Foreign Exchange and Exchange Rates

1. Foreign Exchange and Exchange Rates The International Price of Money

2. Motivation for Foreign Exchange • The international economy brings unique aspects to economic accounting • Trade brings (at least) two issues • Measuring the demand (in US) for other currencies to pay for imports, and the demand for US dollars (in other currencies) to pay for exports. Called the Balance of Payments • Finding the value of other currencies in terms of the US dollar. Called the Exchange Rate

3. Motivation (cont.)Why Trade Matters • Recall equilibrium in AE model: X + I + G = S + T + M which when rearranged can be written I = S + (T-G) + (M-X) or Investment = savings + government surplus + trade deficit • The larger the trade deficit, the largerinvestment • The Trade Deficit is a form of Foreign Savings • Foreign producers have the ability to save the excess • But we are sending wealth overseas, which can be bad • So want to keep track of the balances

4. Motivation (cont.)Exchange Rate and Balance of Payments • Balance of Payments is the accounting part of international trade and finance • Keeps track of flows in and out of a country • Is the accounting of Foreign Exchange, which are currency and bank deposits denominated in foreign money • Exchange Rate is the outcome of foreign exchange balances • It is the value of the foreign currency in terms of the domestic currency.

5. Exchange Rates • Exchange rates can be quoted two ways • US Dollar per foreign currency (Econweb) • Foreign currency per US dollar • They are inverses of one another. • eg: 1.828=1/0.547 • These are exchange rates on October 22, 2004

6. Foreign Exchange Values • The Exchange rate is the value of the foreign currency in terms of the US $ (e.g., dollars per GB ₤, now about $1.8 per GB ₤) • If the dollar appreciates, the exchange rate falls. $1 will buy more of the other currency • At current rate, $1 buys 0.547 GB ₤ (1.8=1/.547). • If $ appreciated, so $1 bought 0.75 GB ₤ (notice the dollar buys more, so it is worth more), the exchange rate falls to 1/0.75 = 1.33 • If the dollar depreciatesthe exchange rate gets larger.

7. Supply and Demand for Dollars • Foreign Trade requires foreign currency • Imports create demand for foreign currency • When a US consumer buys a German car, eventually someone must convert US dollars to German Marks. • US customer has dollars, German producer wants Marks (creates demand for Marks) • Exports create supply of foreign currency • When a US farmer sells apples to China, someone must convert Yuan to dollars • Chinese customer has Yuan, US farmer wants dollars (creates supply of Yuan)

8. Imports and the Demand for Foreign Exchange • Recall the Exchange Rate is the value of the other currency in terms of the US dollar • If the dollar appreciates, imports are cheaper (in US) • If the exchange rate is $1.8 per GB ₤, something that cost 1 GB ₤ in England cost the US consumer $1.8. • If the exchange rate falls to $1.33 per GB ₤, that same item now costs the US consumer $1.33 • Falling exchange rate increases imports, because foreign goods are cheaper • Lower exchange rate ═> more imports, thus larger quantity demanded for foreign exchange

9. The Demand for Foreign Exchange Exchange Rate (e.g., $ per Yen) Exchange Rate (e.g., $ per Foreign currency) As the exchange rate goes down, … the quantity demanded of foreign exchange in the foreign exchange market increases. D Quantity of foreign currency

10. Exports and the Supply of Foreign Exchange • Again the Exchange Rate is the value of the other currency in terms of US dollars • If the value of the dollar goes up (the $ appreciates), US exports are more expensive (in other countries) • If the exchange rate is $1.8 per GB ₤, something that cost $1 in the US costs the English consumer 0.547 GB ₤ (= $1/1.8) • If the exchange rate falls to $1.33 per GB ₤, the same item now costs the English consumer 0.75 GB ₤ (= $1/1.33). • Falling exchange rate decreases exports, since US goods are more expensive overseas • lower exchange rate ═> fewer exports, thus a smaller quantity supplied of foreign exchange

11. The Supply of Foreign Exchange Exchange Rate (e.g., $ per Foreign currency) S As the exchange rate goes up, the quantity supplied of foreign currency inthe foreign exchange market increases. Quantity of foreign currency

12. Exchange rates, imports and exports: summary • Dollar appreciates – it is worth more • Foreign exchange rate falls • Imports increase • Exports decrease • Dollar depreciates – it is worth less • Exchange rate rises • Imports decrease • Exports increase

13. Other Sources of Supply and Demand for Currency • Speculators (money traders) and central banks also will supply foreign currency • If the foreign exchange rate goes up, they supply a greater amount (upward sloping supply curve) • If the foreign exchange rate goes down, they demand a greater amount (downward sloping demand) • Foreign Investment • US investment in other countries (capital outflows) increases the demand of foreign exchange (other currencies) • Foreign investment in the US (capital inflows) increases the supply of foreign exchange (other currencies)

