Foreign Exchange Rates Do FOREX rates affect the

Foreign Exchange Rates

Do FOREX rates affect the BP? • No – in the long-run; in equilibrium: • Yes – in the short-run; in disequilibrium:

No- in the long-run: in equilibrium Recall that the only thing that really matters for BP in long-run was domestic economic conditions of I-S + T-G = X-M. FOREX rates simply reflect the relative ‘Nominal Economic Conditions’ and ‘Real Economic Conditions’ of the two countries.

Nominal conditions? • Relative Monetary conditions • Particularly, relative Money Supply conditions • Interest Rate Differentials and Relative Price Level 1) i – if affects capital account 2)S = P / Pf affects trade account 3) Note that i (if )and P(Pf)are eventually all related to M and Mf.

Thus in a two-country model, • The external value of a country with a less increase in money supply and thus with a less inflation will get stronger than that of the other country.

Real Conditions? * If there occurs Macroeconomic Innovations or Productivities, then FOREX will simply reflect it: Still FOREX rates do not ‘cause’ productivity changes or innovations.

In a two-country model, • FOREX rates will change in the way that a country with more innovation and higher productivity will have a higher value of its currency against the other country.

Yes – in the short-run; in disequilibrium: FOREX rates can affect Exports and Imports in the short-run to some extent. X = X(Yf , S Pf/P; many others such as Productivity, Quality, Innovations) M = M(Yf , S Pf/P; many others)