Chapter 17. Exchange Rates and International Economic Policy

Chapter 17 Exchange Rates and International Economic Policy

Preview To examine the financial market that determines exchange rates in the long and short runs To understand the role of exchange rates in our everyday lives To develop a supply and demand analysis to understand how exchange rates are determined To examine the impact of exchange rate fluctuations on the economy and their impact on macroeconomic policy Copyright 2015 Pearson Education, Inc. All rights reserved. 17-2

The Distinction Between Real and Nominal Exchange Rates The nominal exchange rate is the relative price of one currency in terms of another (not how much foreign goods and services the currency can buy) The real exchange rate, or the terms of trade, is the relative price of goods in two countries, i.e., the rate at which you can exchange domestic goods for foreign goods Copyright 2015 Pearson Education, Inc. All rights reserved. 17-3

The Distinction Between Real and Nominal Exchange Rates (cont d) ε = E (P/P*) Real Nominal Relative Exchange = Exchange Price Rate Rate Levels The real exchange rate is the nominal exchange rate times the relative price levels The real exchange rate indicates whether a currency is relatively cheap or expensive When it is low (below 1), domestic goods are cheap relative to foreign goods; when it is high, domestic goods are expensive relative to foreign goods. Copyright 2015 Pearson Education, Inc. All rights reserved. 17-4

The Importance of Exchange Rates The real exchange rate equation indicates that if prices are sticky meaning price levels change slowly over time and can be taken as given in the short run then exchange rates affect the relative price of domestic and foreign goods Copyright 2015 Pearson Education, Inc. All rights reserved. 17-5

The Importance of Exchange Rates (cont d) When a country s currency appreciates (rises in value relative to other currencies), with sticky prices the country s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. Copyright 2015 Pearson Education, Inc. All rights reserved. 17-7

Exchange Rates in the Long Run According to the law of one price, if two countries produce an identical good and transportation costs and trade barriers are very low, the price of the good should be the same in both countries no matter which country produces it As a result, the exchange rate makes the price of a good equal in two countries Copyright 2015 Pearson Education, Inc. All rights reserved. 17-9

Exchange Rates in the Long Run (cont d) The theory of purchasing power parity (PPP) states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries PPP is an application of the law of one price If PPP holds, the real exchange rate is always equal to 1.0, so the purchasing power of the dollar is the same as the purchasing power of other currencies There is evidence that PPP holds in the very long run, but the theory is questionable over short periods Copyright 2015 Pearson Education, Inc. All rights reserved. 17-10

Box: Big Macs and PPP Every year, The Economist magazine publishes data on the cost of a Big Mac in both local currency and U.S. dollars in different countries If PPP held exactly, then the real exchange rate would be 1.0 and all the prices in terms of dollars would be identical The 2013 data show that this is not the case: The price of Big Macs in some countries (Norway, and Switzerland) are well above that in the United States, while in others it is well below (China, Indonesia, and Malaysia) Copyright 2015 Pearson Education, Inc. All rights reserved. 17-11

Exchange Rates in the Short Run Two approaches to determining exchange rates in the short run: 1. Asset market approach that emphasizes the demand for the stock of domestic assets 2. An approach that emphasizes the demand for flows of exports and imports over short periods The asset market approach is more accurate because export and import transactions are small relative to the amount of domestic and foreign assets at any given time Copyright 2015 Pearson Education, Inc. All rights reserved. 17-14

Supply Curve for Domestic Assets Assume that domestic assets are denominated in dollars and foreign assets are denominated in euros Assume further that the quantity of dollar assets supplied (bank deposits, bonds and equities etc.) is fixed with respect to the exchange rate, so that the supply curve, S, is vertical Copyright 2015 Pearson Education, Inc. All rights reserved. 17-15

Demand Curve for Domestic Assets If there is capital mobility so that assets are traded freely between countries, the most important determinant of the quantity of domestic assets demanded is the expected return of domestic assets relative to foreign assets E e t+1, such as interest and an expected change in value The demand curve is downward sloping because a lower value of the exchange rate implies that the dollar is more likely to rise in value (appreciate), which will in turn raise the expected return on dollar (domestic) assets and thus the quantity of dollar assets demanded Copyright 2015 Pearson Education, Inc. All rights reserved. 17-17

Equilibrium in the Foreign Exchange Market The foreign exchange market is in equilibrium when the quantity of dollar assets demanded equals the quantity supplied An exchange rate higher than the equilibrium exchange rate of E* implies that the quantity of dollar assets supplied is greater than the quantity demanded (excess supply) An exchange rate lower than the equilibrium exchange rate of E* implies that the quantity of dollar assets supplied is less than the quantity demanded (excess demand) Copyright 2015 Pearson Education, Inc. All rights reserved. 17-18

