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Exchange Rates and The Open Economy

Exchange Rates and The Open Economy. Exchange Rates. Nominal Exchange Rate The rate at which two currencies can be traded for each other. Nominal Exchange Rates for the U.S. Dollar. Country Foreign currency/dollar Dollar/foreign currency. United Kingdom (pound) 0.6393 1.5643

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Exchange Rates and The Open Economy

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  1. Exchange Rates and The Open Economy

  2. Exchange Rates • Nominal Exchange Rate • The rate at which two currencies can be traded for each other Chapter 17: Exchange Rates and the Open Economy

  3. Nominal Exchange Ratesfor the U.S. Dollar Country Foreign currency/dollar Dollar/foreign currency United Kingdom (pound) 0.6393 1.5643 Canada (Canadian dollar) 1.5674 0.6380 Mexico (peso) 9.9850 0.1002 Japan (yen) 118.000 0.00848 Switzerland (Swiss franc) 1.4760 0.6775 South Korea (won) 1,190.1000 0.00084 Chapter 17: Exchange Rates and the Open Economy

  4. Exchange Rates • Nominal Exchange Rates • The exchange rate between British and Canadian currencies • 0.6393 British pounds = $1 U.S. • 1.5674 Canadian $s = $1 U.S. • 0.6393 British pounds = 1.5674 Canadian $s • 0.6393/1.5674 = 0.4079 pounds = 1 Canadian $ • British/Canadian exchange 0.4079 pounds per Canadian dollar Chapter 17: Exchange Rates and the Open Economy

  5. The U.S. NominalExchange Rate, 1973-2002 More Recent Series: http://research.stlouisfed.org/fred2/series/TWEXBMTH/95/5yrs Chapter 17: Exchange Rates and the Open Economy

  6. Exchange Rates • Appreciation • An increase in the value of a currency relative to other currencies • Depreciation • A decrease in the value of a currency relative to other currencies Chapter 17: Exchange Rates and the Open Economy

  7. Exchange Rates • Some Definitions • e = nominal exchange rate • e = the number of units of foreign currency that the domestic currency will buy • If e increases, it is an appreciation of the domestic currency. • If e decreases, it is a depreciation of the domestic currency. Chapter 17: Exchange Rates and the Open Economy

  8. Exchange Rates • Flexible Exchange Rate • An exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market Chapter 17: Exchange Rates and the Open Economy

  9. Exchange Rates • Foreign Exchange Market • The market on which currencies of various nations are traded for one another Chapter 17: Exchange Rates and the Open Economy

  10. Exchange Rates • Fixed Exchange Rate • An exchange rate whose value is set by official government policy Chapter 17: Exchange Rates and the Open Economy

  11. Exchange Rates • The Real Exchange Rate • Nominal exchange rate • The price of the domestic currency in terms of a foreign currency • Real exchange rate • The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency Chapter 17: Exchange Rates and the Open Economy

  12. Exchange Rates • Example • Should you buy a Japanese or American computer for your company? • Price of U.S. computer = $2,400 • Price of Japanese computer = 242,000 yen • Exchange rate = 110 yen/dollar Chapter 17: Exchange Rates and the Open Economy

  13. Exchange Rates • Example • Should you buy a Japanese or American computer for your company? • Price in yen = price in dollars x value of dollar in terms of yen • Price in dollars = price in yen/yen-dollar exchange rate • Price in dollars = 242,000 yen/110 = $2,200 Chapter 17: Exchange Rates and the Open Economy

  14. Exchange Rates • Example • Should you buy a Japanese or American computer for your company? • Japanese computer is cheaper. • Real exchange rate = $2,400/$2,200 = 1.09 Chapter 17: Exchange Rates and the Open Economy

  15. Exchange Rates • Real Exchange Rate Chapter 17: Exchange Rates and the Open Economy

  16. Exchange Rates • The Computer Example, revisited • E = 110/$1 • P = $2,400 • Pf = 242,000 yen Chapter 17: Exchange Rates and the Open Economy

  17. Exchange Rates • The Real Exchange Rate • A high real exchange rate implies that domestic producers will have difficulty exporting to other countries. • A high real exchange rate will attract imports. Chapter 17: Exchange Rates and the Open Economy

