Ch 9 The Exchange Rate and the Balance

Ch. 9: The Exchange Rate and the Balance of Payments. Ø Exchange rates • Definition • Determinants • Short run • Long run • Purchasing power parity • Interest rate parity Ø Balance of payments accounts Ø Causes of an international deficit Ø Alternative exchange rate policies and their long-run effects

Currencies and Exchange Rates ØU. 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. ) • this is the supply of $ ØForeign citizens buy dollars in the foreign exchange market with foreign currency in order to • purchase U. S. exports • purchase U. S. assets. • this is the demand for $

Currencies and Exchange Rates ØForeign Exchange Rates • The price at which one currency exchanges for another. ØCurrency depreciation • A fall in the value of one currency in terms of another currency – Makes imports more expensive – Makes exports more affordable ØCurrency appreciation • A rise in value of one currency in terms of another currency. –Opposite effect of depreciation on imports/exports.

1/EXUSEU = Euros/$ 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. (Higher value implies stronger $)

The Foreign Exchange Market The Demand for One Currency Is the Supply of Another Currency ØForeign citizens demanding U. S. dollars supply their own country’s money. ØFactors that influence the demand for U. S. dollars also influence the supply of foreign currencies. ØFactors 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. • ceteris paribus, 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 Ø Exports effect § As P of $ drops §foreign citizens wish to purchase more U. S. exports §quantity of $ demanded rises. Ø 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 ØThe quantity of $ 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 ØCeteris paribus, as P of $ rises, the greater is the quantity of $ supplied in the foreign exchange market. ØImports effect • As P of $ rises, U. S. citizens increase imports and sell more $ to purchase more imports. Ø 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 Equilibrium If $ is “too strong”, surplus of $ If $ is “too weak”, shortage of $

Exchange Rate Fluctuations ØChanges in exchange rate cause movement along the demand curve, NOT a change in demand. ØChanges 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 ØChanges in the exchange rate cause a movement along the supply curve, NOT a change in supply ØChanges 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 ØThe exchange rate changes when it is expected to change. ØBut expectations about the exchange rate are driven by deeper forces. Two such forces are § Interest rate parity § Purchasing power parity

Interest Rate Parity ØExpected $ return on investment in foreign currency = interest rate on foreign currency + expected change in value of foreign currency ØInterest rate parity exists when interest rates are such that expected returns on currencies are equal across countries. ØMarket forces achieve interest rate parity very quickly. ØExample: • U. S. interest rate=5%; German interest rate=8% –What’s required for interest rate parity?

Interest Rate Parity ØExample: 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 ØExists when the exchange rate is such that a currency has the same “purchasing power” in all countries. ØIf 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 ØRecord a country’s international trading, borrowing, and lending. ØTransactions leading to an inflow of currency into the U. S. create a + (credit) in a balance of payments account ØTransactions 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. ØThe sum of the three account balances is zero.

Financing International Trade Borrowers and Lenders ØA net borrower has a current account deficit ØA net lender has a current account surplus ØThe U. S. is currently a net borrower but during the 1960 s and 1970 s, the U. S. was a net lender.

Financing International Trade ØDebtors 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. • Borrower/lender status based upon one year • Debtor/creditor status based upon entire history of borrowing/lending.

Financing International Trade ØIs 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 ØDeterminants of U. S. Borrowing/lending from rest of world ØC+S+T=C+I+G+NX ØNX=(S-I) + (T-G) • (S-I) = private sector balance • (T-G) = public sector balance if balance>0, surplus if balance<0, deficit ØCeteris paribus, U. S. borrowing from rest of world rises as public or private sector balance decreases

Financing International Trade ØFor the United States in 2010, < Net exports were -$536 billion. < Government sector balance was -$1, 295 billion < Private sector balance was $759 billion

Financing International Trade Three Sector Balances ØThe private sector balance and the government sector balance tend to move in opposite directions. ØNet 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 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 supply by direct intervention in the foreign exchange market. A fixed exchange rate requires active intervention in the foreign exchange market.

Exchange Rate Policy ØSuppose that the target is 100 yen per U. S. dollar. ØIf demand increases, the central bank sells U. S. dollars to increase supply. ØEffect of “undervalued dollar” and subsequent intervention on 1. U. S. money supply? 2. U. S. Inflation?

Exchange Rate Policy ØIf demand decreases, the central bank buys U. S. dollars (with foreign reserves) to decrease supply. ØEffect 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?