Transcript PPT chapter 14

Chapter 14
Exchange rates and
the
open economy
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Learning objectives
1. What is a nominal exchange rate?
2. What is the different between fixed and floating exchange
rates?
3. What is the difference between a nominal and a real exchange
rate?
4. What assumptions underlie the purchasing power parity theory
of exchange rates?
5. What factors determine the supply of dollars/demand for dollars
in the international currency market?
6. How does a flexible exchange rate regime work?
7. How does a fixed exchange rate work?
8. What factors influence a country’s choice of fixed or flexible
exchange rates?
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Nominal exchange rates
• In international trade, the seller requires the purchase
price in their own currency, while the buyer
possesses their own country’s currency.
– Therefore, in international trade, international currencies also
need to be traded for one another.
• Nominal exchange rate
– The relative values at which different currencies can be
traded for each other.
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Tab. 14.1 Nominal exchange rates for
the Australian dollar (4 pm, 6 Sept. 2010)
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Appreciation and depreciation
• e is used to denote nominal exchange rate
= the number of units of the foreign currency that the
domestic currency will buy.
– An increase in the exchange rate means more foreign
currency can be traded for $AUS1, and is called an
appreciation.
– A decrease in the exchange rate means less foreign
currency can be traded for $AUS1, and is called a
depreciation.
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Trade weighted index
Figure 14.1 Australia’s trade weighted nominal exchange rate
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Flexible versus fixed exchange rates
• Foreign exchange market
– The market on which currencies of various nations are
traded for one another
• Flexible exchange rate
– An exchange rate whose value is not officially fixed, but
varies according to the supply and demand for the currency
in the foreign exchange market.
• Fixed exchange rate
– An exchange rate whose value is set by official
government policy.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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The real exchange rate
• A country’s real exchange rate compares prices of
the average domestic good or service relative to the
average foreign good or service.
• Let P = domestic price level, as measured by the
consumer price level, which we will use as a measure
of the price of an average domestic good or service.
• Similarly, let Pf = the foreign price level, a measure of
the price of an average foreign good or service.
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The real exchange rate (cont.)
• As these two values are in different currencies, the
nominal exchange rate needs to be included.
• Real exchange rate = price of domestic good
price of foreign good, in dollars
=
P
(Pf / e)
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Example: Comparing prices expressed
in different currencies
Example: An Australian-made computer costs $2400
and a very similar Japanese computer costs ¥242 000.
The exchange rate is ¥110 = $1.
Real exchange rate =
price in dollars
price in yen / yen-dollar exchange rate
=
$2400
¥242 000 / ¥110
=
$2400
$2200
= 1.09
In general, a country’s ability to compete in the
international market depends on its prices relative to
other countries’ prices.
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Interpreting the real exchange rate
• Fluctuations in the real exchange rate reflect changes
in the relative price between two countries:
– When the real exchange rate is high, domestic goods are
more expensive than foreign goods and net exports are
likely to be low.
– When the real exchange rate is low, domestic goods are less
expensive than foreign goods and net exports are likely to
be high.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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The law of one price
• The law of one price states that if transportation costs
are relatively small, the price of an internationally
traded commodity must be the same in all locations.
• Otherwise, a profit would be made by buying the
commodity where it is cheaper and selling it where it
is more expensive.
• If this is true for all goods and services, then it can be
used to determine the nominal exchange rate.
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Example: Purchasing power parity
Example: If the price of a bushel of wheat costs $5 in
Sydney and 150 rupees in Mumbai, the exchange rate
would be:
$AUS5 = 150 rupees
$AUS1 = 30 rupees
This is the purchasing power parity theory: that nominal
exchange rates are determined as necessary for the
law of one price to hold.
This theory predicts that the currency of a country that
experiences significant inflation will tend to depreciate.
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Example: Purchasing power parity
(cont.)
