Transcript SECTION8

Ec 123 Section 8
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Development to Debt Crisis
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Ec 123 Section 8
1
Currency Exchange ($ for Peso)
(Mexico Perspective)
Price of
Peso in
Dollars
SPeso
$0.0759
Supply of Peso to $
exchange comes from
Mexicans:
•Buying U.S. Imports
•Travel to U.S.
•‘Investing’ in the U.S.
•Speculation
•Central Banks
Demand for $ to Peso
exchange comes from
Americans:
•Buying Mexican exports
•Travel to Mexico.
•‘Investing’ in Mexico.
•Speculation
DPeso
Quantity
of exchange
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Fixed Exchange Rates are a Price Support
Price of
Peso in
Dollars
The peso is UNDERVALUED or
its price would APPRECIATE
without govt. influence.
SPeso
S’Peso
The central bank must
increase the supply of Peso
to $ exchange.
The government commits
to a fixed or pegged price
of their currency.
$0.0759
Demand for $ to Peso
exchange increases. For
example, American demand
for Mexican products
increases.
D’Peso
DPeso
Quantity
of exchange
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Fixed Exchange Rates are a Price Support
Price of
Peso in
Dollars
The peso is OVERVALUED or
its price would DEPRECIATE
without govt. influence.
SPeso
S’Peso
Supply for Peso to $
exchange INCREASES. For
example, there is speculation
that the Peso will devalue.
The government commits
to a fixed or pegged price
of their currency.
The central bank must
increase the demand for
Peso to keep the exchange
rate up.
$0.0759
D’Peso
DPeso
Quantity
of exchange
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Impact of Fixed Exchange Rates
If the currency is UNDERVALUED:
• Central Banker must meet excess demand for the currency by supplying
it.
– Must be following an expansionary monetary policy.
• Shows up as DEBIT on official settlements in BOP:
– (Own) Currency is flowing out; Currency reserves (other country’s currencies)
or gold increasing.
• Exports are cheaper; imports are more expensive than what they would
be without the fixed rate.
If the currency is OVERVALUED.
• Central Banker must meet excess demand for the currency by supplying
it.
– Must be following a contractionary monetary policy.
• Shows up as CREDIT on official settlements in BOP:
– (Own) Currency is flowing in; Currency reserves (other country’s currencies) or
gold decreasing.
• Exports are more expensive; imports are cheaper than what they would
be without the fixed rate.
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Timing of Impact on Foreign Exchange Markets
Influences on foreign exchange markets can be categorized by
time interval in which they have an impact:
• Short Run
– Interest rate fluctuations
– Expectations
• Intermediate Run
– Fluctuations in goods, services and investment transactions
– Example: Recession dampens demand for imports
• Long Run
– Purchasing-Power Parity
– Expectations
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Some useful questions
Why do countries attempt to control the
exchange rate?
What happens when a currency devalues (or
depreciates)?
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Real Exchange Rate
The real exchange rate is the exchange rate adjusted for pricelevel differences among countries.
– Provides a measure of the amount of goods your money will buy in
another country.
Formally,
ER = E ×(Pdomestic/Pforeign)
Sometimes it easier to think of in terms of % changes:
%ΔER=%ΔE + %ΔPdomestic - %ΔPforeign
Where %Δmeans ‘percentage change.’
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Purchasing-Power Parity
Purchasing-Power Parity theory says that the quantity
of goods & services a currency can buy (or its
purchasing power) should be the same in all
countries.
– Based upon the microeconomic assumption of the law of
one price.
– Only works for goods that are tradable.
– Transportation costs and other transaction costs are
assumed to be low.
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Purchasing-Power Parity
In the long run the real exchange rate must be 1, or
ER =1= E × (Pdomestic/Pforeign) or Pforeign= E × Pdomestic
Links exchange rate pressures to inflation:
%ΔE = %ΔPforeign - %ΔPdomestic
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The Big Mac Index
USA
China
Euro
Japan
Iceland*
Big Mac
Price in $
3.54
1.83
4.32
3.23
5.97
Implied PPP
of the $
3.53
1.04
81.9
131.37
Valuation
against the
$ (%)
-48
+24
-9
+67
Source: The Economist May 8, 2009, *June 2008
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Mexico: From Stabilized Development to Debt
Crisis
What were the pressures on Mexico to
devalue the peso?
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Mexico: From Stabilized Development to Debt
Crisis
Who (or what) was most at fault for the debt
crisis?
Could this happen to the U.S.?
Ec 123 Section 8
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