International Trade Exchange Rates and Open Macroeconomic Models October 17, 2006
International trade is more complicated than domestic trade. • There are no national borders to be crossed when, say, California wine is shipped to Delaware. The consumer in Newark pays with Dollars, just the currency that the wine maker in California wants.
If that same vintner ships her wine to Europe, however, consumers there will have only Euros with which to pay, rather than the Dollars the wine maker in California wants. Thus, for international trade to take place, there must be some way to convert one currency into another.
The exchange rate states the price in terms of one currency at which such conversions are made. There is an exchange rate between every pair of currencies.
For example the British Pound in 2002 was the equivalent of about $1.40. The exchange rate between the Pound and the Dollar, then, may be expressed as roughly "$1.40 to the Pound" (meaning that it costs $1.40 to buy a Pound) or about "71 pence to the Dollar" (meaning that it costs 71 British pence to buy a Dollar). (Currently the rate is $1.86 and .57 respectively)
A nation’s currency is said to appreciate when the exchange rates change so that a unit of its currency can buy more units of a foreign currency. • A nation’s currency is said to depreciate when the exchange rates change so that a unit of its currency can buy fewer units of a foreign currency.
For example if the cost of a Pound rises from $1.40 to $2.00, the cost of a U.S. dollar in terms of pounds simultaneously falls from 71 pence to 50 pence. • The UK has experienced an appreciation while the U.S. has experienced a depreciation in its currency.
When an officially set exchange rate is altered so that a unit of a nation’s currency can buy fewer units of foreign currency, we say that a devaluation of that currency has taken place. When the exchange rate is changed so that the nation’s currency buys more units of a foreign currency, a revaluation has taken place.
Assume that the Dollar and the Euro are the only currencies on earth, so the market needs to determine only one exchange rate. • Figure 1 depicts the determination of this exchange rate at the point in the figure where demand curve D1 crosses supply curve S1.
At this price ($0.90 per euro), the number of Euros demanded is equal to the number of Euros supplied.
Euro Market Figure 1 $/Euro S1 D shifts to the right D shifts to the left .90 S shifts to the right S shifts to the left D1 Q of Euros 0 Q1
Why does anyone demand Euros? • International trade in goods and services. (In general, demand for Europe’s exports leads to demand for its currency, Euros) • International trade in financial instruments such as stocks and bonds. (In general demand for Europe’s financial assets leads to demand for it’s currency, Euros)
Purchases of a country’s (Europe’s) physical assets such as factories and machinery overseas by foreigners (e.g. U.S. citizens). (In general, direct foreign investment leads to demand for Europe’s currency, the Euro)
Where does the supply of Euros come from? • Europeans want to buy U.S. goods (the other side of 1 above) • Europeans want to buy U.S. stocks and bonds (the other side of 2 above) • Europeans purchase physical assets in the U.S. (the other side of 3 above) (can use the supply and demand graphs we have already created)
To illustrate the usefulness of even this simple supply and demand analysis, think about how the exchange rate between the Dollar and the Euro should change if Europeans become attracted by the prospects of large gains on the U.S. stock markets.
To purchase U.S. stocks, foreigners will first have to purchase U.S. Dollars, which means selling some of their Euros.
In terms of the supply-demand diagram in Figure 2, the increased desire of Europeans to acquire U.S. stocks would shift the supply curve for Euros out from S1 to S2 . Equilibrium would shift from point Q1 to point Q4, and the exchange rate would fall: e.g. from $0.90 per Euro to $0.80 per Euro.
Market for Euros $/Euro S1 D shifts to the right D shifts to the left .90 S shifts to the right S shifts to the left D1 Q of Euros 0 Q1
Market for Euros $/Euro S1 D shifts to the right D shifts to the left S2 .90 S shifts to the right S shifts to the left .80 D1 Q of Euros 0 Q4 Q1
Thus the increased supply of Euros by European citizens would cause the Euro to depreciate relative to the dollar. This is what happened during the U.S. stock market boom of the late 1990s.
Summary: Suppose that Europeans have an interest in investing in the U.S. stock market. (straight forward supply and demand) • To purchase stocks, Europeans need to purchase $ => selling Euros. • (supply curve for Euros shifts to the right => causing the $ price of the Euro to fall)
Interest Rates and Exchange Rates: The Short Run • Main determinant in the short run: interest rates, in particular interest rate differentials, and financial flows.
As an example, suppose the Italian government bonds pay a 5 percent rate when yields on equally safe U.S. government securities rise to 7 percent.
Italian investors will be attracted by the higher interest rates in the United States and will offer Euros for sale. • Why? • To buy Dollars and use those Dollars to buy U.S. securities. • At the same time, U.S. investors will find it more attractive to keep their money at home, so fewer Euros will be demanded by Americans.