Analysis of Changes in Exchange Rates Given that the supply curve does not shift, factors that causes changes in the demand for domestic assets: 1. Domestic real interest rate, r D An increase in the domestic real interest rate shifts the demand curve for domestic assets, D, to the right and causes the domestic currency to appreciate (E ) A decrease in the domestic real interest rate shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate (E ) 2. Foreign real interest rate, r F 3. Changes in the expected future exchange rate, E e t+1 Copyright 2015 Pearson Education, Inc. All rights reserved. 17-19

Analysis of Changes in Exchange Rates (cont d) Given that the supply curve does not shift, factors that causes changes in the demand for domestic assets: 1. Domestic real interest rate, r D 2. Foreign real interest rate, r F An increase in the foreign real interest rate r F shifts the demand curve D to the left and causes the domestic currency to depreciate A fall in the foreign real interest rate r F shifts the demand curve D to the right and causes the domestic currency to appreciate 3. Changes in the expected future exchange rate, E e t+1 Copyright 2015 Pearson Education, Inc. All rights reserved. 17-21

Analysis of Changes in Exchange Rates (cont d) Given that the supply curve does not shift, factors that causes changes in the demand for domestic assets: 1. Domestic real interest rate, r D 2. Foreign real interest rate, r F 3. Changes in the expected future exchange rate, E e t+1 A rise in E e t+1 shifts the demand curve to the right and causes an appreciation of the domestic currency A fall in E e t+1 shifts the demand curve to the left and causes a depreciation of the currency Copyright 2015 Pearson Education, Inc. All rights reserved. 17-23

Application: Why Are Exchange Rates So Volatile? The asset market approach to exchange rate determination explains why exchange rates are so volatile Because expected appreciation of the domestic currency affects the relative expected return on domestic deposits, expectations about the future play an important role in determining the exchange rate When these expectations change, our model implies that there will be an immediate effect on the expected return on domestic deposits and therefore on the exchange rate Copyright 2015 Pearson Education, Inc. All rights reserved. 17-25

Exchange Rates and Aggregate Demand and Supply Analysis In the short run, prices are sticky, so that a rise (fall) in the nominal exchange rate implies a rise (fall) in the real exchange rate E Þ M, X Þ NX Þ Y E Þ M, X Þ NX Þ Y Copyright 2015 Pearson Education, Inc. All rights reserved. 17-26

Exchange Rate Regimes In a fixed exchange rate regime, the value of a currency is pegged relative to the value of one other currency (called the anchor currency) A currency board in a fixed exchange rate regime in which the domestic currency is backed 100% by the anchor currency In a floating (or flexible) exchange rate regime, the value of a currency is determined by supply and demand in the foreign exchange market In a managed float regime (or a dirty float), countries attempt to influence their exchange rates by buying and selling currencies Copyright 2015 Pearson Education, Inc. All rights reserved. 17-28

The Policy Trilemma The policy trilemma (or the impossible trinity) describes the situation in which a country can only pursue two of the following three policies at the same time: 1) free capital mobility, 2) a fixed exchange rate, and 3) an independent monetary policy For example: China has chosen an option with a fixed exchange rate and an independent monetary policy, but it does not have free capital mobility because they have capital controls, which are restrictions on the free movement of capital across the borders. Copyright 2015 Pearson Education, Inc. All rights reserved. 17-29

Application: How Did China Accumulate Over $3 Trillion of International Reserves? Increased demand for China s exports has raised the long-run value of its currency so that the yuan has become undervalued To keep the yuan from appreciating above its pegged exchange rate to the U.S. dollar, the Chinese central bank has been engaging in massive purchases of U.S. dollar assets, making the Chinese government today one of the largest holders of U.S. government bonds in the world Copyright 2015 Pearson Education, Inc. All rights reserved. 17-31

Policy and Practice: Will the Euro Survive? The global financial crisis of 2007-2009 hit the countries in the southern part (e.g., Spain) of the Eurozone harder than those in the northern part (e.g., Germany) However, the European Central Bank conducts monetary policy for the entire Eurozone This straight jacket effect of the euro has resulted in argument for the abandonment of the euro in the weaker, southern countries as well as the stronger, northern countries for different reasons Copyright 2015 Pearson Education, Inc. All rights reserved. 17-32

Policy and Practice: The Collapse of the Argentine Currency Board In April 1991, Argentina decided to end its inflationary cycles by adopting a currency board, which fixed the peso/dollar exchange rate at one to one Under the currency board system, the Central Bank of Argentina had no control over monetary policy so that it was unable to use monetary policy to deal with the severe recessions in the 1990s In January 2002, the currency board finally collapsed and the peso depreciated by more than 70% Copyright 2015 Pearson Education, Inc. All rights reserved. 17-33