  18. Exchange Rates • The Real Exchange Rate • NX will tend to be low when the real exchange rate is high. • Real and nominal exchange rates tend to move in the same direction Chapter 17: Exchange Rates and the Open Economy

  19. Exchange Rates • Economic Naturalist • Does a strong currency imply a strong economy? Chapter 17: Exchange Rates and the Open Economy

  20. The Determination of the Exchange Rate • Law of One Price • If transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations Chapter 17: Exchange Rates and the Open Economy

  21. The Determination of the Exchange Rate • Example • How many Indian rupees equal to one Australian dollar? • Bushel of grain cost 5 Australian dollars or 150 rupees • 5 Australian dollars = 150 rupees • Nominal exchange should equal 30 rupees/Australian dollar Chapter 17: Exchange Rates and the Open Economy

  22. The Determination of the Exchange Rate • Purchasing Power Parity (PPP) • The theory that nominal exchange rates are determined as necessary for the law of one price to hold Chapter 17: Exchange Rates and the Open Economy

  23. The Determination of the Exchange Rate • Purchasing Power Parity (PPP) • In the long run, the currencies of countries that experience significant inflation will tend to depreciate. Chapter 17: Exchange Rates and the Open Economy

  24. The Determination of the Exchange Rate • Example • How many Indian rupees equal one Australian dollar? • Price of grain in India increases from 150 to 300 rupees • Price of grain in Australia equals 5 Australian dollars Chapter 17: Exchange Rates and the Open Economy

  25. The Determination of the Exchange Rate • Example • How many Indian rupees equal one Australian dollar? • 5 Australian dollars = 300 rupees • 1 Australian dollar = 60 rupees • Nominal exchange rate increased from 30 to 60 rupees/Australian dollar • Indian currency depreciated • Australian currency appreciated Chapter 17: Exchange Rates and the Open Economy

  26. Inflation and Currency Depreciationin South America, 1995-2001 Chapter 17: Exchange Rates and the Open Economy

  27. The Determination of the Exchange Rate • Example • Shortcomings of the PPP Theory • The theory has been successful in the long run but not the short run. Chapter 17: Exchange Rates and the Open Economy

  28. The Determination of the Exchange Rate • Example • Limits to the PPP Theory • Not all goods and services are traded internationally. • The greater the share of non-traded goods, the less precise the PPP theory • Not all internationally traded goods and services are perfectly standardized commodities. Chapter 17: Exchange Rates and the Open Economy

  29. The equilibrium exchange rate (e*) or fundamental exchange rate equates the quantity of dollars supplied and demanded Supply of dollars e* Demand for dollars The Supply and Demand for Dollars In The Yen-Dollar Market Yen/dollar exchange rate Quantity of dollars traded Chapter 17: Exchange Rates and the Open Economy

  30. The Determination of the Exchange Rate • Changes in the Supply of Dollars • Factors that increase the supply of dollars • An increase in the preference for Japanese goods • An increase in U.S. real GDP • An increase in the real interest rate on Japanese assets Chapter 17: Exchange Rates and the Open Economy

  31. Supply of dollars increases from S to S’ • The value of the dollar in terms of yen falls • e* falls to e*’ S S’ E e* F e*’ D An Increase In The Supply of Dollars Lowers The Value of The Dollar • Increase in demand for Japanese video games Yen/dollar exchange rate Quantity of dollars traded Chapter 17: Exchange Rates and the Open Economy

  32. The Determination of the Exchange Rate • Changes in the Demand for Dollars • Factors that increase the demand for dollars • Increased preference for U.S. goods • Increase in real GDP abroad • An increase in the real interest rate on U.S. assets Chapter 17: Exchange Rates and the Open Economy

  33. S • The demand for dollars rises • Exchange rate appreciates from e* to e*’ F e*’ E e* D’ D A Tightening of Monetary Policy Strengthens the Dollar • Tighter monetary policy raises the domestic real interest rate • Foreign demand for U.S. assets increase Yen/dollar exchange rate Quantity of dollars traded Chapter 17: Exchange Rates and the Open Economy

  34. Monetary Policy andthe Exchange Rate • Economic Naturalist • Why did the dollar appreciate nearly 50 percent in the first half of the 1980s? Chapter 17: Exchange Rates and the Open Economy

