Transcript exchange rate - McGraw

International Finance
Chapter 21
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved
Exchange Rates:
The Global Link
The exchange rate is the price of
one country’s currency expressed in
terms of another’s.
It is the domestic price of a foreign
currency.
It is the price of one currency in terms
of another.
2
Foreign-Exchange Markets
Money is a commodity to be bought
and sold like any other.
An exchange rate is subject to the
same influences that determine all
market prices: demand and supply.
LO1
3
The Demand for Dollars
The market demand for U.S. dollars
originates in:
Foreign demand for American exports.
Foreign demand for American
investments.
Speculation.
LO1
4
The Supply of Dollars
The demand for foreign currency
represents a supply of U.S. dollars.
The supply of dollars originates in:
American demand for imports.
American investments in foreign
countries.
Speculation.
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5
The Value of the Dollar
A higher dollar price for euros will
raise the dollar costs of European
goods.
Dollar price euro price dollar price

X
of BMW
of BMW
of euro
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6
The Supply Curve
The supply of dollars is upwardsloping.
If the value of the dollar rises,
Americans can buy more euros.
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7
The Demand Curve
The demand for dollars arises from
the foreign demand for U.S. exports
and investments.
As dollars become cheaper, all
American exports effectively fall in
price.
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8
Equilibrium
Just like any other commodity, the
intersection of market demand and
supply curves gives the equilibrium
price of the dollar.
Equilibrium price – The price at which
the quantity of a good demanded in a
given time period equals the quantity
supplied.
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9
EURO PRICE OF DOLLAR
(euros per dollar)
Foreign-Exchange Market
3.0
2.5
2.0
Supply of dollars
1.5
0.90
0.5
Equilibrium
Demand for dollars
0
QUANTITY OF DOLLARS per time period
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10
Foreign-Exchange Market
The value of the dollar can also be
expressed in terms of other
currencies.
11
Foreign-Exchange Market
Foreign Exchange Rates (March 23, 2007)
Country
U.S. Dollar per Unit
Currency per U.S. Dollar
dollar price of foreign currency
foreign price of U.S. dollar
Brazil (real)
0.4852
2.0610
Britain (pound)
1.9621
0.5096
Canada (dollar)
0.8614
1.1609
China (yuan)
0.1293
7.7325
Indonesia (rupiah)
0.0001
Japan (yen)
0.0085
Mexico (peso)
0.0907
11.0217
Russia (ruble)
0.0384
26.055
Euroland (euro)
1.3289
9,107.00
118.064
0.7525
12
The Balance of Payments
The balance of payments is a
summary of a country’s international
economic transactions in a given
period of time.
It is an accounting statement of all
international money flows in a given
time period.
13
Trade Balance
The trade balance is the difference
between exports and imports of
goods and services.
Trade balance = exports – imports
14
Trade Balance
A trade deficit represents a net
outflow of dollars to the rest of the
world.
Trade deficit – The amount by which
the value of imports exceeds the value
of exports in a given time period.
15
Current-Account Balance
The current-account balance is the
most comprehensive summary of our
trade relations.
Current - account  trade  unilateral
balance
balance transfer
16
Capital-Account Balance
The capital account balance takes
into consideration assets bought and
sold across international borders.
Capital
Foreign
U.S. purchases
account  purchase of –
of foreign
balance
U.S. assets
assets
17
Capital-Account Balance
The capital-account surplus must
equal the current-account deficit.
Net
balance of
payments

currentaccount
balance
–
capitalaccount
balance
 0
18
U. S. Balance of Payments, 2006
Item
Amount (in billions)
1. Merchandise exports
$1,035
2. Merchandise imports
(1,880)
3. Service exports
431
4. Service imports
(349)
Trade Balance (items 1-4)
–763
5. Income from U.S. overseas investments
621
6. Income outflow for foreign U.S. investments
(630)
7. Net U.S. government grants
(28)
8. Net private transfers and pensions
(56)
Current-Account Balance (items 1-8)
–856
9. U.S. capital inflow
1,464
10. U.S. captial outflow
(1,043)
11. Increase in U.S. official reserves
12. Increase in foreign official assets in U.S.
Capital-Account Balance (items 9-12)
13. Statistical discrepancy
Net Balance (items 1-13)
(2)
300
723
133
0
19
Market Dynamics
Exchange rates are always changing
in response to shifts in demand and
supply.
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20
Depreciation and Appreciation
Depreciation (currency) refers to a
fall in the price of one currency
relative to another.
