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.

The Foreign Exchange Market 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 price at which one currency exchanges for another is called the exchange rate. A fall in the value of one currency in terms of another currency is called currency depreciation e.g., the value of the US dollar falls from 2 euros/dollar to 1 euro/ dollar – the dollar depreciates. A rise in value of one currency in terms of another currency is called currency appreciation In the above example: the value of the euro appreciates from 0.5 dollars/euro to 1 dollar/ euro.

May 2, 2017. Euro Depreciation

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 demand for US dollars in the foreign exchange market - a negative relationship between the price of dollars (yen per dollar, (¥/$) and the quantity of dollars demanded. When the price of the dollar falls (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 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.

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 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 (curve shifts) for U.S. dollars. These other influences are World demand for U.S. exports (Boeing Aircraft) U.S. interest rate relative to the foreign interest rate The expected future exchange rate (not covered)

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. 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 How the demand curve for U.S. dollars shifts in response to changes in Demand for U.S. exports U.S. interest rates differential

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. interest rates relative to the foreign interest rate The expected future exchange rate (not covered)

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 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

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 European investors …. or US interest rates are high relative to foreign interest rates … 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 European investors …. or US interest rates fall relative to foreign interest rates. 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 European stocks become more attractive to US investors …. or foreign interest rates are more attractive to US investors …. 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 European stocks become less attractive to US investors …. or foreign interest rates are _____attractive to US investors …. 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 (SKIP) 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.

Arbitrage and Speculation Speculation (SKIP Pages 220 to end of chapter and focus on next 7 slides ) 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 Higher inflation 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, British buyers see U.S. goods getting more expensive and reduce their demand for U.S. exports. 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 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 If U.S. interest rates rise relative to British interest rates, British citizens holding pounds will be attracted into the U.S. securities market. To buy bonds in the United States, British buyers 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 the pound depreciates and the 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 more competitive in world markets, and foreign-made goods look expensive to U.S. citizens. Exports increase and imports decrease. A depreciation of a country’s currency is likely to increase NX and increase RGDP. If the economy is operating close to capacity, the increase in aggregate demand is likely to result in higher prices.

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) Monetary policy is more effective.

Open Economy - Fiscal Policy Flexible Exchange Rates We know from earlier discussion, the multiplier is smaller with imports - as income increases, 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. Also, as interest rates rise, private investment may be crowded out, also lowering the multiplier.

Open Economy - Fiscal Policy Flexible Exchange Rates 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) Fiscal policy is less effective.