Example: If India experiences inflation and the price of a
bushel of wheat increases to 300 rupees in Mumbai, the
exchange rate would be:
$AUS5 = 300 rupees
$AUS1 = 60 rupees
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Inflation and currency depreciation
Figure 14.2 Inflation and currency depreciation in South America, 1995–2002
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Shortcomings of the PPP theory
• PPP is useful for predicting changes in nominal rates
over the long run, but works less well in the short run.
• It relies on the law of one price, which works well for
standardised products that are internationally traded,
like gold and grain.
• However, not all goods and services are traded
internationally, and many are not standardised.
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Shortcomings of the PPP theory (cont.)
• Examples of goods not traded internationally are:
– those with large transportation costs, like hairdressing
services and heavy construction materials
– those that cannot be traded, like agricultural land and
buildings
– highly perishable food items.
• Not all goods and services are standardised:
– Japanese and Australian cars differ in many respects, and if
Japanese cars cost 10% more than Australian, many would
still be purchased.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and
demand analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Supply and demand analysis
• Although PPP is useful to explain long-run behaviour
of the exchange rate, supply and demand analysis is
more useful for the short run.
• Demand for Australian dollars is from foreigners who
seek to purchase Australian goods and assets;
supply of Australian dollars is by Australians who
seek to purchase foreign goods and assets.
• The equilibrium exchange rate is the rate that
equates the demand and supply of the currency in
the foreign exchange market.
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The supply of dollar
• The principal suppliers of the Australian dollar to the
foreign exchange market are Australian households
and firms, so they can:
– purchase foreign goods and services
– purchase foreign assets.
• The higher the exchange rate, the more
the Australian dollar will be supplied, as foreign
currency denominated prices become cheaper and
therefore more purchases are made.
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The demand for dollar
• The principal demanders of the Australian dollar in
the foreign exchange market are foreign households
and firms, so they can:
– purchase Australian goods and services
– purchase Australian assets.
• The lower the exchange rate, the more the Australian
dollar will be demanded, as Australian denominated
prices become cheaper to foreign purchasers, so
more purchases are made.
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Demand and supply of the Australian
dollar
Figure 14.3 The supply and demand for dollars in the yen–dollar market
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Shifts in supply of the Australian dollar
• Factors that increase the supply of the Australian
dollar, and therefore shift the supply curve to
the right:
– An increased preference for the foreign country’s goods or
services
– An increase in Australian real GDP, which will increase
consumption in Australia, part of which will be on foreign
goods and services
– An increase in the real interest rate on foreign assets, which
would make them more attractive to Australians
• Conversely, the supply curve shifts to the left if there
is a reduction in these factors.
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An increase in the supply of dollars
Figure 14.4 An increase in the supply of dollars lowers the value of the dollar
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Shifts in demand for the Australian
dollar
• Factors that increase the demand for the Australian
dollar, and therefore shift the demand curve to
the right:
– An increased preference for Australian goods or services
– An increase in real GDP abroad, which will increase
incomes, part of which will be spent on Australian goods
and services
– An increase in the real interest rate on Australian assets,
which would make them more attractive to foreigners
• Conversely, the demand curve shifts to the left if
there is a reduction in these factors.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Monetary policy and the exchange rate
• The monetary policy of the country’s central bank is
one of the most important factors that influences the
exchange rate.
• A tightening of monetary policy will increase the
interest rate. This makes Australian assets more
attractive to foreigners.
• The increased demand for Australian dollars will shift
the demand curve to the right and increase the
equilibrium exchange rate.
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Effects of tight monetary policy
Figure 14.5 A tightening of monetary policy strengthens the dollar
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Example: The rise of the Australian
dollar over 2009–2010
Figure 14.6 Official interest rates in Australia and the United States
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Monetary policy and aggregate
demand
• We saw previously that in a closed economy,
tightening of monetary policy reduces aggregate
demand (AD) through reducing C and I.
• In an open economy with a flexible exchange rate,
tightening monetary policy will also increase the
exchange rate.
• The higher exchange rate reduces exports and
increases imports. Net exports reduces AD further,
and reinforces the monetary policy.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Fixed exchange rates
• Fixed exchange rates are determined by the
government of a nation.