14. Equilibrium in Foreign Exchange and the Exchange Rate Exchange Rate (e.g., $ per Foreign currency) S Equilibrium in the foreign exchange market occurs when the quantity demanded for foreign exchange equals the quantity supplied of foreign exchange. E The exchange rate is where these two quantities are equal. D Q Quantity of foreign currency

15. Changes in the Exchange Rate I Exchange Rate (e.g., $ per Foreign currency) If the demand for foreign exchange increases (say by an increase in wealth in the US, which will increase imports)… S1 E2 E1 The exchange rate will increase (the dollar depreciates) and the quantity of foreign currency exchanged goes up. D2 D1 Q1 Q2 Quantity of foreign currency

16. Changes in the Exchange Rate II Exchange Rate (e.g., $ per Foreign currency) If the supply of foreign currency increases (say by an increase in wealth overseas, which will increase exports)… S1 S2 E1 The exchange rate will decrease (the dollar appreciates) and the quantity of foreign currency exchanged goes up. E2 D1 Q1 Q2 Quantity of foreign currency

17. Exchange Rate Regimes Three general ways exchange rates are determined • Fixed Exchange Rates: The value of one currency in terms of another is fixed. • Essentially like having a single currency • World had fixed exchange rates prior to 1961 • Causes imbalances in currency supply and demand, so requires lots of central bank intervention (we’ll talk about this later).

18. Exchange Rate Regimes (cont.) • Managed Float or Crawling Peg: • Value of currencies are allowed to vary within a predetermined range • Central banks intervene to keep the exchange rate within this range • Used from 1961 to 1970 • Full Float or Floating Exchange Rates • Values of currencies depends on supply and demand • Current system

19. Fixed and Pegged Exchange Rates Exchange Rate (e.g., $ per Foreign currency) Suppose a fixed exchange rate is set above the equilibrium level, say at E1 … S The quantity supplied of foreign currency … E1 Will exceed the quantity demanded. Without intervention the exchange rate would fall. E0 Central banks can support the high exchange rate by buying the excess supply of foreign currency = Qs-Qd D Qd Q Qs Quantity of foreign currency

20. Fixed and Pegged Exchange Rates II Exchange Rate (e.g., $ per Foreign currency) Suppose a fixed exchange rate is set below the equilibrium level, say at E2 … S The quantity demanded of foreign currency … Will exceed the quantity supplied. E0 Without intervention the exchange rate would rise. E2 Central banks can support the low exchange rate by selling foreign currency to meet the excess demand = Qd-Qs D Qs Q Qd Quantity of foreign currency

21. Fixed and Pegged Exchange Rates • With fixed or pegged exchange rates, central banks or governments must buy or sell dollars. • Often involves buying or selling gold, if enough dollars aren’t in reserve. • Can deplete gold reserves. • We’ll do more on this next week.

22. Flexible Exchange Rates and Trade Deficit • It is self correcting • With a shortage of foreign currency (exports less than imports) the exchange rate should increase (dollar depreciates). • US goods become less expensive in terms of other currencies • Other countries’ goods become more expensive in terms of dollars • Exports should increase, imports should decrease … closing the trade surplus

23. Flexible Exchange Rates and Trade Surplus • Again it is self correcting • With a surplus of foreign currency (exports exceeding imports) the exchange rate should decrease (dollar appreciates). • US goods become more expensive in terms of other currencies • Other countries’ goods become less expensive in terms of dollars • Imports should increase, exports should decrease … closing the trade surplus

24. Exchange Rate Change and the Trade Deficit

25. Trade Deficits and Exchange Rate Change • Expect large trade deficits would lead the dollar to depreciate • Previous graph shows that general pattern • Persistent trade deficits • Exchange rate change generally positive, so dollar is depreciating • But pattern is not as strong as expected • Why? The Answer is Balance of Payments

26. Example: US $ vs. Euro • From May 2004 to November 2004 the foreign exchange rate for the Euro ($ price of Euros) has gone from ~ $1.17 to ~1.29 • It is easier for US companies to sell in Europe and harder for European companies to sell in US. • Tupperware, a US company, has seen European sales increase. • Wedgewood, an Irish company, has see US sales fall

27. Example: US $ vs Euro (cont) • US exports of goods and services reached a record $97.5 billion in September • US goods became cheaper in other countries • American companies in general (IBM, Amazon, Levi Strauss) are seeing large increases in profits from Europe • European companies (Nokia in Finland, Adidas-Soloman in Germany) see profits from US sales dropping.