause trade (and current account) deficits, both rapid growth and a healthy investment environment are signs of a strong economy, not a weak one.

• A trade deficit (or surplus) is an aggregate that reflects the voluntary choices of individuals and businesses. In contrast with a budget deficit, no legal entity is responsible for the trade deficit.

• The trade deficits of the U.S. during the 1980s and 90s were largely the result of rapid growth and a favorable investment climate.

Should Trade Between value; the peso is overvalued

Countries Balance?

• Political leaders often imply that U.S. exports to a country, China or Japan for example, should be approximately equal to our imports from that country.

• This is a fallacious view.

• Under a flexible exchange rate system, overall purchases from foreigners will balance with overall sales to foreigners, but there is no reason why bilateral trade between any two countries will balance.