• They are usually set in terms of a major currency,
such as the $US or a basket of currencies.
• We will assume that once the exchange rate has
been fixed, the government usually tries to keep it
unchanged for some time (although the crawling peg
and target zone systems are possible, too).
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Example: A fixed exchange rate regime
Figure 14.7 An overvalued exchange rate
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Example: A fixed exchange rate regime
(cont.)
•
This means the peso is overvalued. There are three
ways Latinia can deal with this:
1. Latinia can devalue its currency and allow it to trade at 10
pesos to the dollar. However, doing this frequently would be
like having a flexible exchange rate.
2. Latinia could impose restrictions on international
transactions to manipulate the fundamental value. This
would reduce the benefits from trade and capital flows to
their households.
3. Latinia’s government could become a demander of its own
currency, buying an amount of pesos equivalent to AB, to
add to private demand so as to match to private supply.
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An overvalued exchange rate:
Balance-of-payments deficit
• To be able to buy enough currency to match demand
with supply, the government needs to hold foreign
currency assets called international reserves.
• A country with an overvalued exchange rate needs to
use part of its reserves to support the value of the
currency, and its international reserves will decline.
• The net decline (increase) in a country’s stock of
international reserves over a year is called its balanceof-payments deficit (surplus).
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Speculative attacks on currency
• A government can maintain an overvalued exchange
rate for some time, but there is a limit as their
international reserves are finite.
• A speculative attack can end the overvaluation
quickly and unexpectedly.
• This occurs because of a fear that an overvalued
currency will soon be devalued.
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A speculative attack
Figure 14.8 A speculative attack on the peso
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Monetary policy and fixed
exchange rates
• There is no really satisfactory way to maintaining a
fixed exchange rate above its fundamental value, as
we have seen.
• An alternative to trying to maintain an overvalued
exchange rate is to take actions that increase the
fundamental value, to the point of the official value.
• The most effective way is through monetary policy.
Tightening monetary policy will increase the demand
for the currency, eliminating the overvaluation.
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A tightening of monetary policy
eliminates an overvaluation
Figure 14.9 A tightening of monetary policy eliminates an overvaluation
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Fixed versus flexible exchange rates
• There are two major issues to consider between a
fixed and a flexible exchange rate system.
1. The first is that the type of exchange rate a country has
impacts on their ability to use monetary policy to stabilise
the economy. A flexible exchange rate strengthens the
impact of monetary policy on AD, but a fixed exchange
rate prevents policy-makers from using it to stabilise
the economy.
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Fixed versus flexible exchange rates
(cont.)
2. The second important issue is the effect of the exchange
rate on trade and economic integration. Fixed exchange
rates can be argued to provide a level of certainty about
an important factor in the profitability of trade and crossborder economic co-operation, where flexible exchange
rates do not.
However, fixed exchange rates are not guaranteed to
remain fixed forever, and may lead suddenly and
unpredictably to a large devaluation.
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Chapter organisation
14.1
Nominal exchange rates
14.2
The real exchange rate
14.3
The determination of the exchange rate
14.4
The determination of the exchange rate: A supply and demand
analysis
14.5
Monetary policy and the exchange rate
14.6
Fixed exchange rates
14.7
Should exchange rates be fixed or flexible?
Summary
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Summary
• The nominal exchange rate between two currencies
is the rate at which the currencies can be traded for
each other.
• The real exchange rate is the price of the average
domestic good or service relative to the price of the
average foreign good or service, when prices are
expressed in terms of a common currency.
• The PPP theory predicts that the currencies of
countries that experience significant inflation will tend
to depreciate in the long run.
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Summary (cont.)
• Supply and demand analysis is useful in determining
the fundamental value of the exchange rate.
• In a flexible exchange rate regime, a tight monetary
policy increases the demand for the currency and
causes it to appreciate.
• In a fixed exchange rate regime, an overvalued
currency may be prone to speculative attacks.
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