ch26-8e the exchange rate and the balance of payments

7/27/2019 Ch26-8e the Exchange Rate and the Balance of Payments

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The Exchange Rate and the

Balance of Payments

CHAPTER 26


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After studying this chapter you will be able to

Describe the foreign exchange market, define theexchange rate, and distinguish between the nominal

exchange rate and the real exchange rateExplain how an exchange rate is determined day by day

Explain the long-run trends in the exchange rate andexplain interest rate parity and purchasing power parity

Describe the balance of payments accounts and explainwhat causes an international deficit

Describe the alternative exchange rate policies andexplain their long-run effects.


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Many Monies!

The dollar, the yen, and the euro are three of the worldsmonies. But they are among more than 100 differentmonies that circulate in the global economy.

The dollar and the yen have been around for a long time.

The euro was created in the 1990s.

In August 2002, 1 dollar bought 1.02 euros. In August2006, 1 dollar bought 0.78 euros. Why do currencyexchange rates fluctuate?

The U.S. economy has become attractive to foreigninvestors.

What determines the amount of international borrowing andlending?


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Currencies and Exchange Rates

To buy goods and services produced in another countrywe need money of that country.

Foreign bank notes, coins, and bank deposits are calledforeign currency.

We get foreign currency in the foreign exchange market.


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The Foreign Exchange Market

We get foreign currency and foreigners get U.S dollars inthe foreign exchange market.

The foreign exchange market is the market in which thecurrency of one country is exchanged for the currency ofanother.


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Foreign Exchange Rates

The price at which one currency exchanges for another iscalled a foreign exchange rate.

A fall in the value of one currency in terms of anothercurrency is called currency depreciation.

A rise in value of one currency in terms of anothercurrency is called currency appreciation.


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Figure 26.1 showshow the U.S. dollarhas moved against

other currenciesfrom 1995 to 2005.


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Nominal and Real Exchange Rates

The nominal exchange rate is the value of the U.S. dollarexpressed in units of foreign currency per U.S. dollar.

It is a measure of how much of one money exchanges fora unit of another currency.

The real exchange rate is the relative price of foreign-produced goods and services.

It is a measure of the quantity of real GDP of othercountries that we get for a unit of U.S. real GDP.


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Trade-Weighted Index

The trade-weighted indexis the average exchange

rate of the U.S. dollaragainst other currencies,with individual currenciesweighted by theirimportance in U.S.

international trade.


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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 andthey supply that other countrys money.

So the factors that influence the demand for U.S. dollarsalso influence the supply of Canadian dollars, E.U. euros,

U.K. pounds, and Japanese yen.

And the factors that influence the demand for anothercountrys money also influence the supply of U.S. dollars.


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Demand in the Foreign Exchange Market

The quantity of U.S. dollars that traders plan to buy in theforeign exchange market during a given period depends

on1. The exchange rate

2. World demand for U.S. exports

3. Interest rates in the United States and other countries

4. The expected future exchange rate


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Expected Profit Effect

The larger the expected profit from holding U.S. dollars,the greater is the quantity of U.S. dollars demanded today.

But expected profit depends on the exchange rate.

The lower todays exchange rate, other things remaining

the same, the larger is the expected profit from buyingU.S. dollars and the greater is the quantity of U.S. dollarsdemanded today.


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The Demand Curve

for U.S. Dollars

Figure 26.3 illustrates

the demand curve forU.S. dollars on theforeign exchangemarket.


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Imports Effect

The larger the value of U.S. imports, the larger is thequantity of U.S. dollars supplied on the foreign exchangemarket.

And the higher the exchange rate, the greater is the valueof U.S. imports, so the greater is the quantity of U.S. dollarssupplied.


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Supply Curve for

U.S. Dollars

Figure 26.4 illustratesthe supply curve ofU.S. dollars in theforeign exchange

market.


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Market Equilibrium

Figure 26.5 shows howdemand and supply in

the foreign exchangemarket determine theexchange rate.


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If the exchange rate is toohigh, a surplus of U.S.dollars drives it down.

If the exchange rate is toolow, a shortage of U.S.dollars drives it up.

The market is pulled

(quickly) to the equilibriumexchange rate at whichthere is neither a shortagenor a surplus.


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Exchange Rate Fluctuations

Changes in the Demand for U.S. Dollars

A change in any influence on the quantity of U.S.dollarsthat people plan to buy, other than the exchange rate,

brings a change in the demand for U.S. dollars and a shiftin the demand curve for U.S. dollars.

These other influences are

World demand for U.S. exports U.S. interest rate relative to the foreign interest rate

The expected future interest rate


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World Demand for U.S. Exports Increases

At a given exchange rate, if world demand for U.S. exportsincreases, the demand for U.S. dollars increases and the

demand curve for U.S. dollars shifts rightward.U.S. Interest Rate Relative to the Foreign Interest Rate

The U.S. interest rate minus the foreign interest rate iscalled the U.S. interest rate differential.

