Transcript Chapter 9 Slides PPT

9
OPEN ECONOMY
THE EXCHANGE RATE
AND THE BALANCE OF
PAYMENTS
In this chapter:
 Define the foreign exchange rate and explain
how the exchange rate is determined
 Explain the alternative exchange rate policies
and explain their effects
 Describe the balance of payments accounts
and explain what causes an international
deficit
The Foreign Exchange Market
• To buy goods and services produced in
another country we need money of that
country.
• Foreign bank notes (cash), coins, and bank
deposits are called foreign currency.
• The foreign exchange market is the market
in which the currency of one country is
exchanged for the currency of another.
The Foreign Exchange Market
Exchange Rates
• The price at which one currency exchanges for
another is called the exchange rate.
• A fall in the value of one currency in terms of another
currency is called currency depreciation – e.g., the
value of the US dollar falls from 2 euros/dollar to 1
euro per dollar – the dollar depreciates.
• A rise in value of one currency in terms of another
currency is called currency appreciation - e.g.,
0.5 dollars/ euro rises to 1 dollar per euro – the
dollar appreciates and the euro depreciates.
The Foreign Exchange Market
Questions we want to answer
• How is the exchange rate determined?
• Why does the U.S. dollar (or currencies in general)
appreciate and sometimes depreciate?
• How does the Fed operate in the foreign exchange
market?
• How do exchange rate fluctuations influence the
balance of trade and the balance of payments of a
country?
The Foreign Exchange Market
An Exchange Rate Is a Price
• Like all prices, an exchange rate is determined in a
market by supply and demand.
• The U.S. dollar is demanded and supplied by
thousands of traders every hour of every day.
• With many traders and no restrictions, the foreign
exchange market is a competitive market.
The Foreign Exchange Market
Demand for US Dollars in the Foreign
Exchange Market
The quantity of U.S. dollars that traders plan to buy
in the foreign exchange market during a given
period depends in general on
• World demand for U.S. exports
• Interest rates in the United States and other
countries
• The expected future exchange rate
The Foreign Exchange Market
The Law of Demand Applies for Foreign Exchange
People demand U.S. dollars so that they can buy
US -produced goods and services or assets.
Other things remaining the same, the lower the exchange
rate, the larger is the quantity of U.S. dollars demanded in
the foreign exchange market.
The Demand for US Dollars
THE DEMAND FOR US DOLLARS (SUPPLY OF JAPANESE YEN)
1. Firms, households, or governments that import US
goods into Japan or wish to buy US - made goods and
services
2. Japanese citizens traveling in the US
3. Holders of Japanese yen who want to buy US
stocks, bonds, or other financial instruments
4. Japanese companies that want to invest in the US
5. Speculators who anticipate an increase in the value
of the dollar relative to the yen). They expect the dollar
to appreciate and the yen to depreciate.
The Foreign Exchange Market
Supply of US Dollars in the Foreign Exchange Market
The quantity of U.S. dollars supplied in the foreign
exchange market is the amount that traders plan to sell
during a given time period at a given exchange rate.
This quantity depends on many factors but the main ones
are
• U.S. demand for imports
• Interest rates in the United States and other countries
• The expected future exchange rate
The Foreign Exchange Market
The Law of Supply Applies for Foreign Exchange
People supply U.S. dollars so that they can buy
foreign -produced goods and services or foreign assets.
Other things remaining the same, the higher the exchange
rate, the larger is the quantity of U.S. dollars supplied in
the foreign exchange market.
The Market for Foreign Exchange
THE SUPPLY OF US DOLLARS (DEMAND FOR JAPANESE YEN)
1. Firms, households, or governments that import
Japanese goods into the US or wish to buy
Japanese -made goods and services
2. US citizens traveling in the Japan
3. Holders of dollars who want to buy stocks, bonds, or
other financial instruments in Japan
4. US companies that want to invest in Japan
5. Speculators who anticipate the yen to appreciate
and the dollar to depreciate
The Foreign Exchange Market
The demand for US dollars in
the foreign exchange market
shows a negative relationship
between the price of dollars
(yen per dollar, (¥/$) and the
quantity of dollars demanded.
When the price of the dollar
falls (the exchange rate falls),
US - made goods and services
appear less expensive to
Japanese buyers. If US
domestic prices are constant,
Japanese buyers will buy more
US goods and services, and
the quantity demanded of
dollars will increase.
The Foreign Exchange Market
The supply of dollars in the
foreign exchange market shows
a positive relationship between
the price of dollars (Yen per
dollar (¥/$) and the quantity of
dollars supplied.
When the price of dollars rises,
US buyers can obtain more yen
for each dollar. This means that
Japanese products are less
expensive to US buyers. If prices
of Japanese products are
constant , the quantity of dollars
supplied will rise with the
exchange rate.
The Foreign Exchange Market
Market Equilibrium
Demand and supply in the
foreign exchange market
determine the exchange
rate.
The Foreign Exchange Market
If the exchange rate is too
high, a surplus of U.S.
dollars drives it down.
If the exchange rate is too
low, a shortage of U.S.
dollars drives it up.
The market is pulled
(quickly) to the equilibrium
exchange rate at which
there is neither a shortage
nor a surplus.
Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
A change in any influence on the quantity of U.S. dollars
that people plan to buy, other than the exchange rate,
brings a change in the demand for U.S. dollars.
These other influences are
 World demand for U.S. exports
 U.S. interest rate relative to the foreign interest rate
 The expected future exchange rate
Exchange Rate Fluctuations
World Demand for U.S. Exports
At a given exchange rate, if world demand for U.S. exports
increases, the demand for U.S. dollars increases and the
demand curve for U.S. dollars shifts rightward.
U.S. Interest Rate Relative to the Foreign Interest Rate
The U.S. interest rate minus the foreign interest rate is
called the U.S. interest rate differential.
If the U.S. interest differential rises (i.e., US interest rates
rise relative to foreign interest rates), the demand for U.S.
dollars increases and the demand curve for U.S. dollars
shifts rightward.
Exchange Rate Fluctuations
The Expected Future Exchange Rate
At a given current exchange rate, if the expected future
exchange rate for U.S. dollars rises,
the demand for U.S. dollars increases and the demand
curve for dollars shifts rightward.
Exchange Rate Fluctuations
How the demand curve for
U.S. dollars shifts in
response to changes in
 U.S. exports
 The U.S. interest rate
differential
 The expected future
exchange rate
Exchange Rate Fluctuations
Changes in the Supply of U.S. Dollars
A change in any influence on the quantity of U.S. dollars
that people plan to sell, other than the exchange rate,
brings a change in the supply of dollars.
These other influences are
 U.S. demand for imports (want more French wine)
 U.S. interest rates relative to the foreign interest rate
 The expected future exchange rate
Exchange Rate Fluctuations
U.S. Demand for Imports
At a given exchange rate, if the U.S. demand for imports
increases, the supply of U.S. dollars on the foreign
exchange market increases and the supply curve of U.S.
dollars shifts rightward.
U.S. Interest Rate Relative to the Foreign Interest Rate
If the U.S. interest differential rises, (US interest rates rise
relative to Foreign interest rates) the supply of U.S. dollars
decreases and the supply curve of U.S. dollars shifts
leftward.
Exchange Rate Fluctuations
The Expected Future Exchange Rate
At a given current exchange rate, if the expected future
exchange rate for U.S. dollars rises, …
the supply of U.S. dollars decreases and the supply curve
of U.S. dollars shifts leftward.
Exchange Rate Fluctuations
How the supply curve of
U.S. dollars shifts in
response to changes in
 U.S. demand for
imports
 The U.S. interest rate
differential
 The expected future
exchange rate
Exchange Rate Fluctuations
Changes in the Exchange Rate

