Transcript Document

Exchange Rates and
Macroeconomic Policy
© 2003 South-Western/Thomson Learning
Foreign Exchange
Markets and Exchange Rates
Foreign Exchange Market
The market in which one country’s currency is
traded for another country’s currency
Exchange Rate
•The amount of one country’s currency that is
traded for one unit of another country’s currency
•The price of foreign currency in dollars
The Demand
for British Pounds
•The Demand for Pounds Curve
•Shifts in the Demand for Pounds
Curve
The Demand
for British Pounds
In our model of the market for
pounds, we assume that American
households and businesses are the
only buyers.
The Demand
for British Pounds
Why do Americans want to buy
pounds?
• To buy goods/services from British
firms
• To buy British assets
The Demand
for Pounds Curve
Demand Curve for Foreign Currency
A curve indicating the quantity of a
specific foreign currency that Americans
will want to buy, during a given period, at
each different exchange rate
The Demand
for Pounds Curve
(a)
(b)
Dollars
per Pound
$2.25
Dollars
per Pound
A
Fall in price of
pound moves us
rightward along
demand for
pounds curve
Demand for pounds curve
shifts rightward when:
• U.S. real GDP
• U.S. relative price level
• U.S. tastes shift towards
British goods
• U.S. interest rate
• Pound is expected to
appreciate
E
1.50
£
£
D
200
300 Millions of
British Pounds
£
D2
D1
Millions of
British Pounds
The Demand
for Pounds Curve
Price of
pounds
British
goods
cheaper to
Americans
Americans
buy more
British
goods
Quantity
of pounds
demanded
Shifts in the Demand
for Pounds Curve
Variables That Shift the Demand for Pounds
Curve
•
•
•
•
•
U.S. Real GDP
Relative Price Levels
Americans’ Tastes for British Goods
Relative Interest Rates
Expected Changes in the Exchange Rate
The Supply
of British Pounds
• The Supply of Pounds Curve
• Shifts in the Supply of Pounds
Curve
The Supply
of Pounds Curve
Supply Curve for Foreign Currency
A curve indicating the quantity of a
specific foreign currency that will be
supplied, during a given period, at each
different exchange rate
The Supply
of Pounds Curve
(a)
(b)
Dollars
per Pound
Dollars
per Pound
S
F
$2.25
1.50
£
£
S1
£
S2
Rise in price of
pound moves
us rightward
along supply of
pounds curve
E
300
Supply of pounds curve
shifts rightward if:
• British real GDP
• U.S. relative price level
• British tastes shift
towards U.S. goods
• U.S. interest rate
• Pound is expected to
depreciate
400
Millions of
British Pounds
Millions of
British Pounds
The Supply
of Pounds Curve
Price of
pounds
U.S. goods
goods
cheaper to
British
British
buy more
U.S.
goods
British
need
more
dollars
Quantity
of pounds
supplied
Shifts in the Supply
of Pounds Curve
Variables That Shift the Supply of Pounds Curve
•
•
•
•
•
Real GDP in Britain
Relative Price Levels
British Tastes for U.S. Goods
Relative Interest Rates
Expected Changes in the Exchange Rate
The Equilibrium
Exchange Rate
Floating Exchange Rate
An exchange rate that is freely
determined by the forces of supply and
demand.
The Equilibrium
Exchange Rate
Dollars
per Pound
£
S
Dollars
per Pound
Equilibrium
in the market
for pounds
$1.50
E
£
S
$2.00
C
E
1.50
£
D2
£
D
300
Millions of British
Pounds
Higher U.S.
real GDP leads
to a higher
price per pound
300
£
D1
Millions
of British
Pounds
The Equilibrium
Exchange Rate
When the exchange rate floats - that is,
when the government does not intervene
in the foreign currency market - the
equilibrium exchange rate is determined
at the intersection of the demand curve
and the supply curve.
What Happens
When Things Change?
• How Exchange Rates Change over
Time
• The Very Short Run: “Hot Money”
• The Short Run: Macroeconomic
Fluctuations
• The Long Run: Purchasing Power
Parity
What Happens When Things
Change?
Appreciation
An increase in the price of a currency in
a floating-rate system
Depreciation
A decrease in the price of a currency in
a floating-rate system
What Happens When Things
Change?
When a floating exchange rate changes,
one country’s currency will appreciate
(rise in price) and the other country’s
currency will depreciate (fall in price).
How Exchange Rates Change
Over Time
Dollars
per Pound
B
A
E
C
Years
The Very Short Run
•Relative interest rates and
expectations of future exchange rates
are the dominant forces moving
exchange rates in the very short run.
•“Hot money” consists of funds that
can be moved from one type of
investment to another on very short
notice.
Hot Money in the Very Short Run
Dollars
per Pound
£
S1
£
S2
$1.50
1.00
E
G
£
D1
£
D2
Q1 Q2
Millions of British Pounds
per Month
The Short Run:
Macroeconomic Fluctuations
In the short run, movements in exchange
rates are caused largely by economic
fluctuations.
• All else equal, a country whose GDP rises
relatively rapidly will experience a depreciation
of its currency.
• A country whose GDP falls more rapidly will
experience an appreciation of its currency.
