Exchange rates


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  • Vertical axis is a weighted index of the dollar's value against other major currencies, 1973 = 100
  • Exchange rates

    1. 1. GT01003Macroeconomics
    2. 2.  Every day, news draws our attention to theglobal economy The US sub-prime mortgage crisis of 2007 – 2008quickly became a worldwide event because of thetrade in mortgage securities Since the mid 1980s, international trade hasgrown faster than GDP Changing trading patterns have reduced thesensitivity of foreign economies to the events inthe US Innovations in transportation and communicationcan make events abroad an immediate issueworldwide
    3. 3. 1. Define the nominal exchange rate Use the terms appreciation and depreciation todescribe movements in exchange rates2. Use supply and demand to analyze how thenominal exchange rate is determined in theshort run3. Distinguish between flexible and fixedexchange rates
    4. 4.  Domestic purchases are made with localcurrency Purchases of goods abroad requires convertingyour local currency to their local currency The exchange rate is the price for that transaction Exchange rates are set in the foreignexchange market, with a small number ofexceptions Rates are determined by supply and demand Affect the value of imported goods and the costsof foreign investment Changes in exchange rates can have a significanteffect on most economies
    5. 5.  The nominal exchange rate is the rate atwhich two currencies can be traded for eachotherRates forMarch 20, 2008Foreign Currency /DollarDollar / ForeignCurrencyUK (£) 0.5442 1.9823Canada (Canadian $) 1.0265 0.9742Mexico (peso) 10.7230 0.0933Japan (¥) 98.79 0.0101Switzerland (SFr) 1.0107 0.9894South Korea (won) 1,009.15 0.0010European Union (€) 0.6486 1.5417
    6. 6.  Consider 3 currencies: $, C$, and £ One dollar buys £ 0.5045 or C$ 1.0265 The exchange rate between UK pounds andCanadian dollars can be calculated from thisinformation£ 0.5045 = C$ 1.0265£ 1 = C$ 1.0265 / 0.5045£ 1 = C$ 2.035ORC$ 1 = £ 0.5045 / 1.0265C$ 1 = £ 0.4915
    7. 7.  Appreciation is an increase in the value of acurrency relative to other currencies Example: US dollar appreciates when it goesfrom $1 = £ 0.5 to $1 = £ 0.6 A dollar buys more of the foreign currency Depreciation is a decrease in the value of acurrency relative to other currencies Example: the Canadian dollar depreciates whenit goes from C$ 1 = ¥ 96 to C$ 1 = ¥ 95 A Canadian dollar buys fewer yen
    8. 8.  Definition e = the number of units of foreign currency thatthe domestic currency will buy Example, e is the number of Swiss francs you can buywith $1 e is the nominal exchange rate Domestic currency appreciates if e increases Domestic currency depreciates if edecreases
    9. 9.  Foreign exchange market is the market on whichcurrencies of various nations are traded Flexible exchange rate is a system that setsthe exchange rate according to demand andsupply of a countrys currency Fixed exchange rate is an exchange rate setby official government policy Can be set independently or by agreement with anumber of other governments Fixed rates can be set relative to the dollar, theeuro, or even gold
    10. 10.  Countries that have flexible exchange ratessee the values of their currencies changecontinually. Exchange rates are set by supply and demandin the foreign exchange market US supplies dollars to buy foreign exchangein order to buy foreign goods or foreignassets Not the same as the money supply controlled bythe Fed Supply of dollars in the foreign exchange marketis the number of dollars offered for sale for agiven foreign currency
    11. 11.  Anyone who holds dollars is a potentialsupplier US households and firms are the most commonsuppliers Supply curve has a positive slope The more foreign currency per dollar, the largerthe quantity of dollars supplied This makes foreign goods cheaper When $1 = ¥ 100, a ¥ 5,000 item costs $50 If $1 = ¥ 200, that same ¥ 5,000 item costs $25 When the dollar appreciates, quantity of dollarssupplied increases
    12. 12.  Anyone who holds yen can demand dollars Japanese households and firms are the mostcommon demanders Demand curve has a negative slope The more foreign currency per dollar, the smallerthe quantity of dollars demanded This makes US goods more expensive When $1 = ¥ 100, a $30 item costs ¥ 3,000 If $1 = ¥ 200, that same $30 item costs ¥ 6,000 When the dollar appreciates, quantity of dollarsdemanded decreases
