9 OPEN ECONOMY THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS Notes and teaching tips: 4, 5, 8, 35, 37, 38, 39, 51, 52, 53, 65, and 68. To view a full-screen figure during a class, click the expand button. To return to the previous slide, click the shrink button. To advance to the next slide, click anywhere on the full screen figure. Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action. (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining. (2) Once or twice a semester, set an assignment, for credit, with the following instructions: (a) Find a news article about an economic topic that you find interesting. (b) Make a short bullet-list summary of the article. (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article. Use the Economics in the News features in your textbook as models.

In this chapter: Define the foreign exchange rate and explain how the exchange rate is determined Explain the alternative exchange rate policies and explain their effects Describe the balance of payments accounts and explain what causes an international deficit

The Foreign Exchange Market To buy goods and services produced in another country we need money of that country. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollar (120 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollar, stick to the “120 yen per dollar” format in your lectures.

The Foreign Exchange Market Exchange Rates The exchange rate - The price at which one currency exchanges for another. Currency depreciation - A fall in the value of one currency in terms of another currency. e.g., the value of the US dollar falls from 2 euros/dollar to 1 euro/ dollar – the dollar depreciates. Currency appreciation - A rise in value of one currency in terms of another currency. e.g., the value of the US dollar rises from 1 euro/dollar to 2 euros/ dollar – the dollar appreciates.

May 2, 2017. Euro Depreciation

The Foreign Exchange Market Questions we want to answer How is the exchange rate determined? Why do currencies appreciate and sometimes depreciate? How does the Fed operate in the foreign exchange market? How is macro policy affected? How do exchange rate fluctuations influence the balance of trade and the balance of payments of a country?

The Foreign Exchange Market An Exchange Rate Is a Price Like all prices, an exchange rate is determined in a market by supply and demand. The U.S. dollar is demanded and supplied by thousands of traders every hour of every day. With many traders and no restrictions, the foreign exchange market is a competitive market. Classroom activity Check out Economics in Action: The U.S. Dollar More Down than Up

The Foreign Exchange Market Demand for US Dollars in the Foreign Exchange Market The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends in general on World demand for U.S. exports Interest rates in the United States and other countries The expected future exchange rate

The Foreign Exchange Market The Law of Demand Applies for Foreign Exchange People demand U.S. dollars so that they can buy US-produced goods and services or assets – stocks, bonds, land……. Other things remaining the same, the lower the exchange rate, the larger the quantity of U.S. dollars demanded in the foreign exchange market. 2 euros/dollar to falls to 1 euro/ dollar

The Foreign Exchange Market The demand for US dollars in the foreign exchange market shows a negative relationship between the price of dollars (yen per dollar, (¥/$) and the quantity of dollars demanded. When the price of the dollar falls (the exchange rate falls), US - made goods and services appear less expensive to Japanese buyers. If US domestic prices are constant, Japanese buyers will buy more US goods and services, and the quantity demanded of dollars will increase.

The Demand for US Dollars THE DEMAND FOR US DOLLARS (SUPPLY OF JAPANESE YEN) 1. Firms and households that import US goods into Japan or wish to buy US - made goods and services 2. Japanese citizens traveling in the US 3. Holders of Japanese yen who want to buy US stocks, bonds, or other financial instruments 4. Japanese companies that want to invest in the US 5. Speculators who anticipate an increase in the value of the dollar (relative to the yen). They expect the dollar to appreciate and the yen to depreciate (buy at 100 yen/dollar expecting to sell at 125 yen/dollar) If you think the U.S. dollar is going to decline in value relative to the pound, you may want to hold some of your wealth in the form of pounds.

The Foreign Exchange Market Supply of US Dollars in the Foreign Exchange Market The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. This quantity depends on many factors but the main ones are U.S. demand for imported goods and services Interest rates in the United States and other countries The expected future exchange rate. They expect the dollar to depreciate (sell at 100 yen/dollar expecting to buy back at 80 yen/dollar)

The Foreign Exchange Market The Law of Supply Applies for Foreign Exchange People supply U.S. dollars so that they can buy foreign-produced goods and services or foreign assets. Other things remaining the same, the higher the exchange rate, the larger is the quantity of U.S. dollars supplied in the foreign exchange market.

The Foreign Exchange Market The supply of dollars in the foreign exchange market shows a positive relationship between the price of dollars (Yen per dollar (¥/$) and the quantity of dollars supplied. When the price of dollars rises, US buyers can obtain more yen for each dollar. This means that Japanese products are less expensive to US buyers. If prices of Japanese products are constant , the quantity of dollars supplied will rise with the exchange rate.

