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Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates 20 Part 2 CHAPTER OUTLINE The Open Economy with Flexible Exchange Rates The Market for Foreign Exchange Factors That Affect Exchange Rates The Effects of Exchange Rates on the Economy An Interdependent World Economy Appendix: World Monetary Systems Since 1900 © 2014 Pearson Education, Inc. 1 of 34 Exchange Rate When people in countries with different currencies buy from and sell to each other, an exchange of currencies must also take place. © 2014 Pearson Education, Inc. 2 of 34 Appreciation and Depreciation appreciation of a currency The rise in value of one currency relative to another. depreciation of a currency The fall in value of one currency relative to another E ↓ Home currency appreciates and foreign currency depreciates. Similarly, E ↑ Home currency depreciates and foreign currency appreciates. © 2014 Pearson Education, Inc. 3 of 34 The Open Economy with Flexible/Floating Exchange Rates floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. The Market for Foreign Exchange foreign exchange All currencies other than the home currency of a given country. The Supply of and Demand for USD (Home Currency is Baht) Governments, private citizens, banks, and corporations exchange USD for Baht, and Baht for USD every day. Those who demand/buy USD are holders of Baht seeking to exchange them for USD. Those who supply/sell USD are holders of USD seeking to exchange them for Baht. © 2014 Pearson Education, Inc. 4 of 34 Some Buyers and Sellers in International Exchange Markets: US and Thailand The Demand for USD 1. Firms, households, or governments that import US goods into Thailand or want to buy US-made goods and services (IMPORTS—Buy US goods) 2. Thai citizens traveling to/in US (Buy US scenery) 3. Holders of Baht who want to buy US stocks or bonds (Buy US assets) 4. Thai companies that want to invest in US (Buy US factories) 5. Speculators who anticipate a decline in the value of Baht relative to USD (Buy US currency) The Supply of USD 1. Firms, households, or governments that export Thai goods into US or want to buy Thailand-made goods and services (EXPORTS—Sell Thai goods to US) 2. US citizens traveling to or in Thailand (Sell Thai scenery to US) 3. Holders of USD who want to buy Thai stocks or bonds (Sell Thai assets to US) 4. US companies that want to invest in Thailand (Sell Thai factories to US) 5. Speculators who anticipate a rise in the value of Baht relative to USD © 2014 Pearson Education, Inc. 5 of 34 Price of USD (Baht/USD) Price of USD (Baht/USD) USD USD FIGURE20.2 20.2 The TheDemand Demand for for USD in FIGURE the Foreign Exchange Market (Thai Pounds in the Foreign Exchange Market Imports) When falls, Whenthe theprice priceofofpounds USD falls, USmade goodsgoods and services appear British-made and services less expensive to Thaito buyers. appear less expensive U.S. If US prices are constant, Thai buyers. buyers prices will buyare more US goods and If British constant, U.S. services quantity ofgoods USD buyers willand buythe more British demanded and serviceswill andrise. the quantity of pounds demanded will rise. © 2014 Pearson Education, Inc. FIGURE 20.3 Supply of of USD in the in FIGURE 20.3The The Supply Pounds Foreign Exchange Market (Thai Exports) the Foreign Exchange Market When the price of USD rises, When the can priceobtain of pounds rises,for the Americans more Baht British can obtain more dollars for each USD. eachmeans pound.that Thailand-made This This means that U.S.-made goods goods and services appear less and services appear less expensive expensive to US buyers. Thus, the quantity to British buyers. of USD supplied isThus, likelythe to rise with the exchange quantity of pounds rate. supplied is likely to rise with the exchange rate. 6 of 34 FIGURE 20.4 The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined by the forces of supply and demand. An excess demand for USD will cause the USD to appreciate against the Baht. An excess supply of USD will lead to a depreciating USD. © 2014 Pearson Education, Inc. 7 of 34 Factors That Affect Exchange Rates The Law of One Price © 2014 Pearson Education, Inc. 8 of 34 Factors That Affect Exchange Rates Purchasing Power Parity 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 relatively high-inflation countries to depreciate. © 2014 Pearson Education, Inc. 9 of 34 FIGURE 20.5 Exchange Rates Respond to Changes in Relative Prices The higher price level in Thailand makes imports relatively less expensive. Thai citizens are likely to increase their spending on imports from US, shifting the demand for USD to the right, from D0 to D1. At the same time, Americans see Thai goods getting more expensive and reduce their demand for exports from Thailand. The supply of USD shifts to the left, from S0 to S1. The result is an increase in the price of USD. The USD appreciates, and the Baht is worth less. © 2014 Pearson Education, Inc. 10 of 34 Relative Interest Rates FIGURE 20.6 Exchange Rates Respond to Changes in Relative Interest Rates If Thailand’s interest rates rise relative to US interest rates, US citizens holding USD may be attracted into the Thai securities market. To buy bonds/assets in Thailand, American buyers must exchange USD for Baht. The supply of USD shifts to the right, from S0 to S1. However, Thai citizens are less likely to be interested in US securities because interest rates are higher at home. The demand for USD shifts to the left, from D0 to D1. The result is a depreciated USD and a stronger Baht. © 2014 Pearson Education, Inc. 11 of 34 Exchange Rates and the Balance of Trade: The J Curve J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. FIGURE 20.7 The Effect of a Depreciation on the Balance of Trade (the J Curve) Initially, a depreciation of a country’s currency may worsen its balance of trade. The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports. Baht prices of exports and imports change due to depreciation but both quantity of exports and imports remain unchanged as they take time to adjust. balance of trade (Thailand) = Baht price of exports × quantity of exports − Baht price of imports × quantity of imports © 2014 Pearson Education, Inc. 12 of 34 Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level. Monetary Policy with Flexible Exchange Rates A cheaper Baht is a good thing if the goal of the Central Bank is to stimulate the domestic economy. Process is described as follows. Money supply increases Thai interest rate decreases Thai citizens want to buy more assets in foreign countries and foreigners wants to buy less assets in Thailand demand for USD increases and supply of USD decreases exchange rate increases Baht depreciates Exports increase and imports decrease AD shifts to the right. © 2014 Pearson Education, Inc. 13 of 34 REVIEW TERMS AND CONCEPTS appreciation of a currency marginal propensity to import (MPM) balance of payments net exports of goods and services (EX − IM) balance of trade price feedback effect balance on capital account purchasing-power-parity theory balance on current account trade deficit depreciation of a currency trade feedback effect exchange rate Planned aggregate expenditure in an open economy: floating, or market-determined, exchange rates AE ≡ C + I + G + EX − IM foreign exchange Open-economy multiplier = J-curve effect 1 1 ( MPC MPM ) law of one price © 2014 Pearson Education, Inc. 14 of 34