(from) CHAPTER 13

1. (from) CHAPTER 13 Exchange Rates and The Foreign Exchange Market

2. Nominal Exchange Rate The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency. i.e The nominal exchange rate is 110 yen per dollar: one dollar can be exchanged for 110 yen The foreign exchange market: where transactions between currencies occurs. Flexible-exchange-rate system / floating-exchange-rate system: exchange rates are determined by supply and demand and may change daily. when enom falls  nominal depreciation (or it has become weaker) when enom rises  nominal appreciation (or it has become stronger) Fixed-exchange-rate system: exchange rates determined by governments. a devaluation a weakening of the currency a revaluation a strengthening of the currency

3. Real Exchange Rate The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good. If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, where you can buy 1 Japanese burger or 5 American burgers with $10; then the relative price is 0.2 Japanese hamburgers per U.S. hamburger. The real exchange rate is the price of domestic goods relative to foreign goods, or e = enom (P/PFor) If a country's real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country. price indexes

4. Purchasing Power Parity “similar goods have the same price in terms of the same currency “ P = PFor / enom PPP holds in the long run but not in the short run because (i) countries produce different goods, (ii) some goods aren't traded, (iii) there are transportation costs and (iv) legal barriers to trade. Δe/e = Δenom/enom + ΔP/P - ΔPFor/PFor Δenom/enom = Δe/e + πFor - π If Δe/e = 0 then relative purchasing power parity shows that movements in relative inflation rates are much larger than movements in real exchange rate in high inflation countries.

5. J-Curve The effect of a change in the real exchange rate is weak in the short run and can even go the "wrong" way: Long-run: the real exchange rate↓ net exports↑ in the long run. Short-run: it may be difficult to quickly change imports and exports. As a result, after a depreciation, a country will import and export the same amount of goods for a time, with higher relative prices on the foreign goods, thus decreasingnetexports in the short-run.

6. Foreign Exchange Market • Demanding dollars means wanting to buy dollars in exchange for the foreign currency: • (1) To buy U.S. goods and services (U.S. exports) • (2) To buy U.S. real and financial assets (U.S. financial inflows) • Supplying dollars means offering dollars in exchange for the foreign currency. • To buy foreign goods and services (U.S. imports) • To buy foreign real and financial assets (U.S. financial outflows)

7. Change in enom When the quality of US goods ↑ then demand for US goods ↑ and demand for US Dollars ↑. D curve shifts to the right and new equilibrium gives a higher enom. Higher domestic output (income) or the foreign real interest rate causes the demand for dollars to fall and exchange rate to fall. Higher foreign output (income), the domestic real interest rate, or the world demand for domestic goods causes demand for dollars increase and the exchange rate to rise.

8. Overvalued Exchange Rate • When the official rate is above its fundamental value, the currency is said to be overvalued. • The government could: • devalue the currency, reducing the official rate to the fundamental value. • restrict international transactions to reduce the supply of its currency to the foreign exchange market. • supply the currency to make the fundamental value equal to the official rate (buy its own currency).

9. Undervalued Exchange Rate • When the official rate is below its fundamental value, the currency is said to be undervalued. • The government could: • revalue the currency, reducing the official rate to the fundamental value. • encourage international transactions to increase the supply of its currency to the foreign exchange market. • reduce supply the currency to make the fundamental value equal to the official rate (sell its own currency).

10. The Asian Crisis Currencies in East Asia came under speculative attack in 1997 and 1998: (1) Thailand had pegged its currency, the baht, to the U.S. dollar for over a decade, but was forced to devalue in July 1997. (2) The attack spread to South Korea, Indonesia, and Malaysia— each had to devalue. (3) Contagion: the tendency of speculative attacks to spread from country to country. Economic damage was great: Stock and land prices falls, bank runs occurred in some countries, some banks and corporations had borrowed money denominated in foreign currencies, so the devaluation increased their debt in terms of their own currency, which forced many banks and firms into bankruptcy.

11. Cause and Effect Cause: (1) Some claimed it was just a self-fulfilling prophecy—some investors panicked, causing others to follow suit. (2) But economic fundamentals were a real cause: - Loans made to banks in Asia (from foreign investors) were invested poorly  bad loans. - As foreign investors sell their Asian assets  crisis. After: By 1999, many Asian countries were recovering, with assistance from the International Monetary Fund and other agencies. Lessons:(1) Fixed exchange rates + with large financial inflows = dangerous, because of the potential for speculative attack. (2) Banking markets in emerging economies need structure to promote economically sound lending, rather than crony capitalism (loans based on politics or connections).

12. End of Lecture 2 Week 15 Nominal vs Real Exchange Rate Purchasing Power Parity J-Curve Foreign Exchange Market Overvalued vs Undervalued Currency The Asian Crisis