The Market for Foreign Exchange THE SUPPLY OF US DOLLARS (DEMAND FOR JAPANESE YEN) Firms and households that import Japanese goods into the US or wish to buy Japanese-made goods and services US citizens traveling in the Japan Holders of dollars who want to buy stocks, bonds, or other financial instruments in Japan US companies that want to invest in Japan Speculators who anticipate the yen to appreciate and the dollar to depreciate If you think the U.S. dollar is going to decline in value relative to the pound, you may want to hold some of your wealth in the form of pounds.

The Foreign Exchange Market Market Equilibrium Demand and supply in the foreign exchange market determine the exchange rate.

Exchange Rate Fluctuations Changes in the Demand for U.S. Dollars A change in any influence on the quantity of U.S. dollars that people plan to buy, other than the exchange rate, brings a change in the demand for U.S. dollars. Other influences include: World demand for U.S. exports Relative inflation rates U.S. interest rate relative to the foreign interest rate The expected future exchange rate

Exchange Rate Fluctuations World Demand for U.S. Exports At a given exchange rate, if world demand for U.S. exports increases, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward. If US inflation is < foreign inflation, US products more attractive demand curve for U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate If interest rates in the US rise relative to foreign interest rates, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward.

Exchange Rate Fluctuations The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward.

Exchange Rate Fluctuations How the demand curve for U.S. dollars shifts in response to changes in Demand for U.S. exports Inflation differential U.S. interest rates differential Expected future exchange rate.

Exchange Rate Fluctuations Changes in the Supply of U.S. Dollars A change in any influence on the quantity of U.S. dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars. These other influences are U.S. demand for imports (want more French wine) U.S. inflation relative to foreign inflation. U.S. interest rates relative to the foreign interest rate The expected future exchange rate

Exchange Rate Fluctuations U.S. Demand for Imports At a given exchange rate, if the U.S. demand for imports increases, the supply of U.S. dollars on the foreign exchange market increases and the supply curve of U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate If the U.S. interest rates fall relative to foreign interest rates the supply of U.S. dollars increases and the supply curve of U.S. dollars shifts rightward. If the U.S. interest rates rise relative to foreign interest rates the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.

Exchange Rate Fluctuations The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, … the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.

Exchange Rate Fluctuations How the supply curve of U.S. dollars shifts in response to changes in U.S. demand for imports The U.S. interest rate differential The expected future exchange rate

Exchange Rate Fluctuations Changes in the Exchange Rate If demand for U.S. dollars increases and supply does not change, the exchange rate rises - the dollar appreciates. French demand for California wine increases (change in taste) or Great Britain is booming, YGB is increasing => IM = mxY increases. or US stocks become more attractive to Japanese investors …. on and on………. Euro/$ S0 1.10 0.95 D1 Classroom activity Check out Economics in Action: The Dollar on a Roller Coaster Check out Economics in the News: The Rising U.S. Dollar D0 Quantity of Dollars

Exchange Rate Fluctuations Changes in the Exchange Rate If demand for U.S. dollars decreases and supply does not change, the exchange rate falls – the dollar depreciates. European demand for California wine decreases (change in taste) or Great Britain in recession, YGB is decreasing => IM = mxY decreases. or US stocks become less attractive to Japanese investors …. on and on………. Euro/$ S0 1.10 0.90 D0 Classroom activity Check out Economics in Action: The Dollar on a Roller Coaster Check out Economics in the News: The Rising U.S. Dollar D1 Quantity of Dollars

Exchange Rate Fluctuations Changes in the Exchange Rate If supply of U.S. dollars increases and demand does not change, the exchange rate falls - the dollar depreciates. US demand for French wine increases (change in taste) or US is booming, YUS is increasing => IM = mxY increases. or Japanese stocks become more attractive to US investors …. on and on………. Euro/$ S0 S1 1.10 0.95 Classroom activity Check out Economics in Action: The Dollar on a Roller Coaster Check out Economics in the News: The Rising U.S. Dollar D0 Quantity of Dollars

Exchange Rate Fluctuations Changes in the Exchange Rate If supply of U.S. dollars decreases and demand does not change, the exchange rate rises - the dollar appreciates. US demand for French wine decreases (change in taste) or US is in a recession, YUS is decreasing => IM = mxY decreases. or Japanese stocks become less attractive to US investors …. on and on………. Euro/$ S1 S0 1.10 0.95 Classroom activity Check out Economics in Action: The Dollar on a Roller Coaster Check out Economics in the News: The Rising U.S. Dollar D0 Quantity of Dollars

The Open Economy with Flexible Exchange Rates Purchasing Power Parity: The Law of One Price law of one price If the costs of transportation are small, the price of the same good in different countries should be roughly the same. purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same. Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market.

