19 The World of International Finance

HOW EXCHANGE RATES ARE DETERMINED What Are Exchange Rates? exchange rate The price at which currencies trade for one another in the market. appreciation of a currency An increase in the value of a currency relative to the currency of another nation. depreciation of a currency A decrease in the value of a currency relative to the currency of another nation.

HOW EXCHANGE RATES ARE DETERMINED How Demand and Supply Determine Exchange Rates  The Demand for and Supply of U.S. Dollars

HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply  Shifts in the Demand for U.S. Dollars

HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply  Shifts in the Supply of U.S. Dollars

HOW EXCHANGE RATES ARE DETERMINED Changes in Demand or Supply Key facts about the foreign exchange market, using dollars and euros as our example: 1Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar. 2Decreases in U.S. interest rates and increases in U.S. prices will decrease the demand for dollars, leading to a depreciation of the dollar. 3Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar. 4Decreases in European interest rates and increases in European prices will decrease the supply of dollars in exchange for euros, leading to an appreciation of the dollar.

REAL EXCHANGE RATES AND PURCHASING POWER PARITY real exchange rate The price of U.S. goods and services relative to foreign goods and services, expressed in a common currency. law of one price The theory that goods easily tradable across countries should sell at the same price expressed in a common currency. purchasing power parity A theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

THE CURRENT ACCOUNT &THE FINANCIAL ACCOUNT Balance of payments (BP) A system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period. Financial account (FA) includes financial assets (stocks, bonds) and direct foreign investment (businesses, real estate). This account tracks U.S. owned assets abroad and foreign owned assets in the U.S. Current account (CA) includes merchandise trade, services, interest and dividend income, and one- way transfers

THE CURRENT ACCOUNT & THE FINANCIAL ACCOUNT The current and financial accounts of a country are linked by a very important relationship: Balance of Payments=current account + financial account = 0  Current account deficits must be offset by financial account surpluses (increasing capital inflows)  (CA‹0)=( FA›0) so BP=0  Current account surpluses must be offset by financial account deficits (increasing capital outflows)  (CA›0) = (FA‹0) so BP=0 Any action that gives rise to a demand for foreign currency is a deficit item. Any action that gives rise to a supply of foreign currency is a surplus item.

FIXED AND FLEXIBLE EXCHANGE RATES What happens when a country’s exchange rate appreciates—increases in value? There are two distinct effects: 1The increased value of the exchange rate makes imports less expensive for the residents of the country where the exchange rate appreciated. 2The increased value of the exchange rate makes U.S. goods more expensive on world markets.

FIXED AND FLEXIBLE EXCHANGE RATES Fixing the Exchange Rate foreign exchange market intervention The purchase or sale of currencies by government to influence the market exchange rate.

FIXED AND FLEXIBLE EXCHANGE RATES Fixed Versus Flexible Exchange Rates flexible exchange rate system A currency system in which exchange rates are determined by free markets. fixed exchange rate system A system in which governments peg exchange rates to prevent their currencies from fluctuating. The flexible exchange rate system has worked well enough since the breakdown of Bretton Woods. Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.

FIXED AND FLEXIBLE EXCHANGE RATES balance of payments deficit Under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate. BALANCE OF PAYMENTS DEFICITS AND SURPLUSES balance of payments surplus Under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate. devaluation A decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system. revaluation An increase in the exchange rate to which a currency is pegged under a fixed exchange rate system.