Euro Market $/Euro Figure 3 S1 D shifts to the right D shifts to the left P1 S shifts to the right S shifts to the left D1 Q of Euros 0 Q1
Euro Market Figure 3 $/Euro S1 D shifts to the right D shifts to the left S2 P1 S shifts to the right P4 S shifts to the left D1 Q of Euros 0 Q4 Q1
Euro Market Figure 3 $/Euro S1 D shifts to the right D shifts to the left S2 P1 = 1.20 S shifts to the right S shifts to the left D1 P2=1.10 D2 Q of Euros 0 Q2 Q1
When the demand schedule shifts inward and the supply curve shifts outward, the effect on price is predictable.
The Euro will depreciate, as Figure 3 shows. In the figure, the supply curve of Euros shifts outward from S1 to S2 when Italian investors seek to sell Euros in order to purchase more U.S. securities.
At the same time, American investors wish to buy fewer Euros because they no longer desire to invest as much in Italian securities. Thus, the demand curve shifts inward from D1 to D2.
The Result: • In our example, there is a depreciation of the Euro from $1.20 to $1.10. • Exercise: Suppose that interest rates are higher in Europe than in the U.S. Demonstrate using supply and demand curves that this would cause the Euro to appreciate.
In general • Other things equal, countries that offer investors higher rates of return attract more capital than countries that offer lower rates. • Thus, a rise in interest rates often will lead to an appreciation of the currency, and a drop in interest rates will lead to a depreciation of the currency.
Interest rate differentials certainly played a predominant role in the stunning movements of the U.S. Dollar in the 1980s. • In the early 1980s, American interest rates rose well above comparable interest rates abroad. • As a result, foreign capital was attracted to the U.S. American capital stayed at home, and the Dollar soared. That is, the Dollar appreciated.
Similarly, a nation that suffers from capital flight, as did Argentina in 2001, must offer extremely high interest rates to attract foreign capital.
Interest Rates and Exchange Rates: The Medium Run • The medium run is where the theory of exchange rate determination is most unsettled.
Economists once reasoned as follows: Because consumer spending increases when income rises and decreases when income falls, the same thing is likely to happen to spending on imported goods. • So a country's imports will rise quickly when its economy booms and rise only slowly when its economy stagnates.
For the reasons illustrated in Figure 4, a boom in the United States should shift the demand curve for Euros outward as Americans seek to acquire more Euros to buy more European goods and services. • And that, in turn, should lead to an appreciation of the Euro (depreciation of the Dollar). In the figure, the Euro rises in value from P1 to P2 Dollars per Euro.
Euro Market Figure 4 $/Euro S1 D shifts to the right D shifts to the left P1 S shifts to the right S shifts to the left D1 Quantity of Euros 0 Q1
Euro Market Figure 4 $/Euro S1 D shifts to the right P2 D shifts to the left P1 D2 S shifts to the right S shifts to the left D1 Quantity of Euros 0 Q1 Q2
However, if Europe was booming at the same time, Europeans would be buying more American exports, which would shift the supply curve of Euros outward. • Europeans must offer more Euros for sale to get the Dollars they need for purchasing U.S. goods and services.
Euro Market Figure 4 $/Euro S1 D shifts to the right S2 D shifts to the left P3 P1 D2 S shifts to the right S shifts to the left D1 0 Q3 Q1 Quantity of Euros
On balance, the value of the Dollar might rise or fall. It appears that what matters is whether exports are growing faster than imports.
A country whose aggregate demand grows faster than the rest of the world's normally finds its imports growing faster than its exports. • Thus, its demand curve for foreign currency shifts outward more rapidly than its supply curve. Other things equal, that will make its currency depreciate. • In the context of figure 4 if the U.S. is growing faster than Europe, D1 will shift out by a larger amount than S1, leading to an appreciation of the Euro.
Conclusion: • This reasoning is sound - so far as it goes. And it leads to the conclusion that a "strong economy" might produce a "weak currency." • But the three most important words in the preceding statement are "other things equal."
Usually, they are not. Specifically, a booming economy will normally offer more attractive prospects to investors than a stagnating one -- higher interest rates, rising stock market values, and so on.
This difference in prospective investment returns, as we have seen, should attract capital and boost its currency value. So there appears to be a kind of "tug of war."
As we see, thinking only about trade in goods and services leads to the conclusion that faster growth should weaken the currency. • But thinking about trade in financial assets (such as stocks and bonds) leads to precisely the opposite conclusion: Faster growth should strengthen the currency. Which side will win this "tug of war"?
In the modern world, the evidence seems to say that trade in financial assets is the dominant factor. • Rapid growth in the United States in the second half of the 1990s led to a sharply appreciating Dollar even though U.S. imports soared. • Why? Investors from all over the world brought funds to America.
We conclude that: • Stronger economic performance appears to lead to currency appreciation because it improves prospects for investing in the country.