Ch. 10: The Exchange Rate and the Balance of Payments.

Ch. 10: The Exchange Rate and the Balance of Payments. • Exchange rates • Definition • Determinants • Short run • Long run • Purchasing power parity • Interest rate parity • Balance of payments accounts • Causes of an international deficit • Alternative exchange rate policies and their long-run effects

Currencies and Exchange Rates • U.S. Citizens sell dollars in the foreign exchange market in order to purchase foreign currency to • purchase imports • purchase foreign assets (stocks, bonds, real estate, etc.) • Foreign citizens buy dollars in the foreign exchange market with foreign currency in order to • Purchase U.S. exports • Purchase U.S. assets.

Currencies and Exchange Rates • Foreign Exchange Rates • The price at which one currency exchanges for another is. • Currency depreciation • A fall in the value of one currency in terms of another currency • Makes country’s imports more expensive • Makes country’s exports more affordable to trading partners • Currency appreciation • A rise in value of one currency in terms of another currency. • Opposite effect of depreciation on imports/exports.

Suppose that the exchange rate is 7 pesos per dollar. If you are in Mexico and must pay 120 pesos for a round of golf, it will cost you $_____ (give your answer to nearest dollar, no dollar sign – e.g. 37) 30

If the exchange changes from 8 yuan per dollar to 10 yuan per dollar, relative to the yuan, the dollar has _____ and the cost of U.S. imports from China _____. • Appreciated; increased • Depreciated; increased • Appreciated; decreased. • Depreciated; decreased. 30

Current exchange rates: http://finance.yahoo.com/currency-investing

Between 2008 and 2009, the dollar appreciated relative to the Mexican peso. • True • False 0% 30

The trade-weighted index is the average exchange rate of the U.S. dollar against other currencies, with individual currencies weighted by their importance in U.S. international trade.

The Foreign Exchange Market • The Demand for One Money Is the Supply of Another Money • When people who are holding one money want to exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money. • Factors that influence the demand for U.S. dollars also influence the supply of foreign currencies. • Factors that influence the demand for another country’s currency also influence the supply of U.S. dollars.

The Foreign Exchange Market • The Law of Demand for Foreign Exchange • The demand for dollars is a derived demand. • People buy U.S. dollars so that they can buy U.S.-produced goods and services or U.S. assets. • Other things remaining the same, the higher the exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market.

The Foreign Exchange Market • The exchange rate influences the quantity of U.S. dollars demanded for two reasons: • Exports effect • As P of $ drops, foreign citizens wish to purchase more U.S. exports and more $. • Expected profit effect • The lower today’s exchange rate, other things remaining the same, the larger is the expected profit from buying U.S. assets and the greater is the quantity of $ demanded today

The Foreign Exchange Market • Supply of $ in the Foreign Exchange Market • The quantity $ supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.

The Foreign Exchange Market • The Law of Supply of Foreign Exchange • Other things remaining the same, the higher the exchange rate, the greater is the quantity of $ supplied in the foreign exchange market. • Imports effect • As P of $ rises, U.S. citizens increase imports and sell more $ to purchase more imports. • Expected profit effect • As P of $ rises, U.S. citizens see greater potential for profits in foreign assets and sell more $ to purchase more foreign assets.

The Foreign Exchange Market • Market Equilibrium If $ is “too strong”, surplus of $ If $ is “too weak”, shortage of $

Exchange Rate Fluctuations • Changes in the Demand for U.S. Dollars • Changes in exchange rate cause movement along the demand curve, NOT a change in demand. • Changes in Demand for $ caused by: • World demand for U.S. exports • U.S. interest rate relative to the foreign interest rate • Expected profits on U.S. assets relative to profits on foreign assets • The expected future exchange rate

Exchange Rate Fluctuations • Changes in the Supply of Dollars • Changes in the exchange rate cause a movement along the supply curve, NOT a change in supply • Changes in the supply of dollar are caused by: • U.S. demand for imports • U.S. interest rates relative to the foreign interest rate • Expected profits on U.S. assets relative to profits on foreign assets • The expected future exchange rate

If U.S. demand for Chinese imports falls as a result of our recession, we should expect the dollar to _____ relative to the yuan because the ____ dollars will fall. • Appreciate; demand for • Appreciate; supply of • Depreciate; demand for • Appreciate; supply of 30

If the Chinese become less willing to buy U.S. bonds because of concerns about default, the dollar will ______ because the _______ dollars will decrease. • Appreciate; demand for • Depreciate; demand for • Appreciate; supply • Depreciate; supply of 30

If everyone begins to believe that the dollar will strengthen over the next several months, this should cause: • An increase in the demand for $ • An increase in the supply of $ • A decrease in the supply of $ • Both A and B • Both A and C 30

Exchange Rate Fluctuations • Exchange Rate Expectations • The exchange rate changes when it is expected to change. • But expectations about the exchange rate are driven by deeper forces. Two such forces are • Interest rate parity • Purchasing power parity

Interest Rate Parity • Expected $ return on investment in foreign currency = interest rate on foreign currency + expected change in value of foreign currency • Interest rate parity exists when interest rates are such that expected returns on currencies are equal across countries. • Market forces achieve interest rate parity very quickly. • Example: • U.S. interest rate=5%; German interest rate=8% • What’s required for interest rate parity?

