Ec 123 Section 81 THIS SECTION Case. Mexico: From Stabilized Development to Debt Crisis NEXT Hong Kong Financial Crisis

Ec 123 Section 82 Currency Exchange ($ for Peso) (Mexico Perspective) Quantity of exchange Price of Peso in Dollars S Peso D Peso $ Demand for $ to Peso exchange comes from Americans: Buying Mexican exports Travel to Mexico. ‘Investing’ in Mexico. Speculation Supply of Peso to $ exchange comes from Mexicans: Buying U.S. Imports Travel to U.S. ‘Investing’ in the U.S. Speculation Central Banks

Ec 123 Section 83 Fixed Exchange Rates are a Price Support Quantity of exchange Price of Peso in Dollars S Peso D Peso $ Demand for $ to Peso exchange increases. For example, American demand for Mexican products increases. The central bank must increase the supply of Peso to $ exchange. D’ Peso S’ Peso The government commits to a fixed or pegged price of their currency. The peso is UNDERVALUED or its price would APPRECIATE without govt. influence.

Ec 123 Section 84 Fixed Exchange Rates are a Price Support Quantity of exchange Price of Peso in Dollars S Peso D Peso $ Supply for Peso to $ exchange INCREASES. For example, there is speculation that the Peso will devalue. The central bank must increase the demand for Peso to keep the exchange rate up. D’ Peso S’ Peso The government commits to a fixed or pegged price of their currency. The peso is OVERVALUED or its price would DEPRECIATE without govt. influence.

Ec 123 Section 85 Impact of Fixed Exchange Rates If the currency is UNDERVALUED: Central Banker must meet excess demand for the currency by supplying it. –Must be following an expansionary monetary policy. Shows up as DEBIT on official settlements in BOP: –(Own) Currency is flowing out; Currency reserves (other country’s currencies) or gold increasing. Exports are cheaper; imports are more expensive than what they would be without the fixed rate. If the currency is OVERVALUED. Central Banker must meet excess demand for the currency by supplying it. –Must be following a contractionary monetary policy. Shows up as CREDIT on official settlements in BOP: –(Own) Currency is flowing in; Currency reserves (other country’s currencies) or gold decreasing. Exports are more expensive; imports are cheaper than what they would be without the fixed rate.

Ec 123 Section 86 Timing of Impact on Foreign Exchange Markets Influences on foreign exchange markets can be categorized by time interval in which they have an impact: Short Run –Interest rate fluctuations –Expectations Intermediate Run –Fluctuations in goods, services and investment transactions –Example: Recession dampens demand for imports Long Run –Purchasing-Power Parity –Expectations

Ec 123 Section 87 Some useful questions Why do countries attempt to control the exchange rate? What happens when a currency devalues (or depreciates)?

Ec 123 Section 88 Real Exchange Rate The real exchange rate is the exchange rate adjusted for price- level differences among countries. –Provides a measure of the amount of goods your money will buy in another country. Formally, E R = E ×(P domestic /P foreign ) Sometimes it easier to think of in terms of % changes: %ΔE R =%ΔE + %ΔP domestic - %ΔP foreign Where %Δmeans ‘percentage change.’

Ec 123 Section 89 Purchasing-Power Parity Purchasing-Power Parity theory says that the quantity of goods & services a currency can buy (or its purchasing power) should be the same in all countries. –Based upon the microeconomic assumption of the law of one price. –Only works for goods that are tradable. – Transportation costs and other transaction costs are assumed to be low.

Ec 123 Section 810 Purchasing-Power Parity In the long run the real exchange rate must be 1, or E R =1= E × (P domestic /P foreign ) or P foreign = E × P domestic Links exchange rate pressures to inflation: %ΔE = %ΔP foreign - %ΔP domestic

Ec 123 Section 811 The Big Mac Index Big Mac Price in $ Implied PPP of the $ Valuation against the $ (%) USA China Euro Japan Iceland* Source: The Economist May 8, 2009, *June 2008

Ec 123 Section 812 Mexico: From Stabilized Development to Debt Crisis What were the pressures on Mexico to devalue the peso?

Ec 123 Section 813 Mexico: From Stabilized Development to Debt Crisis Who (or what) was most at fault for the debt crisis? Could this happen to the U.S.?