mbmc exchange rates and the open economy. mbmc copyright c 2004 by the mcgraw-hill companies, inc....
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Chapter 17: Exchange Rates and the Open Economy Slide 2
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
Nominal Exchange RateThe rate at which two currencies can be
traded for each other
Chapter 17: Exchange Rates and the Open Economy Slide 3
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Nominal Exchange Ratesfor the U.S. Dollar
Country Foreign currency/dollar Dollar/foreign currency
United Kingdom (pound) 0.6393 1.5643
Canada (Canadian dollar) 1.5674 0.6380
Mexico (peso) 9.9850 0.1002
Japan (yen) 118.000 0.00848
Switzerland (Swiss franc) 1.4760 0.6775
South Korea (won) 1,190.1000 0.00084
Chapter 17: Exchange Rates and the Open Economy Slide 4
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
Nominal Exchange RatesThe exchange rate between British and
Canadian currencies0.6393 British pounds = $1 U.S.1.5674 Canadian $s = $1 U.S.0.6393 British pounds = 1.5674 Canadian $s0.6393/1.5674 = 0.4079 pounds = 1 Canadian $British/Canadian exchange 0.4079 pounds per
Canadian dollar
Chapter 17: Exchange Rates and the Open Economy Slide 5
MB MC
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The U.S. NominalExchange Rate, 1973-2002
More Recent Series: http://research.stlouisfed.org/fred2/series/TWEXBMTH/95/5yrs
Chapter 17: Exchange Rates and the Open Economy Slide 6
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
AppreciationAn increase in the value of a currency
relative to other currencies
DepreciationA decrease in the value of a currency
relative to other currencies
Chapter 17: Exchange Rates and the Open Economy Slide 7
MB MC
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Exchange Rates
Some Definitionse = nominal exchange ratee = the number of units of foreign currency
that the domestic currency will buyIf e increases, it is an appreciation of the
domestic currency.If e decreases, it is a depreciation of the
domestic currency.
Chapter 17: Exchange Rates and the Open Economy Slide 8
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
Flexible Exchange RateAn exchange rate whose value is not
officially fixed but varies according to the supply and demand for the currency in the foreign exchange market
Chapter 17: Exchange Rates and the Open Economy Slide 9
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Exchange Rates
Foreign Exchange MarketThe market on which currencies of various
nations are traded for one another
Chapter 17: Exchange Rates and the Open Economy Slide 10
MB MC
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Exchange Rates
Fixed Exchange RateAn exchange rate whose value is set by
official government policy
Chapter 17: Exchange Rates and the Open Economy Slide 11
MB MC
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Exchange Rates
The Real Exchange RateNominal exchange rate
The price of the domestic currency in terms of a foreign currency
Real exchange rateThe price of the average domestic good or
service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency
Chapter 17: Exchange Rates and the Open Economy Slide 12
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
ExampleShould you buy a Japanese or American
computer for your company?Price of U.S. computer = $2,400Price of Japanese computer = 242,000 yenExchange rate = 110 yen/dollar
Chapter 17: Exchange Rates and the Open Economy Slide 13
MB MC
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Exchange Rates
ExampleShould you buy a Japanese or American
computer for your company?Price in yen = price in dollars x value of dollar in
terms of yenPrice in dollars = price in yen/yen-dollar
exchange rateo Price in dollars = 242,000 yen/110 = $2,200
Chapter 17: Exchange Rates and the Open Economy Slide 14
MB MC
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Exchange Rates
ExampleShould you buy a Japanese or American
computer for your company?Japanese computer is cheaper.Real exchange rate = $2,400/$2,200 = 1.09
Chapter 17: Exchange Rates and the Open Economy Slide 15
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
Real Exchange Rate
)( dollars in good, foreign of Price
)( gooddomestic of Price Rate Exchange Real
fP
P
/e Rate Exchange Real
fP
P
fP
eP Rate Exchange Real
Chapter 17: Exchange Rates and the Open Economy Slide 16
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
The Computer Example, revisited E = 110/$1 P = $2,400 Pf = 242,000 yen
yen242,000
$2,400 x yen/$1)(110 Rate Exchange Real
1.09 yen242,000
yen264,000 Rate Exchange Real
Chapter 17: Exchange Rates and the Open Economy Slide 17
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange Rates
The Real Exchange RateA high real exchange rate implies that
domestic producers will have difficulty exporting to other countries.
A high real exchange rate will attract imports.
Chapter 17: Exchange Rates and the Open Economy Slide 18
MB MC
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Exchange Rates
The Real Exchange RateNX will tend to be low when the real
exchange rate is high.Real and nominal exchange rates tend to
move in the same direction
Chapter 17: Exchange Rates and the Open Economy Slide 19
MB MC
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Exchange Rates
Economic NaturalistDoes a strong currency imply a strong
economy?