If the U.S. interest differential rises, the demand for U.S.dollars increases and the demand curve for U.S. dollarsshifts rightward.


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The Expected Future Exchange Rate

At a given exchange rate, if the expected future exchangerate for U.S. dollars rises, the demand for U.S. dollarsincreases and the demand curve for dollars shiftsrightward.


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Changes in the Supply of Dollars

A change in any influence on the quantity of U.S. dollarsthat people plan to sell, other than the exchange rate,

brings a change in the supply of dollars and a shift in thesupply curve of dollars.

These other influences are

U.S. demand for imports U.S. interest rates relative to the foreign interest rate

The expected future exchange rate


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U.S. Demand for Imports

At a given exchange rate, if the U.S. demand for importsincreases, the supply of U.S. dollars on the foreign

exchange market increases and the supply curve of U.S.dollars shifts rightward.

U.S. Interest Rates Relative to the Foreign InterestRate

If the U.S. interest differential rises, the supply for U.S.dollars decreases and the supply curve of U.S. dollarsshifts leftward.


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The Expected Future Exchange Rate

At a given exchange rate, if the expected future exchangerate for U.S. dollars rises, the supply of U.S. dollars

decreases and the demand curve for dollars shiftsleftward.


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Figure 26.7 shows howthe supply curve of U.S.

dollars shifts in responseto changes in U.S.demand for imports, theU.S. interest ratedifferential, and

expectations of futureexchange rates.


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An Appreciating U.S. Dollar: 20002002Between 2000 and 2002, the U.S. dollar appreciatedagainst the yen.

Investors expected higher profits in the United States thanin Japan and the demand for U.S. dollars increased.

Currency traders expected the U.S. dollar to appreciateand the supply of U.S. dollars decreased.

The exchange rate rose from 108 yen per U.S. dollar to127 yen per U.S. dollar.


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Figure 26.8(a) illustratesthe appreciation of theU.S. dollar.

The increase in thedemand for U.S. dollarsand the decrease insupply of U.S. dollarsincreased the U.S. dollarexchange rate.


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A Depreciating Dollar: 20022004Between 2000 and 2002, the U.S. dollar depreciatedagainst the yen.

Investors began to expect higher profits in Japan and thedemand for U.S. dollars increased.

Currency traders expected the U.S. dollar to depreciateand the supply of U.S. dollars increased.

The exchange rate fell from 127 yen per U.S. dollar to 109yen per U.S. dollar


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Figure 26.8(b) illustratesthe depreciation of theU.S. dollar.

The decrease in thedemand for U.S. dollarsand the increase in thesupply of U.S. dollarslowered the U.S. dollar

exchange rate.


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Exchange Rate Expectations

The exchange rate changes when it is expected tochange.

But expectations about the exchange rate are driven bydeeper forces. Two such forces are

Interest rate parity

Purchasing power parity


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Interest Rate Parity

A currency is worth what it can earn.

The return on a currency is the interest rate on that

currency plus the expected rate of appreciation over agiven period.

When the rates of returns on two currencies are equal,interest rate parity prevails.

Interest rate parity means equal interest rates whenexchange rate changes are taken into account.

Market forces achieve interest rate parity very quickly.


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Purchasing Power Parity

A currency is worth the value of goods and services that itwill buy.

The quantity of goods and services that one unit of aparticular currency will buy differs from the quantity ofgoods and services that one unit of another currency willbuy.

When two quantities of money can buy the same quantityof goods and services, the situation is called purchasingpower parity, which means equal value of money.


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Instant Exchange Rate Response

The exchange rate responds instantly to news aboutchanges in the variables that influence demand and

supply in the foreign exchange market.Suppose that the Bank of Japan is considering raising theinterest rate next week.

With this news, currency traders expect the demand for

yen to increase and the demand for dollars to decreasethey expect the U.S. dollar to depreciate.


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Nominal and Real Exchange Rates in Short Run andthe Long Run

The equation that links the nominal exchange rate (E)andreal exchange rate (RER) is

RER= Ex (P/P*)

where Pis the U.S. price level and P* is the Japaneseprice level.

In the short run, this equation determines RER.In the short run, (P/P*) doesnt change and a change in Ebrings an equivalent change in RER.


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In the long run, RERis determined by the real forces ofdemand and supply in markets for goods and services.

So in the long run Edetermined by RERand the pricelevels. That is

E= RERx (P*/P)

A rise in the Japanese price level P* brings anappreciation of the U.S. dollar in the long run.

A rise in the U.S. price level Pbrings a depreciation of theU.S. dollar in the long run.


