©2018 Jennifer P. Wissink, all rights reserved. Trade & Macro Lecture 25 Dr. Jennifer P. Wissink ©2018 Jennifer P. Wissink, all rights reserved. May 2, 2018 1

The Open Economy with Flexible Exchange Rates Recall: The exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another. Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand. Haven’t always been flexible in the U.S. Not all countries have flexible exchange rates now. See Case, Fair & Oster appendix for history.

The Market for Foreign Exchange Consider only 2 countries: the US and the UK. Consider the market for pounds. What does a pound cost in dollars? Suppose 1 pound costs $1.40 (What does a dollar cost in pounds?) 1 dollar costs £0.72 The demand for pounds is comprised of holders of dollars wishing to acquire pounds. The supply of pounds is comprised of holders of pounds seeking to acquire dollars.

The Demand for Foreign Exchange: E.g., British Pounds THE DEMAND FOR POUNDS: derived from the need to obtain pounds to buy UK goods and services Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and services. US citizens traveling in Great Britain. Holders of dollars who want to buy British stocks, bonds, or other financial instruments. US companies that want to invest in Great Britain – build factories there. Speculators who anticipate a decline in the value of the dollar relative to the pound. US wanting to send foreign aid to the UK.

The Demand Curve for Pounds The demand for pounds is downward sloping. When the $price of pounds falls, British made goods and services appear less expensive to US buyers. If British prices are constant, US buyers will buy more British goods and services, and the quantity demanded of pounds will rise.

i>clicker question If the exchange rate goes from EROld to ERNew in this diagram, the dollar has appreciated relative to the pound. depreciated relative to the pound. EROld O ERNew N

The Supply of Foreign Exchange: E.g., British Pounds THE SUPPLY OF POUNDS: derived from the need to obtain dollars to buy US goods and services Firms, households, or governments that import US goods into Great Britain or wish to buy US-made goods and services. British citizens traveling in the United States. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States. British companies that want to invest in the United States. Speculators who anticipate a rise in the value of the dollar relative to the pound. The UK sending foreign aid to the US.

The Supply Curve for Pounds The supply of pounds is upward sloping. When the $price of pounds rises, the British can obtain more dollars for each pound. This means that US made goods and services appear less expensive to British buyers. Thus, the quantity of pounds supplied is likely to rise with the exchange rate.

The Equilibrium Exchange Rate An excess supply of pounds will cause the $price of pounds to fall, the dollar will appreciate against the pound, the pound will depreciate with respect to the dollar. An excess demand for pounds will cause the $price of pounds to rise, the dollar will depreciate against the pound, the pound will appreciate with respect to the dollar.

Purchasing Power Parity - The Law of One Price If the costs of transportation are small, and markets are free, the price of the same good in different countries should be roughly the same. If the law of one price held for all goods, and if each country consumed the same market basket of goods, the exchange rate between the two currencies would be determined simply by the relative price levels in the two countries. The theory that exchange rates are set so that the price of similar goods in different countries is the same is known as the purchasing-power parity. Do we always see that....?

ER Comparative Statics: Tastes i>clicker question If people in the US suddenly want more stuff from the UK then the dollar appreciates. the dollar depreciates. the pound appreciates. the pound depreciates. two answers above are correct.

ER Comparative Statics:  Relative Price Levels A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries there is a general tendency for the currency of relatively higher-inflation country to depreciate. E.g.: Suddenly more inflation in the US relative to the UK… increases the demand for pounds and decreases the supply of pounds. The result is an appreciation of the pound against the dollar. Or depreciation of the dollar against the pound.

ER Comparative Statics:  Relative Interest Rates The level of a country’s interest rates relative to interest rates in another country is another determinant of the exchange rate. For Example: If US interest rates fall relative to British interest rates then…, 1) US citizens may be relatively more attracted to British bonds & securities and 2) Brits are no longer so fond of US bonds & securities. So  we see an increase in the demand for pounds and a decrease in the supply of pounds. The result is a depreciation of the dollar against the pound. Or the dollar weakens against the pound.

ER Comparative Statics:  Relative Rates of Growth-Case A Suppose the US and the UK start to experience growth, and the US is growing faster than the UK. Expect that the US would import more stuff from the UK  demand for pounds increases. Expect that the UK would import more stuff from the US  supply of pounds increases. But if the US is growing faster than the UK, then the demand increase for pounds is larger than the supply increase of pounds. The result is a depreciation of the dollar against the pound. Or the dollar weakens! Sn Dn But…. If this is the case, then why does it seem that not so long ago many argued that the Chinese yuan should be getting stronger against the dollar when it was the case that China was growing faster than the US? According to this analysis, shouldn’t the yuan get weaker? Not stronger??

ER Comparative Statics:  Relative Rates of Growth-Case B (Export Led Growth) In China, growth has been export led, so it’s qualitatively different from the previous story. Let’s look at this from China’s eyes and the market for dollars in China. Both the US and China were growing – China faster than the US. But China was growing via its export markets. So… the increase in the supply of dollars to China by the US was larger than the increase in the demand for dollars by China. So… the yuan would strengthen against the dollar. yuan price of a dollar The prediction was that sooner or later the US would not want to import as much from China & China would want to import more from the US. The complaint often raised and debated was that the Chinese government kept the yuan artificially weak to support their export markets. SO O DO Quantity of $s

The Effects of Exchange Rate es on the Economy, i.e., on Y* If the $ depreciates  the $ is cheaper (weaker) US goods look cheaper to foreigners  EX  Foreign goods look more expensive to US  IM  U.S. products are more competitive in world markets, and foreign-made goods look expensive to U.S. citizens  get expansion in US economy and Y*   so depreciation of a currency can stimulate an economy.  BUT: What’s good for one is not good for all.  AND: Depreciation of $ tends to  price level. Do the opposite story for yourself…

Exchange Rate es and the Price Level SO... how does depreciation of a country’s currency tend to increase the price level? Recall: when the dollar weakens EX and IM  AD shifts rightward. If the economy is on the upward sloping part of SR-AS, the increase in aggregate demand is likely to result in higher prices in the U.S. If the price level rises in US, then wages have a tendency to eventually rise  SR-AS shifts left. Also: if import prices rise due to the weaker dollar, costs may rise for business firms,  SR-AS shifts left.

Monetary Policy w/ Flexible ER i>clicker question Will having flexible exchange rates tend to make monetary policy weaker or stronger? Weaker Stronger

Monetary Policy w/ Flexible ER A=weaker B=stronger Recall: Expansionary Monetary Policy So... with relatively lower interest rates in the US  an increase in the demand for pounds and a decrease in the supply of pounds  the dollar depreciates  EX  and IM   a boost in AEd  Y  a larger multiplier effect! So... if the purpose of the Fed is to stimulate the economy, dollar depreciation might be a good thing – it helps increase the efficacy of the monetary injection.