    13. 13.  Market equilibriumequates the number ofdollars supplied and thenumber demanded at anexchange rate, e* Dollar appreciates if theexchange rate exceeds e* Dollar depreciates if theexchange rate is less thane*Market for DollarsQuantity of dollarsYen/dollarexchangerateDemand fordollarsSupplyof dollarse*Q*Dollarappreciates
    14. 14.  Supply of dollars for Japanese yen isdetermined by The preference for Japanese goods The stronger the preference, the greater the supply ofdollars US real GDP The higher GDP, the greater the supply of dollars Real interest rate on Japanese assets and thereal interest rate on US assets Supply of dollars will be greater if Real interest rate on Japanese assets are higher Real interest rate on US assets is lower
    15. 15.  Initial equilibrium at E Suppose consumers prefer thenew video game system made inJapan Shift in preferences Increase in the supply of dollarsshifts dollar supply curve to theright New equilibrium at F Dollar depreciates to e* Quantity of dollars tradedincreases to Q*Quantity of dollarsYen/dollarexchangerateDSe*EFSQ*e*Q*
    16. 16.  Demand for dollars by holders of yen isdetermined by The preference for US goods The stronger the preference, the greater the demandfor dollars Real GDP in Japan The higher GDP, the greater the demand for dollars Real interest rate on Japanese assets and realinterest rate on US assets Supply of dollars will be greater if Real interest rate on Japanese assets are lower Real interest rate on US assets is higher
    17. 17.  At the G8 Summit in Japan, July, 2008, PresidentBush stated his support for a strong dollar A strong currency means its value is high in terms ofother countries A strong currency is unrelated to a strongeconomy Dollar was strong in 1973, a time of recession The dollar was weak in 2007 but the domesticeconomy was strong Strong currencies reduce net exports Japanese goods look cheap, so NX goes down NX affects spending and aggregate demand
    18. 18.  Monetary policy affects interest rates whichaffect the exchange rate Tighter US monetary policy, leading to a higherreal interest rate Higher interest rates make US assets moreattractive than foreign assets Demand for the dollar increases by foreigners Demand curve shifts to the right Supply of dollars by US decreases Supply curve shifts to the left Dollar appreciates
    19. 19.  Higher real interestrates in US increasedemand for dollars anddecrease supply Dollar appreciates Change in quantity ofdollars traded dependson Size of shifts indemand and supply Slopes of supply anddemandQuantity of dollarsYen/dollarexchangeratee*FSDe*ESD
    20. 20.  Monetary policy was the main cause ofrecent changes in the dollar exchange rate Dollar appreciation in the early 1980s Real interest rate rose from negative values in 1979and 1980 to 7% in 1983 and 1984 Dollar depreciation 2002 - 2005 US economy grew faster than our trading partnerseconomies Foreign exchange demand for imports increased Fed funds rate went from 6% in 2001 to 1% in 2003 Demand for US assets decreased
    21. 21.  Flexible exchange rates make monetarypolicy more effective When the Fed tightens money, it sets off a chainof domestic events And a chain of international events Monetary policy is more effective in an openeconomy with flexible exchange ratesr  C, IP PAE  Y r  e* NX  PAE  Y 
    22. 22.  Most large industrial countries use a flexibleexchange rate Small and developing countries may use fixedexchange rate Fixed rate system was set up after World WarII Began to break down in the 1960s Abandoned by 1976
    23. 23.  To establish a fixed exchange rate system,the government states the value of itscurrency in terms of a major currency May use an average of the currencies of its majortrading partners Government attempts to maintain fixedexchange rate at its existing level The government may change the value of itscurrency in response to market events Devaluation is a reduction in the official value Revaluation is an increase in the official value Analogous to depreciation and appreciation
    24. 24.  A flexible exchange rate actually strengthen theimpact of monetary policy on aggregate demand. However, a fixed exchange rate preventpolicymakers from using monetary policy tostabilize the economy because they must usemonetary policy to ensure that the fundamentalvalue of the exchange rate equals to the officialvalue. In this case, monetary policy is no longer available forstabilizing the domestic economy Limiting monetary policy as a stabilization tool isa strong argument against fixed exchange rates
