Foreign Exchange Rates

Do FOREX rates affect the BP? No – in the long-run; in equilibrium: Yes – in the short-run; in disequilibrium:

No- in the long-run: in equilibrium Recall that the only thing that really matters for BP in long-run was domestic economic conditions of I-S + T-G = X-M. FOREX rates simply reflect the relative ‘Nominal Economic Conditions’ and ‘Real Economic Conditions’ of the two countries.

Nominal conditions? Relative Monetary conditions Particularly, relative Money Supply conditions Interest Rate Differentials and Relative Price Level 1) i – if affects capital account 2)S = P / Pf affects trade account 3) Note that i (if )and P(Pf)are eventually all related to M and Mf.

Thus in a two-country model, The external value of a country with a less increase in money supply and thus with a less inflation will get stronger than that of the other country.

Real Conditions? * If there occurs Macroeconomic Innovations or Productivities, then FOREX will simply reflect it: Still FOREX rates do not ‘cause’ productivity changes or innovations.

In a two-country model, FOREX rates will change in the way that a country with more innovation and higher productivity will have a higher value of its currency against the other country.

Yes – in the short-run; in disequilibrium: FOREX rates can affect Exports and Imports in the short-run to some extent. X = X(Yf , S Pf/P; many others such as Productivity, Quality, Innovations) M = M(Yf , S Pf/P; many others)