exchange rates and the open economy

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Exchange Rates and The Open Economy

Exchange Rates and The Open Economy

Chapter 17: Exchange Rates and the Open Economy Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Exchange Rates

Nominal Exchange RateThe rate at which two currencies can be

traded for each other


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Nominal Exchange Ratesfor the U.S. Dollar

Country Foreign currency/dollar Dollar/foreign currency

United Kingdom (pound) 0.6393 1.5643

Canada (Canadian dollar) 1.5674 0.6380

Mexico (peso) 9.9850 0.1002

Japan (yen) 118.000 0.00848

Switzerland (Swiss franc) 1.4760 0.6775

South Korea (won) 1,190.1000 0.00084


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Exchange Rates

Nominal Exchange RatesThe exchange rate between British and

Canadian currencies0.6393 British pounds = $1 U.S.1.5674 Canadian $s = $1 U.S.0.6393 British pounds = 1.5674 Canadian $s0.6393/1.5674 = 0.4079 pounds = 1 Canadian $British/Canadian exchange 0.4079 pounds per

Canadian dollar


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The U.S. NominalExchange Rate, 1973-2002

More Recent Series: http://research.stlouisfed.org/fred2/series/TWEXBMTH/95/5yrs


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Exchange Rates

AppreciationAn increase in the value of a currency

relative to other currencies

DepreciationA decrease in the value of a currency

relative to other currencies


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Exchange Rates

Some Definitionse = nominal exchange ratee = the number of units of foreign currency

that the domestic currency will buyIf e increases, it is an appreciation of the

domestic currency.If e decreases, it is a depreciation of the

domestic currency.


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Exchange Rates

Flexible Exchange RateAn exchange rate whose value is not

officially fixed but varies according to the supply and demand for the currency in the foreign exchange market


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Exchange Rates

Foreign Exchange MarketThe market on which currencies of various

nations are traded for one another


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Exchange Rates

Fixed Exchange RateAn exchange rate whose value is set by

official government policy


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Exchange Rates

The Real Exchange RateNominal exchange rate

The price of the domestic currency in terms of a foreign currency

Real exchange rateThe price of the average domestic good or

service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency


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Exchange Rates

ExampleShould you buy a Japanese or American

computer for your company?Price of U.S. computer = $2,400Price of Japanese computer = 242,000 yenExchange rate = 110 yen/dollar


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Exchange Rates


computer for your company?Price in yen = price in dollars x value of dollar in

terms of yenPrice in dollars = price in yen/yen-dollar

exchange rateo Price in dollars = 242,000 yen/110 = $2,200


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Exchange Rates


computer for your company?Japanese computer is cheaper.Real exchange rate = $2,400/$2,200 = 1.09


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Exchange Rates

Real Exchange Rate

)( dollars in good, foreign of Price

)( gooddomestic of Price Rate Exchange Real

fP

P

/e Rate Exchange Real

fP

P

fP

eP Rate Exchange Real


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Exchange Rates

The Computer Example, revisited E = 110/$1 P = $2,400 Pf = 242,000 yen

yen242,000

$2,400 x yen/$1)(110 Rate Exchange Real

1.09 yen242,000

yen264,000 Rate Exchange Real


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Exchange Rates

The Real Exchange RateA high real exchange rate implies that

domestic producers will have difficulty exporting to other countries.

A high real exchange rate will attract imports.


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Exchange Rates

The Real Exchange RateNX will tend to be low when the real

exchange rate is high.Real and nominal exchange rates tend to

move in the same direction


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Exchange Rates

Economic NaturalistDoes a strong currency imply a strong

economy?


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The Determination of the Exchange Rate

Law of One PriceIf transportation costs are relatively small,

the price of an internationally traded commodity must be the same in all locations


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ExampleHow many Indian rupees equal to one

Australian dollar?Bushel of grain cost 5 Australian dollars or 150

rupees5 Australian dollars = 150 rupeesNominal exchange should equal 30

rupees/Australian dollar


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Purchasing Power Parity (PPP)The theory that nominal exchange rates

are determined as necessary for the law of one price to hold


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Purchasing Power Parity (PPP)In the long run, the currencies of countries

that experience significant inflation will tend to depreciate.


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ExampleHow many Indian rupees equal one

Australian dollar?Price of grain in India increases from 150 to

300 rupeesPrice of grain in Australia equals 5 Australian

dollars


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ExampleHow many Indian rupees equal one

Australian dollar?5 Australian dollars = 300 rupees1 Australian dollar = 60 rupeesNominal exchange rate increased from 30 to 60

rupees/Australian dollarIndian currency depreciatedAustralian currency appreciated


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Inflation and Currency Depreciationin South America, 1995-2001


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ExampleShortcomings of the PPP Theory

The theory has been successful in the long run but not the short run.


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ExampleLimits to the PPP Theory

Not all goods and services are traded internationally.

o The greater the share of non-traded goods, the less precise the PPP theory

Not all internationally traded goods and services are perfectly standardized commodities.


