Transcript O`Sullivan, Sheffrin, Perez: Economics: Principles, Applications, and

19
The World of International Finance
HOW EXCHANGE RATES ARE DETERMINED
What Are Exchange Rates?
• exchange rate
The price at which currencies
trade for one another in the
market.
• appreciation of a currency
An increase in the value of a
currency relative to the
currency of another nation.
• depreciation of a currency
A decrease in the value of a
currency relative to the
currency of another nation.
HOW EXCHANGE RATES ARE DETERMINED
How Demand and Supply Determine Exchange Rates
The Demand for and Supply of
U.S. Dollars
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
Shifts in the Demand for U.S.
Dollars
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
Shifts in the Supply of
U.S. Dollars
HOW EXCHANGE RATES ARE DETERMINED
Changes in Demand or Supply
Key facts about the foreign exchange market, using dollars and euros as
our example:
1 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.
2 Decreases in U.S. interest rates and increases in U.S. prices will
decrease the demand for dollars, leading to a depreciation of the
dollar.
3 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.
4 Decreases in European interest rates and increases in European
prices will decrease the supply of dollars in exchange for euros,
leading to an appreciation of the dollar.
REAL EXCHANGE RATES AND
PURCHASING POWER PARITY
• real exchange rate
The price of U.S. goods and
services relative to foreign
goods and services, expressed
in a common currency.
• 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.
THE CURRENT ACCOUNT &THE FINANCIAL ACCOUNT
• Balance of payments (BP)
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 (CA)
includes merchandise trade, services, interest and dividend income, and oneway transfers
• Financial account (FA)
includes financial assets (stocks, bonds) and direct foreign investment
(businesses, real estate). This account tracks U.S. owned assets abroad and
foreign owned assets in the U.S.
THE CURRENT ACCOUNT & THE FINANCIAL ACCOUNT
The current and financial accounts of a country are linked by a very
important relationship:
Balance of Payments=current account + financial account = 0
 Current account deficits must be offset by financial account
surpluses (increasing capital inflows)
 (CA‹0)=( FA›0) so BP=0
 Current account surpluses must be offset by financial account
deficits (increasing capital outflows)
 (CA›0) = (FA‹0) so BP=0
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.
FIXED AND FLEXIBLE EXCHANGE RATES
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.
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.
FIXED AND FLEXIBLE EXCHANGE RATES
Fixed Versus Flexible Exchange Rates
• flexible exchange rate system
A currency system in which exchange
rates are determined by free markets.
The flexible exchange rate system has worked well enough
since the breakdown of Bretton Woods.
• fixed exchange rate system
A system in which governments peg
exchange rates to prevent their
currencies from fluctuating.
Fixed exchange rate systems provide benefits, but they require
countries to maintain similar economic policies—especially to
maintain similar inflation rates and interest rates.
FIXED AND 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.