Exchange Rates In The Short Run
(a)
Dollars
per Pound
(b)
Dollars
per Pound
£
S
£
S1
£
S2
B
$1.80
1.50
$1.80
A
1.50
B
C
£
£
D2
£
D1
Millions of
British Pounds
per Month
D2
£
D1
Millions of
British Pounds
per Month
The Long Run: Purchasing
Power Parity
Purchasing Power Parity (PPP) Theory
The idea that the exchange rate will
adjust in the long run so that the average
price of goods in two countries will be
roughly the same
Purchasing Power Parity
Some Important Caveats
• Some Goods Are Difficult to Trade
• High Transportation Costs
• Artificial Barriers to Trade
Interdependent Markets: The
Role of Arbitrage
Arbitrage
Simultaneous buying and selling of
a foreign currency in order to profit
from a difference in exchange rates.
Interdependent Markets: The
Role of Arbitrage
Bilateral Arbitrage
Arbitrage involving one pair of
currencies.
Bilateral arbitrage ensures that the
exchange rate between any two
currencies is the same everywhere
in the world.
Bilateral Arbitrage
(a)
New York
Dollars
per Pound
(b)
London
Dollars
per Pound
£
S
£
S1
£
S2
$1.80
$1.50
E
1.50
E
1.20
£
£
D1
D2
Millions of
British Pounds
per Month
£
D
Millions of
British Pounds
per Month
Interdependent Markets: The
Role of Arbitrage
Triangular Arbitrage
Arbitrage involving trades among
three (or more) currencies
Triangular Arbitrage
Triangular arbitrage ensures that the
price of a foreign currency is the same
whether it is purchased directly - in a
single foreign exchange market - or
indirectly, by buying and selling a third
currency.
Government Intervention in
Foreign Exchange Markets
•Managed Float
•Fixed Exchange Rates
•The Euro
Managed Float
A policy of frequent central
bank intervention to move the
exchange rate.
Managed Float
Under a managed float, a country’s
central bank actively manages its
exchange rate, buying its own currency
to prevent depreciations and selling its
own currency to prevent appreciations.
Fixed Exchange Rate
A government-declared exchange
rate maintained by central bank
intervention in the foreign
exchange market.
Fixed Exchange Rate
(a)
Dollars
per Baht
(b)
Dollars
per Baht
baht
S
$0.06
$0.06
S
Excess
Demand
0.04
Excess
Supply
0.04
D
baht
baht
0.02
0.02
D
100
400
Millions of Baht
per Month
100
baht
400
Millions of Baht
per Month
Fixed Exchange Rate
When a country fixes its exchange rate below
the equilibrium value, the result is an excess
demand for the country’s currency.
To maintain the fixed rate, the country’s
central bank must sell enough of its own
currency to eliminate the excess demand.
Fixed Exchange Rate
When a country fixes its exchange rate above
the equilibrium value, the result is an excess
supply of the country’s currency.
To maintain the fixed rate, the country’s
central bank must buy enough of its own
currency to eliminate the excess supply.
Foreign Currency Crises, the
IMF, and Moral Hazard
Dollars
per Baht
baht
S1
baht
S2
A
$0.04
0.02
B
baht
baht
D1
D2
10 0
400
Millions of Baht
per Month
Foreign Currency Crises, the
IMF, and Moral Hazard
Devaluation
A change in the exchange rate from a
higher fixed rate to a lower fixed rate.
Foreign Currency Crisis
A foreign currency crisis arises when
people no longer believe a country can
maintain a fixed exchange rate above the
equilibrium rate:
–the supply of the currency increases,
–demand for it decreases, and
–the country must use up its reserves of
dollars and other key currencies even faster
in order to maintain the fixed rate.
International Monetary Fund
International Monetary Fund (IMF)
International organization founded in
1945 to help stabilize the world
monetary system
Moral Hazard
Occurs when a decision maker (firm,
individual, government) expects to be
rescued in the event of an unfavorable
outcome, and then changes its behavior
so that the unfavorable outcome is more
likely.
The Euro
Advantages to the Euro:
• Single currency means no commission on
exchange of currency
• Reduced risk of rate changing before accounts
settled
• Easier to sell stocks/bonds throughout Europe
• Cross-country comparison shopping easier
• High-inflation countries will benefit from lower
inflation
The Euro
Disadvantages to the Euro:
• Single monetary policy makes it impossible to
adjust money supply/interest rates to problems
of individual nations
• Requires countries to maintain strict fiscal
discipline that may prevent use of fiscal stimuli
when needed
– Economists question if Europe is an optimum
currency area
The Euro
Optimum Currency Area
A region whose economies perform
better with a single currency than
with separate national currencies
Exchange Rates
and the Macroeconomy
•Exchange Rates and Spending
Shocks
•Exchange Rates and Monetary
Policy
Exchange Rates
and Spending Shocks
• A depreciation of the dollar causes net
exports to rise - a positive spending shock
that increases real GDP in the short run.
• An appreciation of the dollar causes net
exports to drop - a negative spending
shock that decreases real GDP in the short
run.
Exchange Rates
and Monetary Policy
Monetary policy has a stronger effect
when we include the impact on exchange
rates and net exports, rather than just the
impact on interest-sensitive consumption
and investment spending.
Exchange Rates
and Monetary Policy
Money
supply
Interest
rate
a and
IP
Real
GDP
U.S.
assets
less
attractive
Decreased
supply and
increased
demand for
foreign
currency
Dollar
depreciates
Net
exports
Net Effect: GDP  by more when exchange rate’s effect on net
exports is included
Trade Deficit
Trade deficit = imports – exports
Trade surplus = exports – imports
Trade Deficit
Net Capital Inflow
An inflow of funds equal to a
nation’s trade deficit
Trade Deficit
Increase in desire of foreigners to invest
in U.S. contributes to an appreciation of
the dollar:
• U.S. exports become more expensive to
foreigners
• U.S. exports decline
• Imports become cheaper to Americans
• Imports increase
Result is a rise in trade deficit