  35. Monetary Policy andthe Exchange Rate • The Exchange Rate as a Tool of Monetary Policy • When the exchange rate is flexible: • Tighter monetary policy reduces net exports. • Easier monetary policy stimulatesnet exports. Conclusion: • Monetary policy is more effective in an open economy with flexible exchange rates. Chapter 17: Exchange Rates and the Open Economy

  36. Fixed Exchange Rates • How to Fix an Exchange Rate • The government will peg its currency to a major currency or to a “basket” of currencies. • The government may have to devalue or revalue its currency. Chapter 17: Exchange Rates and the Open Economy

  37. Fixed Exchange Rates • Devaluation • A reduction in the official value of a currency (in a fixed-exchange-rate system) • Revaluation • An increase in the official value of a currency (in a fixed-exchange-rate system) • c.f. “Depreciation,” “Appreciation” Chapter 17: Exchange Rates and the Open Economy

  38. Fixed Exchange Rates • Overvalued Exchange Rate • An exchange rate that has an officially fixed value greater than its fundamental value • Undervalued Exchange Rate • An exchange rate that has an officially fixed value less than its fundamental value Chapter 17: Exchange Rates and the Open Economy

  39. The peso’s official value is greater than the fundamental value; the peso is overvalued • To maintain the value, the government must purchase a quantity of pesos (A-B) Supply of pesos A B 0.125 dollar/ peso Official value Fundamental value 0.10 dollar/ peso Demand for pesos An Overvalued Exchange Rate Dollar/peso exchange rate Quantity of pesos traded Chapter 17: Exchange Rates and the Open Economy

  40. Fixed Exchange Rates • How to Fix an Exchange Rate • Responses to an overvalued currency • Devalue the currency • Impose trade barriers • Purchase the currency Chapter 17: Exchange Rates and the Open Economy

  41. Fixed Exchange Rates • International Reserves • Foreign currency assets held by a government for the purpose of purchasing the domestic currency in the foreign exchange market. Chapter 17: Exchange Rates and the Open Economy

  42. Fixed Exchange Rates • How to Fix an Exchange Rate • To purchase its own currency, a country must hold international reserves. • A balance of payments deficit occurs when a country has a net decline in international reserves over a year. Chapter 17: Exchange Rates and the Open Economy

  43. Fixed Exchange Rates • How to Fix an Exchange Rate • A balance-of-payments surplus occurs when a country has a net increase in international reserves over a year. Chapter 17: Exchange Rates and the Open Economy

  44. Fixed Exchange Rates • Example • Latinia’s balance-of-payments deficit • Demand = 25,000 - 50,000e • Supply = 17,600 + 24,000e • Official value of the peso = 0.125 dollars Chapter 17: Exchange Rates and the Open Economy

  45. Fixed Exchange Rates • Example • Latinia’s balance-of-payments deficit • Fundamental value • 25,000 - 50,000e = 17,600 + 24,000e • Solving for e: • 7,400 = 74,000e • e = 0.10 Chapter 17: Exchange Rates and the Open Economy

  46. Fixed Exchange Rates • Example • As the official rate -- 0.125 • D = 25,000 - 50,000(0.125) = 18,750 • S = 17,600 - 24,000 (0.125) = 20,600 • Excess supply = 1,850 pesos • Balance of payments deficit = 1,850 pesos Chapter 17: Exchange Rates and the Open Economy

  47. Fixed Exchange Rates • Speculative Attack • A massive selling of domestic currency assets by financial investors Chapter 17: Exchange Rates and the Open Economy

  48. Peso overvalued at 0.125 • Central bank buys pesos • Investors launch a speculative attack -- sell peso dominated assets S S’ A B C 0.125 dollar/ peso Official value 0.10 dollar/ peso • Supply of pesos increases • Central bank must purchase more pesos D A Speculative Attackon the Peso Dollar/peso exchange rate Quantity of pesos traded Chapter 17: Exchange Rates and the Open Economy

  49. Fixed Exchange Rates • Economic Naturalist • Can a speculative attack occur under flexible exchange rates? Chapter 17: Exchange Rates and the Open Economy

  50. Pesos overvalued at 0.125 • Tightening monetary policy increases D to D’ • Official value = fundamental value S F 0.125 dollar/ peso Official value E 0.10 dollar/ peso D’ D A Tightening of Monetary Policy Eliminates An Overvaluation Dollar/peso exchange rate Quantity of pesos traded Chapter 17: Exchange Rates and the Open Economy

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