Foreign Exchange Markets Exchange Rates Foreign exchange market

Foreign Exchange Markets & Exchange Rates • Foreign exchange market • The market in which one country’s currency is traded for another country’s currency • Exchange rate • The amount of one country’s currency that is traded for one unit of another country’s currency • The price of foreign currency in dollars © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 1

Table 1: Foreign Exchange Rates, September 10, 2009 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 2

Foreign Exchange Markets & Exchange Rates • The demand for British pounds • Assume that American households and businesses are the only buyers • To buy goods and services from British firms • To buy British assets © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 3

Foreign Exchange Markets & Exchange Rates • Demand curve foreign currency • Quantity of a specific foreign currency • That Americans will want to buy • During a given period • At each different exchange rate • Downward-sloping © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 4

Foreign Exchange Markets & Exchange Rates • As we move rightward along the demand for pounds curve: © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 5

Foreign Exchange Markets & Exchange Rates • Shifts in the demand for pounds curve determined by changes in: • • • U. S. real GDP Relative price levels Americans’ Tastes for British Goods Relative Interest Rates Expected Changes in the Exchange Rate © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 6

Figure 1: The Demand for British Pounds Dollars (b) Per Pound Dollars (a) Per Pound A $2. 25 E 1. 50 D£ 200 300 A drop in the price of the pound moves us rightward along the demand for pounds curve. D 1£ D 2£ Millions of British Pounds British Demand for pounds curve shifts rightward when: Pounds • U. S. real GDP ↑ • U. S. relative price level ↑ • U. S. tastes shift toward British goods • U. S. interest rate ↓ • Pound is expected to appreciate © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 7

Foreign Exchange Markets & Exchange Rates • The supply of British pounds • Assumption: British households and firms are the only sellers • To buy goods and services from American firms • To buy American assets © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 8

Foreign Exchange Markets & Exchange Rates • Supply curve foreign currency • Quantity of a specific foreign currency • That will be supplied • During a given period • At each different exchange rate • Upward-sloping © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 9

Foreign Exchange Markets & Exchange Rates • As we move rightward along the supply of pounds curve: © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 10

Foreign Exchange Markets & Exchange Rates • Shifts in the supply for pounds curve determined by changes in: • • • Real GDP in Britain Relative price levels British tastes for U. S. Goods Relative interest rates Expected change in the exchange rate © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 11

Figure 2: The Supply of British Pounds Dollars (a) Per Pound S£ S 1£ S 2£ F $2. 25 1. 50 Dollars (b) Per Pound E Millions of British Pounds The supply of pounds curve shifts rightward if: • British real GDP ↑ • U. S. relative price level ↓ A rise in the price of the pound • British tastes shift toward U. S. goods moves us rightward along the • U. S. interest rate ↑ supply of pounds curve. • Pound is expected to depreciate 300 400 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12

Foreign Exchange Markets & Exchange Rates • Floating exchange rate • Exchange rate that is freely determined by the forces of supply and demand • When the exchange rate floats • When the government does not intervene in the foreign currency market • The equilibrium exchange rate • Determined at the intersection of the demand curve and the supply curve © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 13

Figure 3: The Equilibrium Exchange Rate Dollars (a) Per Pound Dollars (b) Per Pound S£ $2. 25 E S£ C E 1. 50 D 2£ D£ 300 Equilibrium in the market for pounds Millions of British Pounds D 1£ 300 Millions of British Pounds Higher U. S. real GDP leads to a higher price per pound © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 14

What Happens When Things Change? • Appreciation • An increase in the price of a currency in a floating-rate system • Depreciation • A decrease in the price of a currency in a floating-rate system © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 15

What Happens When Things Change? • When a floating exchange rate changes • One country’s currency will appreciate • The other country’s currency will depreciate • How exchange rates change over time • Very short-run: sharp up-and-down spikes • Short run movements • Long-run trend © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 16

Figure 4: Hypothetical Exchange Rate Data over Time These hypothetical data show typical patterns of exchange rate fluctuations. Over the course of a few minutes, days, or weeks, the exchange rate can experience sharp up-and-down spikes. Over several months or a year or two, the exchange rate may rise or fall, as in the appreciation of the foreign currency from points A to B and the depreciation from B to C. Over the long run, there may be a general upward or downward trend, like the depreciation of the foreign currency illustrated by the dashed line connecting points A and E. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 17