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The Supply and Demand for Dollars In The Yen-Dollar Market

Quantity of dollars traded

Yen

/do

llar

exch

ang

e ra

te

Demand for dollars

Supply of dollars

e*

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


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Changes in the Supply of DollarsFactors that increase the supply of dollars

An increase in the preference for Japanese goods

An increase in U.S. real GDPAn increase in the real interest rate on

Japanese assets


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An Increase In The Supply of Dollars Lowers The Value of The Dollar


Yen

/do

llar

exch

ang

e ra

te

D

S

e*E

•Increase in demand for Japanese video games

e*’

S’

F

•Supply of dollars increases from S to S’•The value of the dollar in terms of yen falls•e* falls to e*’


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Changes in the Demand for DollarsFactors that increase the demand for

dollarsIncreased preference for U.S. goodsIncrease in real GDP abroadAn increase in the real interest rate on U.S.

assets


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A Tightening of Monetary Policy Strengthens the Dollar


Yen

/do

llar

exch

ang

e ra

te

D

S

e*E

• Tighter monetary policy raises the domestic real interest rate

• Foreign demand for U.S. assets increase

e*’ F

D’

• The demand for dollars rises• Exchange rate appreciates from

e* to e*’


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Monetary Policy andthe Exchange Rate

Economic NaturalistWhy did the dollar appreciate nearly 50

percent in the first half of the 1980s?


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Monetary Policy andthe Exchange Rate

The Exchange Rate as a Tool of Monetary PolicyWhen the exchange rate is flexible:

Tighter monetary policy reduces net exports.Easier monetary policy stimulates net exports.

Conclusion:Monetary policy is more effective in an open

economy with flexible exchange rates.


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Fixed Exchange Rates

How to Fix an Exchange RateThe 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.


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DevaluationA reduction in the official value of a

currency (in a fixed-exchange-rate system)

RevaluationAn increase in the official value of a

currency (in a fixed-exchange-rate system)

c.f. “Depreciation,” “Appreciation”


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Overvalued Exchange RateAn exchange rate that has an officially

fixed value greater than its fundamental value

Undervalued Exchange RateAn exchange rate that has an officially

fixed value less than its fundamental value


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An Overvalued Exchange Rate

Quantity of pesos traded

Do

llar/

pes

o e

xch

ang

e ra

te

Demand for pesos

Supply of pesos

Official value

Fundamental value0.10 dollar/peso

0.125 dollar/peso

• The peso’s official value is greater than the fundamental value; the peso is overvalued

A B

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


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How to Fix an Exchange RateResponses to an overvalued currency

Devalue the currencyImpose trade barriersPurchase the currency


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International ReservesForeign currency assets held by a

government for the purpose of purchasing the domestic currency in the foreign exchange market.


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How to Fix an Exchange RateTo purchase its own currency, a country

must hold international reserves.A balance of payments deficit occurs when

a country has a net decline in international reserves over a year.


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How to Fix an Exchange RateA balance-of-payments surplus occurs

when a country has a net increase in international reserves over a year.


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ExampleLatinia’s balance-of-payments deficit

Demand = 25,000 - 50,000eSupply = 17,600 + 24,000eOfficial value of the peso = 0.125 dollars


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ExampleLatinia’s balance-of-payments deficit

Fundamental valueo 25,000 - 50,000e = 17,600 + 24,000e

Solving for e: o 7,400 = 74,000eo e = 0.10


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ExampleAs the official rate -- 0.125D = 25,000 - 50,000(0.125) = 18,750S = 17,600 - 24,000 (0.125) = 20,600Excess supply = 1,850 pesosBalance of payments deficit = 1,850 pesos


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Speculative AttackA massive selling of domestic currency

assets by financial investors


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A Speculative Attackon the Peso


Do

llar/

pes

o e

xch

ang

e ra

te

A B

D

S

Official value0.125 dollar/peso

• Peso overvalued at 0.125• Central bank buys pesos• Investors launch a speculative attack -- sell

peso dominated assets

0.10 dollar/peso

S’

C

• Supply of pesos increases• Central bank must purchase

more pesos


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Economic NaturalistCan a speculative attack occur under

flexible exchange rates?


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A Tightening of Monetary Policy Eliminates An Overvaluation


Do

llar/

pes

o e

xch

ang

e ra

te

D

S

Official value

E0.10 dollar/

peso

0.125 dollar/peso

•Pesos overvalued at 0.125

F

D’

•Tightening monetary policy increases D to D’•Official value = fundamental value


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ObservationIf 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.


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ObservationThe 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.


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Economic NaturalistWhat were the causes and consequences

of the East Asian crisis of 1997-1998?


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Economic NaturalistHow did policy mistakes contribute to the

Great Depression?


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Should Exchange Rates Be Fixed or Flexible?

Monetary PolicyFlexible exchange rates can strengthen the

impact of monetary policy.Fixed exchange rates prevent the use of

monetary policy to stabilize the economy.


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Trade and Economic IntegrationFixed 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.


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Economic NaturalistWhy have 11 European countries adopted

a common currency?


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End ofChapterEnd of

Chapter

exchange rates and the open economy

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