Transcript Parkin-Bade Chapter 34

Ch. 10: The Exchange Rate and the
Balance of Payments.
 Exchange rates
• Definition
• Determinants
• Short run
• Long run
• Purchasing power parity
• Interest rate parity
 Balance of payments accounts
 Causes of an international deficit
 Alternative exchange rate policies and their long-run
effects
Currencies and Exchange Rates
•U.S. Citizens sell dollars in the foreign exchange
market in order to purchase foreign currency to
1. purchase imports
2. purchase foreign assets
Foreign citizens buy dollars in the foreign exchange
market with foreign currency in order to
1. Purchase U.S. exports
2. Purchase U.S. assets.
Currencies and Exchange Rates
Foreign Exchange Rates
The price at which one currency exchanges for another is
called a foreign exchange rate.
Currency depreciation
A fall in the value of one currency in terms of another currency

Currency appreciation
A rise in value of one currency in terms of another currency.
Currencies and Exchange Rates
Nominal and Real Exchange Rates
Nominal exchange rate is the value of the U.S. dollar
expressed in units of foreign currency per U.S. dollar.
The real exchange rate is the relative price of foreignproduced goods and services.
It is a measure of the quantity of real GDP of other countries
that we get for a unit of U.S. real GDP.
Currencies and Exchange Rates
The trade-weighted
index is the average
exchange rate of the
U.S. dollar against
other currencies, with
individual currencies
weighted by their
importance in U.S.
international trade.
The Foreign Exchange Market
The Demand for One Money Is the Supply of Another
Money
When people who are holding one money want to
exchange it for U.S. dollars, they demand U.S. dollars and
they supply that other country’s money.
So the factors that influence the demand for U.S. dollars
also influence the supply of Canadian dollars, E.U. euros,
U.K. pounds, and Japanese yen.
And the factors that influence the demand for another
country’s money also influence the supply of U.S. dollars.
The Foreign Exchange Market
Demand for $ in the Foreign Exchange Market
The quantity of U.S. dollars that traders plan to buy in the
foreign exchange market during a given period depends
on
1. The exchange rate (P of $)
2. World demand for U.S. exports
3. Interest rates in the United States and other countries
4. The expected future exchange rate
The Foreign Exchange Market
The Law of Demand for Foreign Exchange
• The demand for dollars is a derived demand.
• People buy U.S. dollars so that they can buy U.S.produced goods and services or U.S. assets.
• Other things remaining the same, the higher the
exchange rate, the smaller is the quantity of U.S. dollars
demanded in the foreign exchange market.
The Foreign Exchange Market
The exchange rate influences the quantity of U.S. dollars
demanded for two reasons:
 Exports effect
 As P of $ drops, foreign citizens wish to purchase more U.S.
exports and more $.
 Expected profit effect
The lower today’s exchange rate, other things remaining the same,
the larger is the expected profit from buying U.S. assets and the
greater is the quantity of $ demanded today
The Foreign Exchange Market
Supply in the Foreign Exchange Market
The quantity $ supplied in the foreign exchange market is
the amount that traders plan to sell during a given time
period at a given exchange rate.
This quantity depends on many factors but the main ones
are
1. The exchange rate
2. U.S. demand for imports
3. Interest rates in the United States and other countries
4. The expected future exchange rate
The Foreign Exchange Market
The Law of Supply of Foreign Exchange
Other things remaining the same, the higher the exchange
rate, the greater is the quantity of $ supplied in the foreign
exchange market.
Imports effect
• As P of $ rises, U.S. citizens increase imports and sell more $ to
purchase more imports.
 Expected profit effect
• As P of $ rises, U.S. citizens see greater potential for profits in
foreign assets and sell more $ to purchase more foreign assets.
The Foreign Exchange Market
Market Equilibrium
If $ is “too strong”,
surplus of $
If $ is “too weak”,
shortage of $
Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
• Changes in exchange rate cause movement along the
demand curve, NOT a change in demand.
Changes in Demand for $ caused by:
 World demand for U.S. exports
 U.S. interest rate relative to the foreign interest rate
 The expected future exchange rate
Exchange Rate Fluctuations
Changes in the Supply of Dollars
•Changes in the exchange rate cause a movement along
the supply curve, NOT a change in supply
Changes in the supply of dollar are caused by:
 U.S. demand for imports
 U.S. interest rates relative to the foreign interest rate
 The expected future exchange rate
Exchange Rate Fluctuations
Analyze effect of each of the following on
Supply/Demand for $ and the exchange rate:
• Increase in U.S. interest rates relative to foreign
interest rates.
• Expectation the U.S. dollar will depreciate in future
• Increase in U.S. demand for imports
• Increase in foreign demand for U.S. exports
• Expectation that U.S. stock market will perform poorly
relative to foreign stock markets.
Exchange Rate Fluctuations
Exchange Rate Expectations
The exchange rate changes when it is expected to
change.
But expectations about the exchange rate are driven by
deeper forces. Two such forces are
 Interest rate parity
 Purchasing power parity
Exchange Rate Fluctuations
Interest Rate Parity
Expected return on a currency =
interest rate on that currency +
expected rate of appreciation over a given period.
interest rate parity exists when return on two currencies
is equal.
Market forces achieve interest rate parity very quickly.
Interest Rate Parity
Example:
U.S. pays 5% interest; Japan pays 4% interest; Value of
$ expected to appreciate by 3% over next year.
•Where will U.S. citizens buy bonds?
•Japanese buy bonds?
