Transcript fixed exchange rate - McGraw Hill Higher Education

Chapter 21: Exchange Rates,
International Trade, and Capital Flows
1. Define the nominal exchange rate and use supply and demand
to analyze how the nominal exchange rate is determined in the
short run
2. Distinguish between fixed and flexible exchange rates and
discuss the advantages and disadvantages of each system
3. Define the real exchange rate and show how it is related to the
prices of goods across pairs of countries
4. Understand the law of one price and apply the purchasing
power parity theory of exchange rates to long-run equilibrium
exchange rate determination
5. Analyze the factors that determine international capital flows
and how these factors affect domestic saving and the
domestic real interest rate
6. Use the relationship between domestic saving and the trade
balance to understand how domestic saving, the trade
balance, and net capital inflows are related
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Nominal Exchange Rates
• The nominal exchange rate is the rate at
which two currencies can be traded for each
other
 Consider 3 currencies: $, C$, and £
 One dollar buys £ 0.5045 or C$ 1.0265
 The exchange rate between UK pounds and
Canadian dollars can be calculated from this
information
£ 0.5045 = C$ 1.0265
£ 1 = C$ 1.0265 / 0.5045
£ 1 = C$ 2.035
OR
C$ 1 = £ 0.5045 / 1.0265
C$ 1 = £ 0.4915
21-2
Importance of Exchange Rates
• Domestic purchases are made with local
currency
– Purchasing goods abroad requires converting your
local currency to their local currency
• The exchange rate measures the rate of conversion
• Exchange rates are set in the foreign exchange
market, with a small number of exceptions
– Rates are determined by supply and demand
– Affect the value of imported goods and the value of
financial investments made across borders
• Changes in exchange rates can have a significant
effect on most economies
21-3
Changes in Exchange Rates
• Appreciation is an increase in the value of a currency
relative to other currencies
• Depreciation is a decrease in the value of a currency
relative to other currencies
Exchange Rates
• Definition
– e = the number of units of foreign currency that each unit of
domestic currency will buy
• Domestic currency appreciates if e increases
• Domestic currency depreciates if e decreases
21-4
Exchange Rate Strategies
– The foreign exchange market is the market on which
currencies of various nations are traded
• A flexible exchange rate is 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
• A fixed exchange rate is an exchange rate set by
official government policy
– Can be set independently or by agreement with a number
of other governments
– Fixed rates can be set relative to the dollar, the euro, or
even gold
21-5
Flexible Exchange Rate in the
Short Run
• Exchange rates are set by supply and demand
in the foreign exchange market
• Dollars are demanded by foreigners who seek to
purchase U.S. goods or financial assets
– Number of dollars foreigners seek to buy
• Dollars are supplied by U.S. residents who need
foreign currency to buy foreign goods or
financial assets
– Not the same as the money supply set by the Fed
– Number of dollars offered in exchange for other
currencies
21-6
Monetary Policy and the
Exchange Rate
• Monetary policy affects interest rates which
affect the exchange rate
– Tighter U.S. monetary policy leads to a higher real
interest rate
– Higher interest rates make U.S. assets more
attractive than foreign assets
• Demand for the dollar increases by foreigners
– Demand curve shifts to the right
• Supply of dollars by U.S. decreases
– Supply curve shifts to the left
– Dollar appreciates
21-7
Tighter Monetary Policy
– Size of the two shifts
– Slopes of the curves
S'
Yen / dollar exchange rate
• Higher real interest
rates in U.S. increase
demand for dollars
and decrease supply
• Dollar appreciates
• Change in quantity of
dollars traded
depends on
F
e
*'
S
E
e
*
D'
D
Quantity of dollars
21-8
Monetary Policy and the
Exchange Rate
• Flexible exchange rates make monetary policy more
effective
– When the Fed tightens monetary policy, it sets off a
chain of domestic events
r
C, IP
PAE 
Y
– And a chain of international events
r
e*
NX 
PAE 
Y
• Monetary policy is more effective in an open
economy with flexible exchange rates
21-9
Fixed Exchange Rates
• Most large industrial countries use a flexible
exchange rate
– Small and developing countries may use a fixed
exchange rate
• Fixed exchange rate system was set up after
World War II
– Began to break down in the 1960s
– Abandoned by 1976
• Fixed exchange rates greatly reduce the
effectiveness of monetary policy as a
stabilization tool
21-10
Fixed Exchange Rates
• To establish a fixed exchange rate system, the