What Happens When Things Change? • The very short run: “hot money” • Funds that can be moved from one type of investment to another at very short notice • Dominant forces moving exchange rates • Relative interest rates • Expectations of future exchange rates © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 18

Figure 5: Hot Money in the Very Short Run Dollars Per Pound $1. 50 S 1£ S 2£ E 1. 00 G D 1£ D 2£ Q 1 Q 2 Millions of British Pounds The market for pounds is initially in equilibrium at point E, with an exchange rate of $1. 50 per pound. A rise in U. S. interest rate relative to British rate will make U. S. assets more attractive to Americans and Britons. Hot-money managers in both countries will shift funds from British to U. S. assets, causing a rightward shift of the supply of pounds curve. American investors will want to buy fewer British assets, causing a decrease in the demand for pounds. The net effect is a lower exchange rate—$1. 00 per pound at point G. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 19

What Happens When Things Change? • Short run: macroeconomic fluctuations • Dominant forces moving exchange rates • Economic fluctuations • A country whose GDP rises relatively rapidly • Will experience a depreciation of its currency • A country whose GDP falls more rapidly • Will experience an appreciation of its currency © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 20

Figure 6: Exchange Rates in the Short Run Dollars (a) Per Pound S£ $1. 80 1. 50 Dollars (b) Per Pound $1. 80 B 1. 50 A D 2£ D 1£ Millions of British Pounds per month S 1£ S 2£ B C D 2£ D 1£ Millions of British Pounds per month Panel (a) shows a situation in which the United States recovers from a recession first. U. S. demand foreign goods and services increases, shifting the demand for pounds curve to the right. The equilibrium moves from A to B —an appreciation of the pound. Panel (b) shows Britain’s subsequent recovery from its recession. As the British begin to buy more U. S. goods and services, the supply of pounds curve shifts rightward. The equilibrium moves from B to C causing the pound to depreciate. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 21

What Happens When Things Change? • Long run: purchasing power parity • The currency of a country with a higher inflation rate • Will depreciate against the currency of a country whose inflation rate is lower • Purchasing power parity (PPP) theory • The exchange rate will adjust in the long run • So that the average price of goods in two countries will be roughly the same © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 22

What Happens When Things Change? • Purchasing power parity – caveats • Some goods are difficult to trade • High transportation costs • Artificial barriers to trade © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 23

Government Intervention in Foreign Exchange Markets • Governments sometime intervene in foreign exchange markets involving their currency: • If the value of a country’s currency rises • To protect export-oriented industries • If the value of a country’s currency falls • To protect import-oriented industries and consumers • Too volatile exchange rate • Can make trading riskier © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 24

Government Intervention in Foreign Exchange Markets • Managed float • A policy of frequent central bank intervention to move the exchange rate • Under a managed float • A country’s central bank actively manages its exchange rate • Buying its own currency to prevent depreciations • Selling its own currency to prevent appreciations © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 25

Government Intervention in Foreign Exchange Markets • Fixed exchange rate • Government-declared exchange rate • Maintained by central bank intervention in the foreign exchange market • If fixed below the equilibrium value • Excess demand for the country’s currency • Central bank must sell its own currency • If fixed above the equilibrium value • Excess supply of the country’s currency • Central bank must buy its own currency © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 26

Figure 7: A Fixed Exchange Rate for the Baht 2. Here the supply and demand curves show the equilibrium exchange rate is $0. 06 per baht. Dollars Per (a) Baht Dollars Per (b) Baht Sbaht 4. With these supply and demand curves, the equilibrium exchange rate is $0. 02 per baht Sbaht $0. 06 Excess Demand 0. 04 Excess Supply $0. 04 Dbaht 0. 02 Dbaht 100 1. In both panels, Thailand fixes the exchange rate at $0. 04 per baht. 400 Millions of Baht per month 3. The Thai Central Bank must sell 300 million baht to keep the baht from appreciating 100 400 5. The Thai Central Bank must buy 300 million baht to keep the baht from depreciating Millions of Baht per month © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 27

Government Intervention in Foreign Exchange Markets • Devaluation • A change in the exchange rate from a higher fixed rate to a lower fixed rate • Foreign currency crisis • A loss of faith that a country can prevent a drop in its exchange rate, leading to a rapid depletion of its foreign currency (e. g. , dollar) reserves © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 28

Government Intervention in Foreign Exchange Markets • International Monetary Fund (IMF) • An international organization founded in 1945 to help stabilize the world monetary system. • Moral hazard • When decision makers • Expecting assistance in the event of an unfavorable outcome • Change their behavior so that the unfavorable outcome is more likely © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 29