If demand for U.S. dollars increases and supply does not
change, the exchange rate rises - the dollar appreciates.

European demand for California wine increases (change in taste)
Euro/$
S0
1.10
0.95
D1
D0
Quantity of Dollars



or Great Britain is booming, YGB is increasing => IM = mxY increases.
or US stocks become more attractive to Japanese investors ….
on and on……….
Exchange Rate Fluctuations
Changes in the Exchange Rate

If demand for U.S. dollars decreases and supply does not
change, the exchange rate falls – the dollar depreciates.

European demand for California wine decreases (change in taste)
$/Euro
S0
1.10
0.90
D0
D1
Quantity of Dollars



or Great Britain in recession, YGB is decreasing => IM = mxY
decreases.
or US stocks become less attractive to Japanese investors ….
on and on……….
Exchange Rate Fluctuations
Changes in the Exchange Rate

If supply of U.S. dollars increases and demand does not
change, the exchange rate falls - the dollar depreciates.

US demand for French wine increases (change in taste)
Euro/$
S0
S1
1.10
0.95
D0
Quantity of Dollars



or US is booming, YUS is increasing => IM = mxY increases.
or Japanese stocks become more attractive to US investors ….
on and on……….
Exchange Rate Fluctuations
Changes in the Exchange Rate

If supply of U.S. dollars decreases and demand does not
change, the exchange rate rises - the dollar appreciates.

