Transcript O'Sullivan Sheffrin Peres 6e

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
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Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall.
2 of 28
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
6/e.
6/e.
Perez Perez
Sheffrin,
Tools
andand
Applications,
Macroeconomics: Principles,
Sheffrin,
O’Sullivan,
ToolsO’Sullivan,
Applications,
Principles,
Macroeconomics:
The World of
International Finance
Today, the world currency markets
are always open. When foreign
exchange traders in New York City
are sound asleep at 3:00 A.M., their
counterparts in London are already
on their phones and computers at
8:00 A.M.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 19
The World of
International Finance
19.1
HOW EXCHANGE RATES ARE DETERMINED
What Are Exchange Rates?
• exchange rate
The price at which currencies
trade for one another in the
market.
• euro
The common currency in
Europe.
An increase in the value of a currency
relative to the currency of another nation
is called an appreciation of a currency.
A decrease in the value of a currency
relative to the currency of another nation
is called a depreciation of a currency.
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C H A P T E R 19
The World of
International Finance
19.1
HOW EXCHANGE RATES ARE DETERMINED
How Demand and Supply Determine Exchange Rates
 FIGURE 19.1
The Demand for and
Supply of U.S. Dollars
Market equilibrium
occurs where the
demand for U.S.
dollars equals the
supply.
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C H A P T E R 19
The World of
International Finance
19.1
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
 FIGURE 19.2
Shifts in the Demand for
U.S. Dollars
An increase in the
demand for dollars will
increase (appreciate) the
dollar’s exchange rate.
Higher U.S. interest rates
or lower U.S. prices will
increase the demand for
dollars.
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C H A P T E R 19
The World of
International Finance
19.1
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
 FIGURE 19.3
Shifts in the Supply of
U.S. Dollars
An increase in the supply
of dollars will decrease
(depreciate) the dollar
exchange rate. Higher
European interest rates or
lower European prices will
increase the supply of
dollars.
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C H A P T E R 19
The World of
International Finance
19.1
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
Let’s summarize the key facts about the foreign exchange market, using euros
as our example:
1 The demand curve for dollars represents the demand for dollars in
exchange for euros. The curve slopes downward. As the dollar
depreciates, there will be an increase in the quantity of dollars demanded
in exchange for euros.
2
The supply curve for dollars is the supply of dollars in exchange for euros.
The curve slopes upward. As the dollar appreciates, there will be an
increase in the quantity of dollars supplied in exchange for euros.
3
Increases in U.S. interest rates and decreases in U.S. prices will increase
the demand for dollars, leading to an appreciation of the dollar.
4
Increases in European interest rates and decreases in European prices
will increase the supply of dollars in exchange for euros, leading to a
depreciation of the dollar.
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C H A P T E R 19
The World of
International Finance
19.2
REAL EXCHANGE RATES AND
PURCHASING POWER PARITY
REAL-NOMINAL PRINCIPLE
What matters to people is the real value of money or income—its purchasing
power—not the face value of money or income..
• real exchange rate
The price of U.S. goods and
services relative to foreign
goods and services, expressed
in a common currency.
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19.2
REAL EXCHANGE RATES AND
PURCHASING POWER PARITY
Macroeconomics: Principles, Applications, and Tools
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C H A P T E R 19
The World of
International Finance
 FIGURE 19.4
Real Exchange Rate and
Net Exports as Percent of
GDP, 1980–2007
The figure shows the real
exchange rate for the
United States compared to
its net exports as a share
of GDP.
Notice that, in general,
when the real (multilateral)
exchange rate increased,
U.S. net exports fell.
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19.2
REAL EXCHANGE RATES AND
PURCHASING POWER PARITY
Macroeconomics: Principles, Applications, and Tools
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6/e.
C H A P T E R 19
The World of
International Finance
• law of one price
The theory that goods easily tradable
across countries should sell at the
same price expressed in a common
currency.
• purchasing power parity
A theory of exchange rates whereby a
unit of any given currency should be
able to buy the same quantity of
goods in all countries.
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C H A P T E R 19
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International Finance
APPLICATION
1
BIG MACS AND PURCHASING POWER PARITY
APPLYING THE CONCEPTS #1: Can the price of
hamburgers around the world give us a clue to the proper
value for exchange rates?
For several years, the Economist measured the price of a Big Mac throughout the
world and checked to see whether the law of one price held. Table 19.1 contains
the results for selected countries and the market-exchange rate predicted by the
theory of purchasing power parity. To obtain the exchange rate, divide the price of
Big Macs in the foreign country by the dollar price.
TABLE 19.1
BIG MAC PRICING AROUND THE WORLD VERSUS ACTUAL EXCHANGE RATES
Country
Price of a
Big Mac in Local
Currency
United States
United Kingdom
Hong Kong
Switzerland
Mexico
Japan
3.41 dollars
1.99 pounds
12.0 HK dollars
6.30 Swiss francs
29.0 pesos
250 yen
Price of a Big
Mac in Dollars
$3.41
4.01
1.54
5.20
2.69
2.29
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Predicted Purchasing
Power Exchange Rate
Based on Big Mac Pricing
(Foreign Currency
per U.S. Dollar)
Actual
Exchange Rate
(Foreign
Currency per
U.S. Dollar)
____
____
0.58
3.52
1.85
8.50
73.30
0.50
7.82
1.21
10.80
109.20
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19.3
THE CURRENT ACCOUNT, THE FINANCIAL
ACCOUNT, AND THE CAPITAL ACCOUNT
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C H A P T E R 19
The World of
International Finance
• balance of payments
A system of accounts that measures
transactions of goods, services, income,
and financial assets between domestic
households, businesses, and
governments and residents of the rest of
the world during a specific time period.