Figure 8: A Foreign Currency Crisis Dollars Per Baht S 1 baht S 2 baht A $0. 04 0. 02 D 1 baht B D 2 baht 100 400 Millions of Baht per Month Initially, the baht is fixed at the equilibrium rate of $0. 04. When the supply and demand curves shift to D 2 and S 2, the equilibrium exchange rate falls to $0. 02. If Thailand continues to fix the rate at $0. 04, it will have to buy up the excess supply of 300 million baht per month, using dollars. As its dollar reserves dwindle, traders will anticipate a drop in the value of the baht, shifting the curves out further, as indicated by the arrows. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 30

Exchange Rates and the Macroeconomy • A depreciation of the dollar • Causes net exports to rise • A positive demand shock • Increases real GDP in the short run • An appreciation of the dollar • Causes net exports to drop • A negative demand shock • Decreases real GDP in the short run © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 31

Exchange Rates and the Macroeconomy • Monetary policy: © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 32

Exchange Rates and the Macroeconomy • Monetary policy: • Has a stronger effect when we include the impact on • Exchange rates • And net exports • Rather than just the impact on • Interest-sensitive consumption and investment spending © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 33

Exchange Rates and the Trade Deficit • Trade deficit = Imports – Exports • The excess of a nation’s imports over its exports during a given period • Trade surplus = Exports – Imports • The excess of a nation’s exports over its imports during a given period © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 34

Exchange Rates and the Trade Deficit • U. S. net financial inflow = U. S. trade deficit • = Foreign purchase of U. S. assets – U. S. purchases of foreign assets • Trade deficit • Results in a transfer of wealth from Americans to foreign residents • Can arise because of forces that cause a financial inflow © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 35

Exchange Rates and the Trade Deficit • U. S. trade deficit • Has been caused by the desire of foreigners to invest in the United States • Result: massive financial inflow and trade deficit that arose in the early 1980 s © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 36

Figure 9: Net financial flows into the U. S. as a percentage of GDP Beginning in the early 1980 s, and continuing today, a massive net financial inflow has led to a U. S. trade deficit. The inflow shrunk during the financial crisis of 2008, but it was still a significant fraction of GDP. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 37

Exchange Rates and the Trade Deficit • How a financial inflow causes a trade deficit • An increase in the desire of foreigners to invest in the United States • Contributes to an appreciation of the dollar • U. S. exports - decline • Become more expensive foreigners • Imports - increase • Become cheaper to Americans • Result: a rise in the U. S. trade deficit © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 38

Figure 10: How a U. S. Financial Inflow Creates a U. S. Trade Deficit Dollars Per Yen $0. 015 S 1¥ Japanese purchases of U. S. assets S 2¥ A C B 0. 010 Increase in Japan's exports to U. S. D¥ 10, 000 15, 000 12, 000 Decrease in Japan's imports from U. S. Billions of Yen per Month © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 39

Exchange Rates and the Trade Deficit • Sources for the rise in the trade deficit during recent decades: • Relatively high interest rates in the 1980 s • A long-held preference for American assets • Grew stronger in the 1990 • A growing demand for funds in the U. S. + high saving in other countries • From the late 1990 s until around 2006 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 40

Exchange Rates and the Trade Deficit • Concerns about the trade deficit • It’s sustainability • The soft-landing scenario • Gradually adjust to a slowdown in foreign purchases of U. S. assets • Require structural changes in the U. S. economy • The hard-landing scenario • Changes: much larger and more sudden • Very serious recession © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 41

The U. S. trade deficit with China • Growing U. S. trade deficit with China • • Special trade agreements Chinese trade policies that have Encouraged exports and discouraged imports China’s undervalued exchange rate © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 42

Figure 11: The growing U. S. trade deficit with China (trade in goods only) © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 43

The U. S. trade deficit with China • When a U. S. trading partner • Fixes the dollar price of its currency below its equilibrium value • U. S. exports decline • Become more expensive to foreigners • U. S. imports increase • Become cheaper to Americans • Result: a rise in the U. S. trade deficit © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 44

Figure 12: How an undervalued Chinese Yuan create a U. S. trade deficit Dollars Per Yuan SYuan Equilibrium value of Yuan A $0. 24 0. 15 B C DYuan Fixed value of Yuan 200 Decrease in China's imports from U. S. 700 1, 000 Billions of Yuan per Month Increase in China's exports to U. S. © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 45