    25. 25.  Fixed exchange rates have benefits Predictability and stability in foreign transactions Certainty of future value of the currencies However, fixed rates are not fixed forever Sudden and unforeseen large changes arepossible. In 1997, the baht depreciated by over67% in just two weeks. Predicting exchange rates over the long term isdifficult under either fixed or flexible rates
    26. 26.  The potential instability of fixed exchange rateshas led to the adoption of a common currency. European Common Market was formed in 1957 Free trade between member countries Fixed exchange rate system stet up in the 1970s wasabandoned in 1992 European Union was created by the MaastrichtTreaty in 1991 Agreed to work toward adopting a common currency The euro was phased in Began as an accounting unit Euro currency was phased in and local currency phasedout in 11 member countries
    27. 27.  Countries with a single currency must have acommon monetary policy The European Central Bank became the centralbank for the euro countries Countries sacrifice some control to be part ofthe euro Economic conditions vary between countries andthe central bank cannot respond to each Slow growth in Germany and rapid growth in Ireland
    28. 28.  Choose between a US computer and acomparable Japanese computer, based on price US computer costs $2,400 Japanese computer costs ¥ 242,000 $1 = ¥ 110 The Japanese computer cost is ¥ 242,000 / (¥110/$1) or $2,200 The Japanese computer is cheaper The relative price of the US computer to theJapanese computer is $2,400 / $2,200 = 1.09 US computer costs 9% more than the Japanese one
    29. 29.  In the short run, domestic prices of goods arefixed In the long run, this assumption is relaxed Real exchange rate is the price of theaverage domestic good relative to the priceof the average foreign good Prices are expressed in a common currency The exchange rate, e, is the number of unitsof foreign currency per dollar To convert a foreign price, Pf, to the dollarprice, Pf$, divide Pf by ePf / e = ¥ 242,000 / (¥ 110/$1) = $2,200
    30. 30. Price of domestic goodPrice of foreign good in $Real exchange rate =Real exchange rate =PPf / eReal exchange rate =(P) (e)PfReal exchange rate =($2,400) (¥ 110 / $1)¥242,000Real exchange rate = 1.09
    31. 31.  In our example, the real exchange rate of1.09 meant the US computer is moreexpensive than the Japanese computer In the general case, the real exchange rateuses an average price of all goods andservices in both countries If the real exchange rate is high, domestic goodsare expensive relative to foreign goods Net exports will tend to be low when the realexchange rate is high An increase in e increases the real exchangerate if P and Pf are constant
    32. 32.  The law of one price is that the price of aninternationally traded commodity must bethe same in all locations Assumes transportation costs are relatively small Suppose wheat in Sydney was half the priceof wheat in Mumbai Buy wheat in Sydney, increasing demand andprice Sell wheat in Mumbai, increasing supply anddecreasing the price The law of one price implies that realexchange rates prevail in the long run
    33. 33.  Purchasing power parity is the theory thatnominal exchange rates are determined asnecessary for the law of one price to hold In the long run, the currencies of countries thatexperience significant inflation will tend todepreciate
    34. 34.  A bushel of grain costs A$ 5 in Sydney and Rs 150 in Mumbai For the price of the bushel of grain to be thesame in both countries, the implied nominalexchange rate is A$ 1 = Rs 30 Suppose that India experiences inflation andthe bushel of grain now costs Rs 300 inMumbai The Australian dollar appreciates to A$ 1 = Rs 60 Price of the wheat is the same in both countries
    35. 35. 45ºline
    36. 36.  Shortcomings of the PPP Theory The theory predicts well in the long run but notthe short run Limits to the PPP Theory Not all goods and services are tradedinternationally The greater the share of non-traded goods, the lessprecise the PPP theory For example, the market for haircuts is very local Not all internationally traded goods and servicesare perfectly standardized commodities