Appreciation refers to a rise in the
price of one currency relative to
another.
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21
Depreciation and Appreciation
Whenever one currency depreciates,
another currency must appreciate.
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22
Market Forces
Exchange rates change whenever
the supply or demand (or both) has
shifted.
Market forces are constantly
changing – keeping foreign-exchange
markets busy.
Foreign-exchange markets are
places where foreign currencies are
bought and sold.
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23
Market Forces
Some of the more important reasons
supply and/or demand may shift:
Relative income changes.
Relative price changes.
Changes in product availability.
Relative interest-rate changes.
Speculation.
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24
Shifts in Foreign-Exchange
Markets
Dollar-euro market
Dollar-yen market
S1
Yen Price of Dollar
Euro Price of Dollar
S2
P2
P1
S1
S2
P1
P2
D
D
Quantity of Dollars
LO2
Quantity of Dollars
25
Changing Values of U.S. Dollar
26
The Asian Crisis of 1997-1998
The Asian crisis of 1997-1998 was
caused by several market forces
moving in the same direction at the
same time.
27
The Asian Crisis of 1997-1998
In July 1997, the Thai government
decided the baht was overvalued and
let market forces find a new
equilibrium.
Within days, the dollar price of the
baht plunged 25 percent and the Thai
price of the U.S. dollar increased.
28
The Asian Crisis of 1997-1998
The devaluation of the baht had a
domino effect on other Asian
currencies.
Holders of the Malaysian ringget, the
Indonesian rupiah and the Korean
won rushed to buy U.S. dollars.
29
The Asian Crisis of 1997-1998
The “Asian contagion” wasn’t
confined to that area of the world.
Hog farmers in the U.S. saw foreign
demand for their pork evaporate.
Koreans stopped taking vacations in
Hawaii.
Thai Airways canceled orders for Boeing
jets.
30
The Asian Crisis of 1997-1998
This loss of export markets slowed
economic growth in the United
States, Europe, Japan, and other
nations.
31
Resistance to Exchange-Rate
Changes
Resistance to exchange rate changes
originates in various micro and macro
economic interests.
32
Micro Interests
People who trade or invest in world
markets want a solid basis for
forecasting future costs, prices, and
profits.
Fluctuating currency exchange rates
are an unwanted burden on trade.
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33
Micro Interests
A change in the price of a country’s
money automatically alters the price
of all of its exports and imports.
Import-competing industries suffer
when currency depreciations make
imports cheaper.
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34
Macro Interests
A micro problem that becomes
widespread enough can turn into a
macro one.
The huge U.S. trade deficits of the
1980s effectively exported jobs to
foreign nations.
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35
U.S. a Net Debtor
From 1914 to 1984, the United States
was a net creditor in the world
economy.
Since 1985, the United States has
been a net debtor.
36
U.S. a Net Debtor
U.S. debtor status can complicate
domestic policy.
A sudden flight from U.S. assets
could severely weaken the dollar and
disrupt the domestic economy.
37
Exchange-Rate Intervention
Governments often intervene in
foreign-exchange markets to achieve
greater exchange-rate stability.
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38
Fixed Exchange Rates
Under a gold standard, each country
determines that its currency is worth
so much gold.
Gold Standard - An agreement by
countries to fix the price of their
currencies in terms of gold; a
mechanism for fixing exchange rates.
LO2
39
Balance of Payment Problems
Market supply and demand of
currency naturally shift.
This moves the equilibrium exchange
rate away from the fixed exchange
rate.
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40
Balance of Payment Problems
Excess demand for a foreign
currency implies:
A balance-of-payments deficit for the
domestic nation, and
A balance-of-payments surplus for the
foreign nation.
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41
Balance of Payment Problems
A balance-of-payments deficit
results from an excess demand for
foreign currency at current exchange
rates.
A balance-of-payments surplus
results from an excess demand for
domestic currency at current
exchange rates.
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42
Balance of Payment Problems
There are only two ways to deal with
balance-of-payments problems when
there are fixed exchange rates:
Allow exchange rates to change.
Alter market supply or demand so that
they intersect at the established
exchange rate.
LO2
43
Dollar Price of Pounds
Fixed Rates and Market Imbalance
D1
D2
S1
Excess demand
for pounds
e2
e1
0
qS
qD
Quantity of Pounds
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44
The Need for Reserves
The Treasury could help maintain the
officially established exchange rate
by selling some of its foreign
exchange reserves.