•Effect on value of $ and interest rates in U.S. and Japan
Interest Rate Parity
Example:
U.S. pays 5% interest; Japan pays 8% interest; Value of
$ expected to depreciate by 5% over next year.
•Where will U.S. citizens buy bonds?
•Japanese buy bonds?
•Effect on value of $ and interest rates in U.S. and Japan
Purchasing Power Parity
Exists when the exchange rate is such that a currency has
the same “purchasing power” in all countries.
If PPP did not exist, one could take advantage of
“arbitrage” opportunities:
• buy item at low price and sell at high price
• drives up price in low price country and drives down price
in high price country.
Purchasing Power Parity
Suppose $1 = 2 francs, price of gold=$500 in U.S. and
800 francs in France.
What’s the arbitrage opportunity?
What will happen to price of gold in
U.S.
France
What will happen to price of $?
Purchasing Power Parity
In the long run, because of PPP:
Exchange rate between foreign currency and dollar =
price in foreign country / price in U.S.
% ch in price of $ (exchange rate)=
% ch in foreign price - % ch in U.S. prices
Purchasing Power Parity
•Amazon.com vs. Amazon.ca
•Big Mac Index
Financing International Trade
Balance of Payments Accounts
We record international transactions in the balance of
payments accounts.
A country’s balance of payments accounts records its
international trading, borrowing, and lending.
Transactions leading to an inflow of currency into the U.S.
create a + in a balance of payments account
Transactions leading to an outflow of currency from the
U.S. create a – in a balance of payments account.
Financing International Trade
Three balance of payments accounts
1. Current account
•The current accounts balance equals the sum of exports minus
imports, net interest income, and net transfers.
2. Capital account
•foreign investment in the United States minus U.S. investment
abroad.
3. Official settlements account
•The official settlements account records the change in U.S. official
reserves.
•U.S. official reserves are the government’s holdings of foreign
currency
•If U.S. official reserves increase, the official settlements account is
negative.
The sum of the three account balances is zero.
Financing International Trade
Borrowers and Lenders
A country that is borrowing more from the rest of the
world than it is lending to it is called a net borrower.
A country that is lending more to the rest of the world
than it is borrowing from it is called a net lender.
The United States is currently a net borrower but during
the 1960s and 1970s, the United States was a net
lender.
Financing International Trade
Debtors and Creditors
A debtor nation is a country that during its entire history
has borrowed more from the rest of the world than it has
lent to it.
Since 1986, the United States has been a debtor nation.
A creditor nation is a country that has invested more in
the rest of the world than other countries have invested in
it.
The difference between being a borrower/lender nation
and being a creditor/debtor nation is the difference
between stocks and flows of financial capital.
Financing International Trade
Being a net borrower is not a problem provided the
borrowed funds are used to finance capital accumulation
that increases income.
Being a net borrower is a problem if the borrowed funds
are used to finance consumption.
Financing International Trade
Current Account Balance
The current account balance (CAB) is
CAB = NX + Net interest income + Net transfers
The main item in the current account balance is net
exports (NX).
The other two items are much smaller and don’t fluctuate
much.
Financing International Trade
The government sector surplus or deficit is equal to net
taxes, T, minus government expenditures on goods and
services G.
The private sector surplus or deficit is saving, S, minus
investment, I.
Net exports is equal to the sum of government sector
balance and private sector balance:
NX = (T – G) + (S – I)
Financing International Trade
For the United States in 2006,
Net exports is a deficit of $784 billion, which equals the
sum of the government sector deficit of $313 billion and
the private sector deficit of $471 billion.
Financing International Trade
The Three Sector Balances
The private sector balance
and the government sector
balance tend to move in
opposite directions.
Net exports is the sum of
the private sector and
government sector
balances.
Exchange Rate Policy
Three possible exchange rate policies are
 Flexible exchange rate
 Fixed exchange rate
 Crawling peg
Flexible Exchange Rate
A flexible exchange rate policy is one that permits the
exchange rate to be determined by demand and supply
with no direct intervention in the foreign exchange market
by the central bank.
Exchange Rate Policy
Fixed Exchange Rate
A fixed exchange rate policy is one that pegs the
exchange rate at a value decided by the government or
central bank and that blocks the unregulated forces of
demand and supply by direct intervention in the foreign
exchange market.
A fixed exchange rate requires active intervention in the
foreign exchange market.
Exchange Rate Policy
Suppose that the target is
100 yen per U.S. dollar.
If demand increases, the
central bank sells U.S.
dollars to increase supply.
Effect of “undervalued
dollar” and subsequent
intervention on
1. U.S. money supply?
2. U.S. Inflation?
Exchange Rate Policy
If demand decreases, the
central bank buys U.S.
dollars to decrease
supply.
Effect of “over-valued”
dollar and subsequent
intervention on:
1. U.S. money supply
and reserves of
foreign currency
2. U.S. inflation
Exchange Rate Policy
Crawling Peg
•selects a target path for the exchange rate with
intervention in the foreign exchange market to achieve that
path.
•China is a country that operates a crawling peg.
•Crawling peg works like a fixed exchange rate except that
the target value changes.
•Avoids wild swings in the exchange rate
Exchange Rate Policy
People’s Bank of China in
the Foreign exchange
Market
China’s official foreign
currency reserves are piling
up.
Exchange Rate Policy
The People’s bank buy
U.S. dollars to maintain the
target exchange rate.
China’s official foreign
reserves increase.
Based on diagram, is $
over- or under-valued
relative to Chinese Yuan?