Chapter 17: Exchange Rates and the Open Economy Slide 20
MB MC
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The Determination of the Exchange Rate
Law of One PriceIf transportation costs are relatively small,
the price of an internationally traded commodity must be the same in all locations
Chapter 17: Exchange Rates and the Open Economy Slide 21
MB MC
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The Determination of the Exchange Rate
ExampleHow many Indian rupees equal to one
Australian dollar?Bushel of grain cost 5 Australian dollars or 150
rupees5 Australian dollars = 150 rupeesNominal exchange should equal 30
rupees/Australian dollar
Chapter 17: Exchange Rates and the Open Economy Slide 22
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The Determination of the Exchange Rate
Purchasing Power Parity (PPP)The theory that nominal exchange rates
are determined as necessary for the law of one price to hold
Chapter 17: Exchange Rates and the Open Economy Slide 23
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The Determination of the Exchange Rate
Purchasing Power Parity (PPP)In the long run, the currencies of countries
that experience significant inflation will tend to depreciate.
Chapter 17: Exchange Rates and the Open Economy Slide 24
MB MC
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The Determination of the Exchange Rate
ExampleHow many Indian rupees equal one
Australian dollar?Price of grain in India increases from 150 to
300 rupeesPrice of grain in Australia equals 5 Australian
dollars
Chapter 17: Exchange Rates and the Open Economy Slide 25
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Determination of the Exchange Rate
ExampleHow many Indian rupees equal one
Australian dollar?5 Australian dollars = 300 rupees1 Australian dollar = 60 rupeesNominal exchange rate increased from 30 to 60
rupees/Australian dollarIndian currency depreciatedAustralian currency appreciated
Chapter 17: Exchange Rates and the Open Economy Slide 26
MB MC
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Inflation and Currency Depreciationin South America, 1995-2001
Chapter 17: Exchange Rates and the Open Economy Slide 27
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The Determination of the Exchange Rate
ExampleShortcomings of the PPP Theory
The theory has been successful in the long run but not the short run.
Chapter 17: Exchange Rates and the Open Economy Slide 28
MB MC
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The Determination of the Exchange Rate
ExampleLimits to the PPP Theory
Not all goods and services are traded internationally.
o The greater the share of non-traded goods, the less precise the PPP theory
Not all internationally traded goods and services are perfectly standardized commodities.
Chapter 17: Exchange Rates and the Open Economy Slide 29
MB MC
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The Supply and Demand for Dollars In The Yen-Dollar Market
Quantity of dollars traded
Yen
/do
llar
exch
ang
e ra
te
Demand for dollars
Supply of dollars
e*
The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded
Chapter 17: Exchange Rates and the Open Economy Slide 30
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Determination of the Exchange Rate
Changes in the Supply of DollarsFactors that increase the supply of dollars
An increase in the preference for Japanese goods
An increase in U.S. real GDPAn increase in the real interest rate on
Japanese assets
Chapter 17: Exchange Rates and the Open Economy Slide 31
MB MC
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An Increase In The Supply of Dollars Lowers The Value of The Dollar
Quantity of dollars traded
Yen
/do
llar
exch
ang
e ra
te
D
S
e*E
•Increase in demand for Japanese video games
e*’
S’
F
•Supply of dollars increases from S to S’•The value of the dollar in terms of yen falls•e* falls to e*’
Chapter 17: Exchange Rates and the Open Economy Slide 32
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The Determination of the Exchange Rate
Changes in the Demand for DollarsFactors that increase the demand for
dollarsIncreased preference for U.S. goodsIncrease in real GDP abroadAn increase in the real interest rate on U.S.
assets
Chapter 17: Exchange Rates and the Open Economy Slide 33
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
A Tightening of Monetary Policy Strengthens the Dollar
Quantity of dollars traded
Yen
/do
llar
exch
ang
e ra
te
D
S
e*E
• Tighter monetary policy raises the domestic real interest rate
• Foreign demand for U.S. assets increase
e*’ F
D’
• The demand for dollars rises• Exchange rate appreciates from
e* to e*’
Chapter 17: Exchange Rates and the Open Economy Slide 34
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Monetary Policy andthe Exchange Rate
Economic NaturalistWhy did the dollar appreciate nearly 50
percent in the first half of the 1980s?
Chapter 17: Exchange Rates and the Open Economy Slide 35
MB MC
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Monetary Policy andthe Exchange Rate
The Exchange Rate as a Tool of Monetary PolicyWhen the exchange rate is flexible:
Tighter monetary policy reduces net exports.Easier monetary policy stimulates net exports.
Conclusion:Monetary policy is more effective in an open
economy with flexible exchange rates.
Chapter 17: Exchange Rates and the Open Economy Slide 36
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
How to Fix an Exchange RateThe government will peg its currency to a
major currency or to a “basket” of currencies.
The government may have to devalue or revalue its currency.
