Chapter 17

Chapter 17

Exchange Rates and Macroeconomic Policy

• Foreign exchange market: a market in which one country’s currency is traded for that of another

Foreign Exchange Markets and Exchange Rates

• Exchange rate: the rate at which one currency is traded for another

Dollars per pound or pounds per dollar

• The exchange rate is the price of foreign currency in dollars

The Demand for British Pounds

• The most important buyers of pounds in the pound-dollar market will be American households and businesses
• 2 reasons why we want to buy pounds
  • To buy goods and services from British firms
  • To buy British assets

Demand for Pounds curve

• Demand curve for foreign currency: tells us the quantity of pounds Americans will want to buy in any given period at each different exchange rate
• Curve slopes downward
• Price of pounds decreases à British goods are cheaper to Americans à Americans buy more British goods à Quantity of pounds demanded increases

Shifts in the Demand for Pounds Curve

• US Real GDP: Real GDP rises à Americans will buy more of everything à Americans will demand more pounds à Rightward shift of the demand
• Relative Price Levels: Price level rises à Americans shift from buying our goods to British goods à Demand for pounds rises à Rightward shift
• Americans’ Tastes for British Goods: Increased taste à Demand for pounds increases à Shifts rightward
• Relative Interest Rates: Lower interest rate à Demand for pounds increases à shift rightward
• Expected Changes in the Exchange Rate: If Americans expect the price of the pound to rise, they will expect a foreign currency gain from buying British assets à demand for pounds curve shifts rightward
• SUMMATION: Price of pounds increases à US goods are cheaper to British à British buy more US goods à British need more dollars à Quantity of pounds supplied increases

Shifts in the Supply of Pounds Curve

• Real GDP in Britain: Real GDP rises à British will buy more of everything à supply more pounds à rightward shift of supply curve
• Relative Price Levels: Rise in price level à Want fewer dollars à supply fewer pounds à shifts supply of pounds leftward
• British Tastes for US goods: A shift in British tastes toward American goods will shift the supply of pounds curve rightward
• Relative interest rates: As the US interest rate rises, and the British buy more US assets, the supply of pounds curve will shift rightward
• Expected Change in the Exchange Rate: Suppose the British expect the price of the pound to fall, the supply of pounds curve will shift rightward

Equilibrium Exchange Rate

• Floating exchange rate: An exchange rate that is freely determined by the forces of supply and demand
• When the exchange rate floats, the price will settle at the level where quantity supplied and quantity demanded are equal

What Happens When Things Change?

• Appreciation: an increase in the price of currency in a floating-rate system
• Depreciation: A decrease in the price of a currency in a floating-rate system
• When a floating exchange rate changes, one country’s currency will appreciate (rise in price) and the other country’s currency will depreciate (fall in price)

How Exchange Rates Change over Time

Very Short Run

• Relative interest rates and expectations of future exchange rates are the dominant forces moving exchange rates in the very short run
• In the short run, movements in exchange rates are caused largely by economic fluctuations
• All else equal, a country whose GDP rises will experience a depreciation of its currency
• A country whose GDP falls will experience an appreciation of its currency

The Long Run: Purchasing Power Parity

• According to the purchasing power parity theory: the exchange rate between two countries will adjust in the long run until the average price of goods is roughly the same in both countries
• In the long run, the currency of a country with a higher inflation rate will depreciate against the currency of a country whose inflation rate is lower

PPP

• Some goods are difficult to trade
• High transportation costs can reduce trading possibilities
• Artificial barriers to trade can hamper trader’s ability to move exchange rates toward PPP

Managed Float

• Many governments let their exchange rate float most of the time, but will intervene on occasion when floating exchange rate moves in an undesired direction
• Under a managed float, a country’s central bank actively manages its exchange rate, buying its own currency to prevent depreciations, and selling its own currency to prevent appreciations

Fixed Exchange Rates

• Fixed exchange rate: A government-declared exchange rate maintained by central bank intervention in the foreign market
• When a country fixes its exchange rate below the equilibrium value, the result is an excess demand for the country’s currency
• To maintain the fixed rate, the country’s central bank must sell enough of its own currency to eliminate the excess demand
• When a country fixes its exchange rate above the equilibrium value, the result is an excess supply of the country’s currency
• To maintain the fixed rate, the country’s central bank must buy enough of its own currency to eliminate the excess supply

Foreign Currency Crises

• Devaluation: to declare a new, lower fixed rate
• Expected changes in the exchange rate shift supply and demand curves for foreign currency
• A 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

Exchange Rates and Demand Shocks

• A depreciation of the dollar causes net exports to rise – a positive demand shock that increases real GDP in the short run
• An appreciation of the dollar causes net exports to drop – a negative demand shock that decreases real GDP in the short run

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

Exchange Rates and Trade Deficits

• Trade deficit = Imports – Exports
• Trade surplus = Exports – Imports

Origins of the US Trade Deficit

• US imports from other countries – US exports to other countries = Foreign purchases of US assets – US purchases of foreign assets
• US trade deficit = US net financial inflow

How a Financial Inflow Causes a Trade Deficit

• An increase in the desire of foreigners to invest in the US contributes to an appreciation of the dollar
• US exports decline
• Imports increase
• The result is a rise in the US trade deficit

Explaining the Net Financial Inflow

• The rise in the US trade deficit came from
  • Relatively high interest rates in the 1980s
  • A long-held preference for American assets that grew stronger in the 1990s
  • A growing demand for funds in the US combined with high saving in other countries beginning in the late 1990s
  • Each contributed to a large net financial inflow, a higher value for the dollar, and a trade deficit

Concerns about the trade deficit

• Soft landing scenario: trade deficit slowly shrinks over time
• Hard landing scenario: dollar plummets in value
  • Begins with a decline in foreign demand for US assets
  • The ability of the Fed to respond is constrained because their inclination to lower interest rates would further compound the value of the dollar problem

Hot money

• Funds that can be moved from one type of investment to another on very short notice