US demand for French wine decreases (change in taste)
Euro/$
S1
S0
1.10
0.95
D0
Quantity of Dollars



or US is in a recession, YUS is decreasing => IM = mxY decreases.
or Japanese stocks become less attractive to US investors ….
on and on……….
The Open Economy with Flexible Exchange Rates
Purchasing Power Parity: The Law of One Price
law of one price If the costs of transportation are small,
the price of the same good in different countries should be
roughly the same.
purchasing-power-parity theory A theory of international
exchange holding that exchange rates are set so that the
price of similar goods in different countries is the same.
Arbitrage is the practice of seeking to profit by buying in
one market and selling for a higher price in another related
market.
The Open Economy with Flexible Exchange Rates
Purchasing Power Parity: The Law of One Price
Arbitrage example: Price of basket balls in Toronto and
Buffalo
Say a basket ball cost $15cad in Toronto and $13usd in
Buffalo and the exchange rate is $0.75usd/$1cad.
I can buy a basket ball in Toronto for $11.25usd and sell in
Buffalo for $13usd => profit = $1.75.
Holding the basket ball price constant, demand for Canadian
dollar increases and the exchange rate increases to
$0.867usd/$1cad.
-In actuality, the price of basket balls will also change,
increase in Toronto and decrease in Buffalo.
Arbitrage and Speculation
Speculation
• Speculation is trading on the expectation of making a
profit.
• Speculation contrast with arbitrage, which is trading on the
certainty of making a profit.
• Most foreign exchange transactions are based on
speculation.
• The expected future exchange rate influences both supply
and demand, so it influences the current equilibrium
exchange rate.
Arbitrage, Speculation, and Market
Fundamentals
Exchange Rate Volatility
An exchange rate might rise one day and fall the next, as
news about the influences on the exchange rate change
the expected future exchange rate.
The influences of expectations and the constant arrival of
news about the influences on supply and demand, make
changes in the exchange rate impossible to predict.
But trends around which the exchange rate fluctuates are
predictable and depend on market fundamentals.
The Open Economy with Flexible Exchange Rates
How Inflation Affects Exchange Rates
A high rate of inflation in one country relative
to another puts pressure on the exchange rate
between the two countries, and there is a
general tendency for the currencies of relative
high-inflation countries to depreciate –
decrease in value.
Next slide looks at the case where inflation in
the US is high relative to Great Britain.
Factors that Affect Exchange Rates - Inflation
Note: the supply curve and
demand curve shift at the same
time, which make exchange rates
volatile.
Exchange Rates Respond to
Changes in Relative Prices
A higher price level in the United
States, relative to Great Britain,
makes British imports more
attractive. U.S. citizens are likely
to increase their spending on
imports from Britain. The demand
for pounds shifts to the right, from
D to D'
At the same time, the British see
U.S. goods getting more
expensive and reduce their
demand for exports from the
United States. The supply of
pounds shifts to the left, from S to
S'. The result is an increase in the
price of the pound from $1.89 to
$2.25.
The pound appreciates, and the
dollar is worth less (depreciates).
The Open Economy with Flexible Exchange Rates
How Relative Interest Rates Affect Exchange Rates
The level of a country’s interest rate relative to
interest rates in other countries is another
determinant of the exchange rate.
If U.S. interest rates rise relative to British
interest rates, British citizens will be attracted
to U.S. securities.
Factors that Affect Exchange Rates – relative interest rates
Exchange Rates Respond to
Changes in Relative Interest Rates
If U.S. interest rates rise relative to
British interest rates, British citizens
holding pounds will be attracted into
the U.S. securities market. To buy
bonds in the United States, British
buyers must exchange pounds for
dollars. The supply of pounds shifts
to the right, from S to S'.
At the same time, U.S. citizens are
less likely to be interested in British
securities because interest rates are
higher at home. The demand for
pounds shifts to the left, from D to D'.
The result is a depreciated pound and
a stronger dollar.
The Effects of Exchange Rates on the Economy
