Transcript The exchange rate and the balance of payments

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
• purchase imports
• purchase foreign assets (stocks, bonds, real estate, etc.)
Foreign citizens buy dollars in the foreign exchange
market with foreign currency in order to
• Purchase U.S. exports
• Purchase U.S. assets.
Currencies and Exchange Rates
Foreign Exchange Rates
•The price at which one currency exchanges for another.
Currency depreciation
• A fall in the value of one currency in terms of another
currency
• Makes country’s imports more expensive
• Makes country’s exports more affordable
Currency appreciation
•A rise in value of one currency in terms of another
currency.
•Opposite effect of depreciation on imports/exports.
Suppose that the exchange rate is 7 pesos per dollar. If
you are in Mexico and must pay 120 pesos for a round of
golf, it will cost you $_____ (give your answer to nearest
dollar, no dollar sign – e.g. 37)
20
Current exchange rates at http://finance.yahoo.com/currency-investing
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 Currency Is the Supply of
Another Currency
When people who are holding one money want to
exchange it for U.S. dollars, they demand U.S.
dollars and they supply their own country’s money.
Factors that influence the demand for U.S. dollars
also influence the supply of foreign currencies.
Factors that influence the demand for another
country’s currency also influence the supply of U.S.
dollars.
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 Law of Demand for Foreign Exchange
Ceteris paribus, as the P of $ drops, quantity of $
demanded rises
 Exports effect
 As P of $ drops
foreign citizens wish to purchase more U.S. exports
quantity of $ demanded rises.
 Expected profit effect
As P of $ drops,
the larger the expected profit from buying U.S. assets
quantity of $ demanded rises
Supply of $ 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.
The Law of Supply of Foreign Exchange
Ceteris paribus, as P of $ rises, 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 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
• Expected profits on U.S. assets relative to profits on
foreign assets
• The expected future exchange rate
Exchange Rate Fluctuations
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
 Expected profits on U.S. assets relative to profits on
foreign assets
 The expected future exchange rate
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
Interest Rate Parity
Expected $ return on investment in foreign currency =
interest rate on foreign currency +
expected change in value of foreign currency
Interest rate parity exists when interest rates are such that
expected returns on currencies are equal across countries.
Market forces achieve interest rate parity very quickly.
Example:
•U.S. interest rate=5%; German interest rate=8%
–What’s required for interest rate parity?
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 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
Financing International Trade
Balance of Payments Accounts
Record a country’s international trading, borrowing, and
lending.
Transactions leading to an inflow of currency into the
U.S. create a + (credit) in a balance of payments account
Transactions leading to an outflow of currency from the
U.S. create a – (debit) in a balance of payments account.
Financing International Trade
Three balance of payments accounts
1. Current account
= NX + Net interest income + Net transfers
2. Capital account
=Foreign invest. in the U.S. - U.S. invest. abroad.
3. 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
(current account deficit)
A country that is lending more to the rest of the world
than it is borrowing from it is called a net lender (current
account surplus)
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
–country that owes more than other countries owe to it.
•A creditor nation
–a country that owes less than other coutnries owe to it.
Since 1986, the United States has been a debtor nation.
•The difference between being a borrower/lender nation
and being a creditor/debtor nation is the difference
between stocks and flows of financial capital over time.
Financing International Trade
Is being a net borrower “bad”?
•Borrowing does not reduce long term economic growth
provided the borrowed funds are used to finance capital
accumulation that increases income.
•can reduce economic growth if the borrowed funds are
used to finance consumption.
•Difficult to determine whether U.S. is borrowing for
consumption or capital accumulation.
–Low savings rates in U.S. may be a concern.
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.
NX = (T – G) + (S – I)
 If NX<0, U.S. is borrowing from rest of world,
Ceteris paribus, U.S. borrowing from rest of
world rises as
• G or I increases, T or S decreases
Financing International Trade
For the United States in 2006,
•Net exports is a deficit of $784 billion
–U.S. was a net borrower
•Government sector deficit of $313 billion
•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
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 (with foreign
reserves) 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.
China will buy $ to drive
up price of $; sell $ to
drive down price of $.
Exchange Rate Policy
The People’s bank buys
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?