• current account
The sum of net exports (exports
minus imports) plus net income received
from abroad plus net transfers from
abroad.
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19.3
THE CURRENT ACCOUNT, THE FINANCIAL
ACCOUNT, AND THE CAPITAL ACCOUNT
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C H A P T E R 19
The World of
International Finance
• financial account
The value of a country’s net sales
(sales minus purchases) of assets.
• capital account
The value of capital transfer and
transaction in nonproduced,
nonfinancial assets in the
international accounts.
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C H A P T E R 19
The World of
International Finance
19.3
THE CURRENT ACCOUNT, THE FINANCIAL
ACCOUNT, AND THE CAPITAL ACCOUNT
Rules for Calculating the Current, Financial, and
Capital Accounts
Here is a simple rule for understanding transactions on the current,
financial, and capital accounts: Any action that gives rise to a
demand for foreign currency is a deficit item. Any action that gives
rise to a supply of foreign currency is a surplus item.
The current, financial, and capital accounts of a country are linked by
a very important relationship:
current account + financial account + capital account = 0
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19.3
THE CURRENT ACCOUNT, THE FINANCIAL
ACCOUNT, AND THE CAPITAL ACCOUNT
Rules for Calculating the Current, Financial, and
Capital Accounts
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 19
The World of
International Finance
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C H A P T E R 19
The World of
International Finance
19.3
THE CURRENT ACCOUNT, THE FINANCIAL
ACCOUNT, AND THE CAPITAL ACCOUNT
Rules for Calculating the Current, Financial, and
Capital Accounts
• net international investment position
Domestic holding of foreign assets
minus foreign holdings of domestic
assets.
• sovereign investment fund
Assets accumulated by foreign
governments that are invested abroad.
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2
WORLD SAVINGS AND U.S. CURRENT ACCOUNT DEFICITS
APPLYING THE CONCEPTS #2: What factors may allow the
United States to continue running large trade deficits with
the rest of the world?
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APPLICATION
O’Sullivan, Sheffrin, Perez
C H A P T E R 19
The World of
International Finance
The 2006 Economic Report of the President directly addressed whether the United
States can continue to run large current account deficits and, of course, financial
account surpluses. In the report, the government recognized that the current
account deficits would eventually be reduced. However, it also highlighted a
number of factors suggesting the deficits could continue for a long period of time.
For the United States to continue to run a current account deficit, other countries in
the world need to continue to purchase U.S. assets.
In recent years, four major countries experienced circumstances that encouraged
them to save by purchasing assets from abroad: Japan, Germany, Russia, and
China.
For the United States to continue to run trade deficits in the future, these or other
countries must want to continue to save more than they want to invest
domestically.
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19.4
FIXED AND FLEXIBLE EXCHANGE RATES
Macroeconomics: Principles, Applications, and Tools
O’Sullivan, Sheffrin, Perez
6/e.
C H A P T E R 19
The World of
International Finance
To set the stage for understanding exchange rate systems, let’s
recall what happens when a country’s exchange rate
appreciates—increases in value. There are two distinct effects:
1
The increased value of the exchange rate makes imports
less expensive for the residents of the country where the
exchange rate appreciated.
2
The increased value of the exchange rate makes U.S.
goods more expensive on world markets.
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C H A P T E R 19
The World of
International Finance
19.4
FIXED AND FLEXIBLE EXCHANGE RATES
Fixing the Exchange Rate
• foreign exchange market intervention
The purchase or sale of currencies by government
to influence the market exchange rate.
 FIGURE 19.5
Government Intervention to
Raise the Price of the Dollar
To increase the price of
dollars, the U.S.
government sells euros in
exchange for dollars.
This shifts the demand
curve for dollars to the
right.
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C H A P T E R 19
The World of
International Finance
19.4
FIXED AND FLEXIBLE EXCHANGE RATES
Fixed versus Flexible Exchange Rates
FLEXIBLE EXCHANGE RATE SYSTEM
• flexible exchange rate system
A currency system in which exchange
rates are determined by free markets.
FIXED EXCHANGE RATES
• fixed exchange rate system
A system in which governments peg
exchange rates to prevent their
currencies from fluctuating.
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C H A P T E R 19
The World of
International Finance
19.4
FIXED AND FLEXIBLE EXCHANGE RATES
Fixed versus Flexible Exchange Rates
BALANCE OF PAYMENTS DEFICITS AND SURPLUSES
• balance of payments deficit
Under a fixed exchange rate system, a situation in
which the supply of a country’s currency exceeds the
demand for the currency at the current exchange rate.
• balance of payments surplus
Under a fixed exchange rate system, a situation in
which the demand of a country’s currency exceeds the
supply for the currency at the current exchange rate.
• devaluation
A decrease in the exchange rate to which a currency is
pegged under a fixed exchange rate system.
• revaluation
An increase in the exchange rate to which a currency is
pegged under a fixed exchange rate system.
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C H A P T E R 19
The World of
International Finance
19.4
FIXED AND FLEXIBLE EXCHANGE RATES
The U.S. Experience with Fixed and Flexible
Exchange Rates
Fixed exchange rate systems provide benefits, but they require
countries to maintain similar economic policies—especially to
maintain similar inflation rates and interest rates.
Higher prices in the United States cause the U.S. real exchange
rate to rise. This increase in the real exchange rate over time
causes a trade deficit to emerge.
Exchange Rate Systems Today
The flexible exchange rate system has worked well enough
since the breakdown of Bretton Woods.
Some economists believe that the world will eventually settle
into three large currency blocs: the euro, the dollar, and the
yen.
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