government states the value of its currency in
terms of a major currency
– May use an average of the currencies of its major
trading partners
• Government attempts to maintain the fixed
exchange rate at its existing level
• The government may change the value of its
currency in response to market events
21-11
Exchange Rates and Monetary
Policy
• Flexible exchange rates strengthen the
effectiveness of monetary policy for stabilization
• Fixed rates require the central bank to choose
between defending the currency and stabilizing the
economy
• Fixed rates can be beneficial for small economies
– Argentina fought hyperinflation by valuing its peso on
par with the dollar
• Inflation quickly decreased and stayed stable for more
than 10 years
• Fixed exchange system broke down because unsound
domestic policies created fears that Argentina would
default on international loans
21-12
Real Exchange Rates
• In the short run, domestic prices of goods are fixed
– In the long run, this assumption is relaxed
• The real exchange rate is the price of the average
domestic good relative to the price of the average
foreign good when prices are expressed in a common
currency
• The nominal exchange rate, e, is the number of units
of foreign currency per dollar
– To convert a foreign price, Pf, to the dollar price, Pf$,
divide Pf by e
Pf / e = ¥ 242,000 / (¥ 110/$1) = $2,200
21-13
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
• Suppose wheat in Sydney was half the price of
wheat in Mumbai
– Buy wheat in Sydney, increasing demand and price
– Sell wheat in Mumbai, increasing supply and
decreasing the price
• The law of one price implies that real exchange
rates prevail in the long run
21-14
Purchasing Power Parity (PPP)
• Purchasing power parity is the theory that nominal
exchange rates are determined as necessary for
the law of one price to hold
– In the long run, the currencies of countries that
experience significant inflation will tend to depreciate
PPP Examined
– The theory works well in the long run but not the
short run
– Not all goods and services are traded internationally
– Not all internationally traded goods and services are
perfectly standardized commodities
21-15
Trade Balance
• Trade balance is another name for net exports
(NX)
– Value of a country's exports minus the value of its
imports
• A trade surplus is a positive trade balance
– Exports > imports
• A trade deficit is a negative trade balance
– Imports > exports
21-16
Capital Flows
• International capital flows are purchases or sales of
real and financial assets across international borders
– Capital inflows are purchases of domestic assets
by foreign households and firms
– Capital outflows are purchases of foreign assets
by domestic households and firms
– Net capital inflows (KI) are capital inflows minus
capital outflows
• Capital flows are not counted as imports or exports
since they refer to the purchase of existing assets
rather than currently produced goods and services
21-17
International Capital Flows
• Highly developed financial markets allow borrowing
and lending across borders
• Transactions are subject to laws in the originating
country and the target country
– Size of international flows for a country depend
on its regulations and laws
– Also depend on economic integration and political
stability
• Lending is acquiring a real or financial asset
– Buying a share of stock or a government bond or
a parcel of land
• Borrowing is selling a real or financial asset
21-18
Two Roles of International
Capital Flows
Trade Imbalances
• International capital flows compensate for trade
imbalances
• Trade surplus means net capital outflows
• Trade deficit means net capital inflows
Efficient Allocation of Savings
• International capital flows allow savers to invest in the
most profitable opportunities
• Independent of location
• Fills savings gap in destination country
21-19
Savings, Investment, Capital
Inflows
• Definition of output
Y = C + I + G + NX
• Solve for I
Y – C – G – NX = I
• National savings, S, is (Y – C – G)
S – NX = I
• Also
NX + KI = 0 OR KI = – NX
• So
S + KI = I
21-20
S + KI = I
Real interest rate (%)
• Savings plus net capital inflows equals investment in
new capital goods
– Foreign savings can supplement domestic savings
to create capital goods to
support economic growth
S + KI
• In a closed economy,
S=I
– In an open economy,
r*
S + KI = I
I
• Capital inflows mean more
investment and lower
S, I
interest rates
Saving and investment
21-21
Exchange Rates, International
Trade, and Capital Flows
• Exchange rates
– Nominal and real
– Fixed and flexible
– Short run and long run
• Purchasing power parity
•
•
•
•
Monetary policy and the exchange rate
Trade balance and net capital inflows
International capital flows
The saving rate and the trade deficit
21-22