• When the U.S. dollar depreciates: U.S. products are more
competitive in world markets, and foreign-made goods
look expensive to U.S. citizens.
• A depreciation of a country’s currency is likely to
increase NX and increase RGDP.
• If the economy is operating close to capacity, the increase
in aggregate demand is likely to result in higher prices.
• Also, if import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
• You should draw the AD and AS curves to demonstrate
this.
Open Economy Monetary Policy with Flexible
Exchange Rates
• Fed actions to lower interest rates result in a
decrease in the demand for dollars and an
increase in the supply of dollars, causing the dollar
to depreciate.
• If the purpose of the Fed is to stimulate the
economy, dollar depreciation is a good thing. It
increases U.S. exports and decreases imports.
• As Ms↑=> r↓=> I↑ => Y↑. (domestic market impact)
• Also, as r↓=> exchange rate depreciates=> NX↑ =>
Y↑ (international market impact)
Open Economy Fiscal Policy Flexible Exchange
Rates
• We know from earlier discussion, the multiplier is smaller - some of the
additional spending leaks out as imports, reducing the multiplier.
• At the same time –
• As income increases, the demand for money increases and interest rates
increase causing the dollar to appreciate.
• Exports fall, imports rise, again reducing the multiplier.
• If interest rates rise, private investment may be crowded out, also
lowering the multiplier.
• Putting it all together –
• Expansionary fiscal policy => Y ↑ => IM↑=> lower multiplier effect.
as Md↑ => r↑=> I↓ => Y ↓ (crowding-out). (domestic market impact)
Also,
As r↑=>exchange rate appreciates=> NX↓ => Y↓ (international market
impact)
Arbitrage, Speculation, and Market
Fundamentals
The Expected Future Exchange Rate
An expectation is a forecast.
Exchange rate forecasts, like weather forecasts, are made
over horizons that run from a few hours to many months
and perhaps y
But exchange rate forecasts are hedged with a lot of
uncertainty, there are many divergent forecasts, and the
forecasts influence the outcome.
The dependence of today’s exchange rate on forecasts of
tomorrow’s exchange rate can give rise to exchange rate
volatility in the short run.
Exchange Rate Policy
Three possible exchange rate policies are
 Flexible exchange rate
 Fixed exchange rate
 Crawling peg
Flexible Exchange Rate
A flexible exchange rate policy is one that permits the
exchange rate to be determined by demand and supply
with no direct intervention in the foreign exchange market
by the central bank.
Exchange Rate Policy
Fixed Exchange Rate
A fixed exchange rate policy is one that pegs the
exchange rate at a value decided by the government or
central bank and is achieved by direct intervention in the
foreign exchange market to block unregulated forces of
demand and supply.
A fixed exchange rate requires active intervention in the
foreign exchange market.
Fixed Exchange Rate Policy
This figure shows how the
Fed, as an example, could
intervene in the foreign
exchange market to keep
the exchange rate close to
a target rate.
Suppose that the target is
100 yen per U.S. dollar.
If the demand for U.S.
dollars increases, the Fed
sells U.S. dollars to
increase supply.
Exchange Rate Policy
If demand for the U.S.
dollar decreases, the Fed
buys U.S. dollars to
decrease supply.
Persistent intervention on
one side of the foreign
exchange market cannot
be sustained.
The US follows a policy of
flexible exchange rates.
Exchange Rate Policy
Crawling Peg
A crawling peg works like a fixed exchange rate except
that the target value changes periodically by small
amounts.
China is a country that operates a crawling peg.
The idea to avoid wild swings in the exchange rate that
might happen if expectations became volatile and to avoid
the problem of running out of reserves, which can happen
with a fixed exchange rate.
Pegging the Yuan
The People’s Bank of China needs to buy $460usd billion to
maintain the exchange rate at 6.0
Yuan per US Dollar
D
S
A
B
China’s Target Exchange Rate
6
5
E
S
D
1000
1460
Quantity of Dollars
52
Balance of Payments Accounts
A country’s balance of payments accounts
records its international trading, borrowing, and
lending.
There are three balance of payments accounts:
1. Current account
2. Capital and financial account
3. Official settlements account
Financing International Trade
The current account records flows of goods and services