Interest Rate Parity • Example: U.S. pays 5% interest; Japan pays 4% interest; Value of $ expected to appreciate by 3% over next year. • Where will U.S. citizens buy bonds? • Japanese buy bonds? • Effect on interest rates in U.S. and Japan

U.S. pays 5% interest; Japan pays 8% interest; Value of $ expected to depreciate by 5% over next year. People should buy their bonds from: • U.S. • Japan 30

U.S. pays 5% interest; Japan pays 8% interest; Value of $ expected to depreciate by 5% over next year. Given the observed buying pattern in prior problem, we should expect interest rates to ___ in U.S. and ___ in Japan. • Rise; fall • Rise; rise • Fall; fall • Fall; rise 30

Purchasing Power Parity • Exists when the exchange rate is such that a currency has the same “purchasing power” in all countries. • If PPP did not exist, one could take advantage of “arbitrage” opportunities: • buy item at low price and sell at high price • drives up price in low price country and drives down price in high price country.

Purchasing Power Parity • Suppose $1 = 2 francs, price of gold=$500 in U.S. and 800 francs in France. • What’s the arbitrage opportunity? • What will happen to price of gold in • U.S. • France • What will happen to price of $?

Purchasing Power Parity • In the long run, because of PPP: • Exchange rate between foreign currency and dollar = • price in foreign country / price in U.S. • % ch in price of $ (exchange rate)= • % ch in foreign price - % ch in U.S. prices

Purchasing Power Parity • Links for exercises below are on eco202 Website. • Gold prices and exchange rates • Big Mac Index

Suppose exchange rate is .75 Euros per dollar. The price of gold is $600 per ounce in U.S.; 500 euros per ounce in Euro-zone. Arbitrage would cause gold prices to ____ in U.S. and ___ in Euro-zone: • Rise; rise • Rise; fall • Fall; fall • Fall; rise 30

Financing International Trade • Balance of Payments Accounts • Record a country’s international trading, borrowing, and lending. • Transactions leading to an inflow of currency into the U.S. create a + (credit) in a balance of payments account • Transactions leading to an outflow of currency from the U.S. create a – (debit) in a balance of payments account.

Financing International Trade Three balance of payments accounts • Current account The current accounts balance equals the sum of exports minus imports, net interest income, and net transfers. • Capital account Foreign investment in the United States minus U.S. investment abroad. • Official settlements account • records the change in U.S. official reserves. • U.S. official reserves are the government’s holdings of foreign currency • If U.S. official reserves increase, the official settlements account is negative. • The sum of the three account balances is zero.

Financing International Trade • Borrowers and Lenders • A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower. • A country that is lending more to the rest of the world than it is borrowing from it is called a net lender. • The United States is currently a net borrower but during the 1960s and 1970s, the United States was a net lender.

Financing International Trade • Debtors and Creditors • A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. • Since 1986, the United States has been a debtor nation. • A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it. • The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

Financing International Trade • Being a net borrower does not reduce long term economic growth provided the borrowed funds are used to finance capital accumulation that increases income. • Being a net borrower can reduce economic growth if the borrowed funds are used to finance consumption.

Financing International Trade • Current Account Balance • The current account balance (CAB) is CAB = NX + Net interest income + Net transfers • The main item in the current account balance is net exports (NX). • The other two items are much smaller and don’t fluctuate much.

Financing International Trade • The government sector surplus or deficit is equal to net taxes, T, minus government expenditures on goods and services G. • The private sector surplus or deficit is saving, S, minus investment, I. • Net exports is equal to the sum of government sector balance and private sector balance: • NX = (T – G) + (S – I)

Financing International Trade • For the United States in 2006, • Net exports is a deficit of $784 billion, which equals the sum of the government sector deficit of $313 billion and the private sector deficit of $471 billion.

Financing International Trade • The Three Sector Balances • The private sector balance and the government sector balance tend to move in opposite directions. • Net exports is the sum of the private sector and government sector balances.

Exchange Rate Policy • Three possible exchange rate policies are • Flexible exchange rate • Fixed exchange rate • Crawling peg • Flexible Exchange Rate • A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.

Exchange Rate Policy • Fixed Exchange Rate • pegs the exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market. • A fixed exchange rate requires active intervention in the foreign exchange market.

Exchange Rate Policy • Suppose that the target is 100 yen per U.S. dollar. • If demand increases, the central bank sells U.S. dollars to increase supply. • Effect of “undervalued dollar” and subsequent intervention on1. U.S. money supply? 2. U.S. Inflation?

Exchange Rate Policy • If demand decreases, the central bank buys U.S. dollars (with foreign reserves) to decrease supply. • Effect of “over-valued” dollar and subsequent intervention on: • U.S. money supply and reserves of foreign currency • U.S. inflation

Exchange Rate Policy • Crawling Peg • selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. • China is a country that operates a crawling peg. • Crawling peg works like a fixed exchange rate except that the target value changes. • Avoids wild swings in the exchange rate

Exchange Rate Policy • People’s Bank of China in the Foreign exchange Market • China’s official foreign currency reserves are piling up.

Exchange Rate Policy • The People’s bank buys U.S. dollars to maintain the target exchange rate. • China’s official foreign reserves increase. • Based on diagram, is $ over- or under-valued relative to Chinese Yuan?

If there is a fixed exchange rate system and the dollar is “undervalued”, the U.S. central bank will be forced to ___ dollars which will ___ the U.S. money supply • Buy ; increase • Buy; decrease • Sell ; increase • Sell; decrease 30

Ch. 10: The Exchange Rate and the Balance of Payments.