Chapter 17: Exchange Rates and the Open Economy Slide 37
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
DevaluationA reduction in the official value of a
currency (in a fixed-exchange-rate system)
RevaluationAn increase in the official value of a
currency (in a fixed-exchange-rate system)
c.f. “Depreciation,” “Appreciation”
Chapter 17: Exchange Rates and the Open Economy Slide 38
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
Overvalued Exchange RateAn exchange rate that has an officially
fixed value greater than its fundamental value
Undervalued Exchange RateAn exchange rate that has an officially
fixed value less than its fundamental value
Chapter 17: Exchange Rates and the Open Economy Slide 39
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
An Overvalued Exchange Rate
Quantity of pesos traded
Do
llar/
pes
o e
xch
ang
e ra
te
Demand for pesos
Supply of pesos
Official value
Fundamental value0.10 dollar/peso
0.125 dollar/peso
• The peso’s official value is greater than the fundamental value; the peso is overvalued
A B
• To maintain the value, the government must purchase a quantity of pesos (A-B)
Chapter 17: Exchange Rates and the Open Economy Slide 40
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
How to Fix an Exchange RateResponses to an overvalued currency
Devalue the currencyImpose trade barriersPurchase the currency
Chapter 17: Exchange Rates and the Open Economy Slide 41
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
International ReservesForeign currency assets held by a
government for the purpose of purchasing the domestic currency in the foreign exchange market.
Chapter 17: Exchange Rates and the Open Economy Slide 42
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
How to Fix an Exchange RateTo purchase its own currency, a country
must hold international reserves.A balance of payments deficit occurs when
a country has a net decline in international reserves over a year.
Chapter 17: Exchange Rates and the Open Economy Slide 43
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
How to Fix an Exchange RateA balance-of-payments surplus occurs
when a country has a net increase in international reserves over a year.
Chapter 17: Exchange Rates and the Open Economy Slide 44
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
ExampleLatinia’s balance-of-payments deficit
Demand = 25,000 - 50,000eSupply = 17,600 + 24,000eOfficial value of the peso = 0.125 dollars
Chapter 17: Exchange Rates and the Open Economy Slide 45
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
ExampleLatinia’s balance-of-payments deficit
Fundamental valueo 25,000 - 50,000e = 17,600 + 24,000e
Solving for e: o 7,400 = 74,000eo e = 0.10
Chapter 17: Exchange Rates and the Open Economy Slide 46
MB MC
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Fixed Exchange Rates
ExampleAs the official rate -- 0.125D = 25,000 - 50,000(0.125) = 18,750S = 17,600 - 24,000 (0.125) = 20,600Excess supply = 1,850 pesosBalance of payments deficit = 1,850 pesos
Chapter 17: Exchange Rates and the Open Economy Slide 47
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
Speculative AttackA massive selling of domestic currency
assets by financial investors
Chapter 17: Exchange Rates and the Open Economy Slide 48
MB MC
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A Speculative Attackon the Peso
Quantity of pesos traded
Do
llar/
pes
o e
xch
ang
e ra
te
A B
D
S
Official value0.125 dollar/peso
• Peso overvalued at 0.125• Central bank buys pesos• Investors launch a speculative attack -- sell
peso dominated assets
0.10 dollar/peso
S’
C
• Supply of pesos increases• Central bank must purchase
more pesos
Chapter 17: Exchange Rates and the Open Economy Slide 49
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
Economic NaturalistCan a speculative attack occur under
flexible exchange rates?
Chapter 17: Exchange Rates and the Open Economy Slide 50
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
A Tightening of Monetary Policy Eliminates An Overvaluation
Quantity of pesos traded
Do
llar/
pes
o e
xch
ang
e ra
te
D
S
Official value
E0.10 dollar/
peso
0.125 dollar/peso
•Pesos overvalued at 0.125
F
D’
•Tightening monetary policy increases D to D’•Official value = fundamental value
Chapter 17: Exchange Rates and the Open Economy Slide 51
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
ObservationIf monetary policy is used to set the
fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy.
Chapter 17: Exchange Rates and the Open Economy Slide 52
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
ObservationThe conflict monetary policymakers face,
between stabilizing the exchange rate and stabilizing the domestic economy, is most severe when the exchange rate is under a speculative attack.
Chapter 17: Exchange Rates and the Open Economy Slide 53
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
Economic NaturalistWhat were the causes and consequences
of the East Asian crisis of 1997-1998?
Chapter 17: Exchange Rates and the Open Economy Slide 54
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Fixed Exchange Rates
Economic NaturalistHow did policy mistakes contribute to the
Great Depression?
Chapter 17: Exchange Rates and the Open Economy Slide 55
MB MC
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Should Exchange Rates Be Fixed or Flexible?
Monetary PolicyFlexible exchange rates can strengthen the
impact of monetary policy.Fixed exchange rates prevent the use of
monetary policy to stabilize the economy.
Chapter 17: Exchange Rates and the Open Economy Slide 56
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Should Exchange Rates Be Fixed or Flexible?
Trade and Economic IntegrationFixed exchange rate proponents argue that
fixed rates promote international trade.The risk of a speculative attack may make
the country less attractive to investors and trade.
Chapter 17: Exchange Rates and the Open Economy Slide 57
MB MC
Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Economic NaturalistWhy have 11 European countries adopted
a common currency?
Should Exchange Rates Be Fixed or Flexible?