receipts from exports of goods and services sold
abroad,

payments for imports of goods and services from
abroad,

net investment income (interest),
•
•

income received on investments less
Income paid on investments
net transfers (such as foreign aid payments).
The current accounts balance = exports - imports + net
investment income + net transfers.
Financing International Trade
The capital and financial account records foreign
investment in the United States minus U.S. investment
abroad. Records flows of capital investment.
The sum of the following (measured in a given period):
• the change in private U.S. investments abroad,
• the change in foreign private investments in the
United States,
• the change in U.S. government assets abroad,
• and the change in foreign government assets in the
United States.
Balance of Payments - Example
•
•
•
Say a U.S. resident buys a $30,000 Japanese
automobile
The Japanese car manufacturer receives $30,000.
Has two options:
Option 1: The Japanese car manufacturer can buy $30,000 of U.S.
goods:
Current Account impact:
U.S. exports = $30,000
US imports = $30,000
NX = 0
Capital Account impact:
Δ Capital Account = 0
Current Account + Capital Account =0
Balance of Payments - Example
Option 2: The Japanese car manufacturer can use the
$30,000 to buy U.S. assets such as land, stocks, bonds, etc.
Current Account impact:
US exports = 0.
US imports = $30,000
NX = - $30,000
Capital Account impact:
Capital inflow = Change in foreign private assets in the
United States
= + $30,000
Current Account + Capital Account = 0
More on the Capital Account
There are many transactions recorded in the capital
account that do not pertain to the exports and imports
recorded in the current account.
US citizen buys German bonds
• US holding of German bonds - private assets abroad↑
• German holdings of USD ↑
Financing International Trade
The official settlements account records the change in
U.S. official reserves.
U.S. official reserves are the government’s holdings of
foreign currency.
If U.S. official reserves decrease, the official settlements
account is positive.
The sum of the balances of the three accounts always
equals zero.
US Balance of Payments
2013 Balance of Payments
Current Account
Billions of Dollars
Exports of G & S
+2,280
Imports of G & S
-2,757
Net Investment Income
+209
Net Transfers
-132
(1) Current Account Balance
-400
Capital and Financial Account
Foreign Investment in US
+1,017
US Investment Abroad
-650
Statistical Discrepancy
+30
(2) Capital and Financial Account Balance
(3) Official Settlements Account
(1) + (2) +(3)
+397
+3
0
Financing International Trade
Borrowers and Lenders
A country that is borrowing more from the rest of the world
than it is lending to it is called a net borrower.
A country that is lending more to the rest of the world than
it is borrowing from it is called a net lender.
Since the early 1980s, except for 1991, the United States
has been a net borrower from the rest of the world.
In 2010, the United States borrowed more than $400
billion from the rest of the world, mostly from China.
Financing International Trade
The Global Loanable Funds Market
The loanable funds market is global, not national.
Financial capital is mobile: It moves to the best advantage
of lenders and borrowers.
Funds flow into the country in which the real interest rate is
highest and out of the country in which the real interest
rate is lowest.
Financing International Trade
A country’s loanable funds market connects with the global
market through net exports.
If a country’s net exports are negative, the rest of the world
supplies funds to that country and the quantity of loanable
funds in that country is greater than national saving.
If a country’s net exports are positive, the country is a net
supplier of funds to the rest of the world and the quantity of
loanable funds in that country is less than national saving.
Financing International Trade
Figure 9.7(a) illustrates the global market.
The world equilibrium real interest rate is 5 percent a year.
Financing International Trade
In part (b), at the world real interest rate, borrowers want
more funds than the quantity supplied by domestic lenders.
The shortage of funds is made up by international borrowing.
Financing International Trade
In part (c), at the world real interest rate, the quantity supplied
by domestic lenders exceeds what domestic borrowers want.
The excess quantity supplied goes to foreign borrowers.
Financing International Trade
Debtors and Creditors
A debtor nation is a country that during its entire history
has borrowed more from the rest of the world than it has
lent to it.
Since 1986, the United States has been a debtor nation.
A creditor nation is a country that has invested more in
the rest of the world than other countries have invested in
it.
The difference between being a borrower/lender nation
and being a creditor/debtor nation is the difference
between stocks and flows of financial capital.
Financing International Trade
Being a net borrower is not a problem provided the
borrowed funds are used to finance capital accumulation
that increases income.
Being a net borrower is a problem if the borrowed funds
are used to finance consumption.
From Chapter 7-The Loanable Funds Market
In the market for loanable funds. The market for funds
that finance investment.
Y = national income
Y is either consumed (C), saved (S) or taxed (T):
Y=C+S+T
We know from Chapter 4:
Y=C+I+G+X–M
We get:
C+S+T=C+I+G+X–M
Solve for I:
I = S + (T - G) + (M - X)
The Loanable Funds Market
Funds that Finance Investment come from three
sources:
1. Household saving (S), called private saving.
2. Government budget surplus (T – G), called public saving.
NOTE: S + (T- G) is called national saving.
3. Borrowing from the rest of the world (M – X)
4. Domestic Investment (I) is financed by national saving plus
foreign borrowing:
I = S + (T - G) + (M - X)