Purchasing Power Parity: The Law of One Price Arbitrage example: Price of basket balls in Toronto and Buffalo. Say a basket ball cost $15(cad) in Toronto and $13(usd) in Buffalo and the exchange rate is $0.75usd/$1cad. I can buy a basket ball in Toronto for $11.25usd (15 x .75) and sell in Buffalo for $13usd => profit = $1.75. Holding the basket ball price constant, demand for Canadian dollar increases and the exchange rate will increase to $0.867usd/$1cad (15cad x .867 = $13us) . -In actuality, the price of basket balls will also change, increasing in Toronto and decreasing in Buffalo.

Arbitrage and Speculation Speculation is trading on the expectation of making a profit. This is different from arbitrage. Arbitrage is trading on the certainty of making a profit. Most foreign exchange transactions are based on speculation. The expected future exchange rate influences both supply and demand, so it influences the current equilibrium exchange rate.

How Inflation Affects Exchange Rates The Open Economy with Flexible Exchange Rates How Inflation Affects Exchange Rates A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries General tendency is for the currency of relative high-inflation countries to depreciate and currency of low-inflation countries to appreciate. Next slide looks at the case where inflation in the US is high relative to Great Britain.

Factors that Affect Exchange Rates - Inflation A higher price level in the United States, relative to Great Britain, makes British imports more attractive. The demand for pounds increases from D to D' At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. The supply of pounds decreases from S to S'. The result is an increase in the price of the pound from $1.89 to $2.25. The pound appreciates, and the dollar is worth less (depreciates). Note: the supply curve and demand curve shift at the same time, which make exchange rates volatile.

How Relative Interest Rates Affect Exchange Rates The Open Economy with Flexible Exchange Rates How Relative Interest Rates Affect Exchange Rates The level of a country’s interest rate relative to interest rates in other countries is another determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British citizens will be attracted to U.S. securities. To buy bonds in the United States, British buyers must exchange pounds for dollars (or supply their pounds in exchange for dollars). With higher interest rates in the United States, U.S. citizens are less likely to be interested in British securities, so they demand less pounds.

Factors that Affect Exchange Rates – relative interest rates Exchange Rates Respond to Changes in Relative Interest Rates If U.S. interest rates rise relative to British interest rates, British citizens will be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S to S'. At the same time, U.S. citizens are less likely to be interested in British securities because interest rates are higher at home. The demand for pounds shifts to the left, from D to D'. The result is a depreciated pound and a stronger dollar (dollar appreciates). To buy bonds in the United States, British buyers must exchange pounds for dollars (or supply their pounds in exchange for dollars). With higher interest rates in the United States, U.S. citizens are less likely to be interested in British securities, so they demand less pounds.

The Effects of Exchange Rates on the Economy When the U.S. dollar depreciates: U.S. products are less expensive in world markets, and foreign-made goods look more expensive to U.S. citizens. Exports increase and imports decrease. A depreciation of a country’s currency is likely to increase NX, increase AD and increase RGDP. If the economy is operating close to capacity, the increase in aggregate demand is likely to result in higher prices. Also, if import prices rise, costs may rise for business firms, shifting the AS curve to the left.

Open Economy - Monetary Policy with Flexible Exchange Rates Fed actions to lower interest rates result in a decrease in the demand for dollars and an increase in the supply of dollars, causing the dollar to depreciate. If the purpose of the Fed is to stimulate the economy, dollar depreciation is a good thing. It increases U.S. exports and decreases imports. As Ms↑=> r↓=> I↑ => Y↑. (domestic market impact) Also, as r↓=> exchange rate depreciates=> NX↑ => Y↑ (international market impact)

Open Economy - Fiscal Policy Flexible Exchange Rates We know from earlier discussion, the multiplier is smaller with imports - some of the additional spending leaks out as imports, reducing the multiplier. At the same time – As income increases, the demand for money increases and interest rates increase causing the dollar to appreciate. Exports fall, imports rise, again reducing the multiplier. If interest rates rise, private investment may be crowded out, also lowering the multiplier. Putting it all together – Expansionary fiscal policy => Y ↑ => IM↑=> lower multiplier effect. as Y ↑ => Md↑ => r↑=> I↓ => Y ↓ (crowding-out). (domestic market impact) Also, as r↑=>exchange rate appreciates=> NX↓ => Y↓ (international market impact)

STOP HERE Arbitrage, Speculation, and Market Fundamentals The Expected Future Exchange Rate An expectation is a forecast. Exchange rate forecasts, like weather forecasts, are made over horizons that run from a few hours to many months and perhaps y But exchange rate forecasts are hedged with a lot of uncertainty, there are many divergent forecasts, and the forecasts influence the outcome. The dependence of today’s exchange rate on forecasts of tomorrow’s exchange rate can give rise to exchange rate volatility in the short run.