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Financing International Trade

Weve seen how the exchange rate is determined, butwhat is the effect of the exchange rate?

How does currency appreciation or appreciation influenceU.S. international trade?

We record international transactions in the balance ofpayments accounts.

Balance of Payments Accounts

A countrys balance of payments accounts records itsinternational trading, borrowing, and lending.


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There are three balance of payments accounts:

1. Current account

2. Capital account

3. Official settlements account

The current account records receipts from exports ofgoods and services sold abroad, payments for imports ofgoods and services from abroad, net interest paid abroad,

and net transfers (such as foreign aid payments).The current accounts balance equals the sum of: exportsminus imports, net interest income, and net transfers.


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The capital account records foreign investment in theUnited States minus U.S. investment abroad.

The official settlements account records the change inU.S. official reserves.

U.S. official reservesare the governments holdings offoreign currency.

If U.S. official reserves increase, the official settlements

account is negative.The sum of the balances of the three accounts alwaysequals zero.


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Figure 26.9 shows the balance of payments (as apercentage of GDP) over the period 1980 to 2005.


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Borrowers and Lenders

A country that is borrowing more from the rest of the worldthan it is lending to it is called a net borrower.

A country that is lending more to the rest of the world thanit is borrowing from it is called a net lender.

The United States is currently a net borrower but duringthe 1960s and 1970s, the United States was a net lender.


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Debtors and CreditorsA debtor nation is a country that during its entire historyhas borrowed more from the rest of the world than it haslent to it.

Since 1986, the United States has been a debtor nation.

A creditor nation is a country that has invested more inthe rest of the world than other countries have invested init.

The difference between being a borrower/lender nationand being a creditor/debtor nation is the differencebetween stocks and flows of financial capital.


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Being a net borrower is not a problem provided theborrowed funds are used to finance capital accumulationthat increases income.

Being a net borrower is a problem if the borrowed fundsare used to finance consumption.


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Current Account Balance

The current account balance (CAB) is

CAB = NX+ Net interest income + Net transfersThe main item in the current account balance is netexports (NX).

The other two items are much smaller and dont fluctuate

much.


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The government sector surplus or deficit is equal to nettaxes, T, minus government expenditures on goods andservices G.

The private sector surplus or deficit is saving, S, minusinvestment, I.

Net exports is equal to the sum of government sectorbalance and private sector balance:

NX= (TG) + (SI)


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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 andthe private sector deficit of $471 billion.


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Where is the Exchange Rate?

In the short run, a fall in the nominal exchange rate lowersthe real exchange rate, which makes our imports morecostly and our exports more competitive.

So in the short run, fall in the nominal exchange ratedecreases the current account deficit.

But in the long run, a change in the nominal exchange rateleaves the real exchange rate unchanged.

So in the long run, the nominal exchange rate plays norole in influencing the current account balance.


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Exchange Rate Policy

Three possible exchange rate policies are Flexible exchange rate

Fixed exchange rate

Crawling peg

Flexible Exchange Rate

A flexible exchange ratepolicy is one that permits theexchange rate to be determined by demand and supply

with no direct intervention in the foreign exchange marketby the central bank.


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Fixed Exchange Rate

A fixed exchange ratepolicy is one that pegs theexchange rate at a value decided by the government orcentral bank and that blocks the unregulated forces of

demand and supply by direct intervention in the foreignexchange market.

A fixed exchange rate requires active intervention in the

foreign exchange market.


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Figure 26.11 shows howthe central bank canintervene in the foreignexchange market to keep

the exchange rate close toa target rate.

Suppose that the target is100 yen per U.S. dollar.

If demand increases, thecentral bank sells U.S.dollars to increase supply.


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If demand decreases, thecentral bank buys U.S.dollars to decrease supply.

Persistent intervention onone side of the foreignexchange market cannotbe sustained.


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Crawling Peg

A crawling pegexchange rate policy is one that selects atarget path for the exchange rate with intervention in theforeign exchange market to achieve that path.

China is a country that operates a crawling peg.

A crawling peg works like a fixed exchange rate except thatthe target value changes.

The idea behind a crawling peg is to avoid wild swings inthe exchange rate that might happen if expectationsbecame volatile and to avoid the problem of running out ofreserves, which can happen with a fixed exchange rate.


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Peoples Bank of China in

the Foreign exchange

Market

Figure 26.12(a) shows theimmediate effect of thefixed yuan exchange rate.

Chinas official foreign

currency reserves are pilingup.


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Figure 26.12(b) illustrateswhat is happening in themarket for U.S. dollarspriced in terms of the yuan.

The Peoples bank buy

U.S. dollars to maintain thetarget exchange rate.

Chinas official foreign

reserves increase.


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THE END

ch26-8e the exchange rate and the balance of payments

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