Foreign-Exchange Reserves Holdings of foreign exchange by official
government agencies, usually the
central bank or treasury.
LO2
45
The Need for Reserves
Foreign exchange reserves may not
be adequate to maintain fixed
exchange rates.
The long-term string of U.S. balance-ofpayments deficits overwhelmed its stock
of foreign exchange reserves.
LO2
46
Dollar Price of Pounds
The Impact of Monetary
Intervention
D2
S1
S2
e1
Excess
demand
0
qS
qD
Quantity of Pounds
LO2
47
The U.S. Balance of Payments:
1950 – 1973
Balance (billions of dollars)
+$4
Surplus
+2
0
–2
–4
–6
Deficit
–8
–10
1950
1955
1960
1965
1970
1973 1975
48
The Role of Gold
Gold reserves are a potential
substitute for foreign-exchange
reserves.
Gold Reserves - Stocks of gold held by
a government to purchase foreign
exchange.
LO2
49
The Role of Gold
Continuing U.S. balance-of-payments
deficits exceeded the holdings in Fort
Knox.
As a result, U.S. gold reserves lost
their credibility as a potential
guarantee of fixed exchange rates.
LO2
50
Domestic Adjustments
Trade protection can be used to prop
up fixed exchange rates.
Deflationary (or restrictive) policies
help correct a balance-of-payments
deficit by lowering domestic incomes
and thus the demand for imports.
LO2
51
Domestic Adjustments
Domestic adjustments require a
deficit country to give up full
employment and a surplus country to
give up price stability.
LO2
52
The Euro Fix
The 12 nations of the European
Monetary Union (EMU) fixed their
exchange rates in 1999.
They eliminated their national
currencies, making the euro the
common currency of Euroland.
53
Flexible Exchange Rates
Flexible exchange rates is a system
in which exchange rates are
permitted to vary with market supply
and demand conditions.
Also called floating exchange rates.
With flexible exchange rates, the
quantity of foreign exchange demand
always equals the quantity supplied.
LO2
54
Flexible Exchange Rates
Someone is always hurt (and others
are helped) by exchange-rate
movements.
Currency depreciation may cause
domestic cost-push inflation by pushing
up input prices.
Currency appreciation reduces exports
by raising the price of domestically
produced goods to foreigners.
LO2
55
Speculation
Speculators often counteract shortterm changes in foreign-exchange
supply and demand.
Sometimes, speculators move “with
the market” and make swings in the
exchange rate even more extreme.
LO2
56
Managed Exchange Rates
Governments may buy and sell
foreign exchange for the purpose of
narrowing exchange-rate movements.
Such limited intervention in foreignexchange markets is referred to as
managed exchange rates.
LO2
57
Managed Exchange Rates
Managed exchange rates is a
system in which governments
intervene in foreign-exchange
markets to limit but not eliminate
exchange rate fluctuations.
Sometimes called “dirty floats.”
LO2
58
Managed Exchange Rates
The basic objective of exchange-rate
management is to provide a
stabilizing force.
LO2
59
Currency Bailouts
The world has witnessed a string of
currency crises:
The Asian crisis of 1997-1998.
The Brazilian crisis of 1999.
The Argentine crisis of 2001-2.
The recurrent ruble crises in Russia.
Periodic panics in Mexico and South
America.
60
Currency Bailouts
In most cases a currency “bailout”
was arranged by the International
Monetary fund, joined by the central
banks of the strongest economies.
61
The Case for Bailouts
The case for currency bailouts
typically rests on the domino theory.
Weakness in one currency can
undermine another.
Industrial countries often offer
currency bailout as a form of selfdefense.
62
The Case Against Bailout
Critics of bailouts argue that such
interventions are ultimately selfdefeating.
Once a country knows that currency
bailouts will occur, it may not pursue
domestic policy adjustments to
stabilize its currency.
63
The Case Against Bailout
A nation can avoid politically
unpopular options such as high
interest rates, tax hikes, or cutbacks
in government spending.
64
The Case Against Bailout
It can also turn a blind eye to trade
barriers, monopoly power, lax lending
policies, and other constraints on
productive growth.
65
Future Bailouts?
To minimize the ill effects of bailouts,
the IMF and other institutions typically
require the crisis nation to pledge
more prudent monetary, fiscal, and
trade policies.
66
Future Bailouts?
As long as the crisis nation is
confident of an eventual bailout,
however, it has a lot of bargaining
power to resist policy changes.
67
International Finance
End of Chapter 21
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies,
All Rights Reserved