Chapter 22 Money, Exchange Rates, and Currency Areas Introduction to Economics (Combined Version) 5th Edition

Foreign Exchange Markets  Foreign exchange markets include all markets where the currency of one country is exchanged for that of another.  Consumers, businesses, and central banks—all participate.  In recent decades, the Fed has not actively participated in foreign exchange markets, yet the central banks of many other countries do so regularly. Introduction to Economics (Combined Version) 5th Edition

Supply and Demand for Foreign Exchange  Dollars are supplied by U.S. residents who want to buy Mexican goods or services, or to make investments in Mexico.  The exchange rate of the peso to the dollar depends on supply and demand.  Dollars are demanded by Mexican residents who want to buy U.S. goods and services or make investments in the United States. Introduction to Economics (Combined Version) 5th Edition

A Change in Supply: An Example  In 2009, an outbreak of swine flu in Mexico reduced tourist travel, shifting the supply curve of dollars to the left.  The result was a depreciation of the peso (appreciation of the dollar), that is, an equilibrium exchange rate with more pesos per dollar. Introduction to Economics (Combined Version) 5th Edition

A Change in Demand: An Example  Suppose an increase in U.S. interest rates makes U.S. securities more attractive to Mexican investors.  The result is an increased demand for dollars.  The peso depreciates (the dollar appreciates). Introduction to Economics (Combined Version) 5th Edition

Nominal and Real Exchange Rates  Nominal exchange rate: the rate at which banks carry out exchanges of one currency for another to serve the needs of traders and travelers  Real exchange rate: the nominal exchange rate which is adjusted to reflect inflation (in both the domestic and foreign economies)  The simplest way to calculate real exchange rate is as follows: Let H = nominal exchange rate expressed as units of domestic currency per unit of foreign currency. h = real exchange rate Pd = domestic price level Pf = foreign price level Then: h = H (Pf/Pd). Introduction to Economics (Combined Version) 5th Edition

Real Effective Exchange Rate (REER) and Purchasing Power Parity (PPP)  The REER is a weighted average of bilateral exchange rates, using as weights the shares of each currency in a given country’s imports and exports.  Purchasing power parity means a situation in which goods cost the same in one country as in another when prices are compared using the market exchange rate. Introduction to Economics (Combined Version) 5th Edition Purchasing Power Parity and International Economic Comparisons

An Exchange Rate Operating Target  Some central banks use the exchange rate as an operating target.  If the demand for dollars increases, the peso would depreciate if nothing was done.  To prevent depreciation, the Mexican central bank increases the supply of dollars by selling dollars from its foreign currency reserves. Introduction to Economics (Combined Version) 5th Edition

Reasons for a Fixed Exchange Rate Target Two principal reasons to maintain an exchange rate target:  To reduce the risks and costs of international trade in goods and services  To anchor the domestic currency to a stable foreign currency in order to fight inflation Introduction to Economics (Combined Version) 5th Edition

When a Fixed Exchange Rate Works Best  An exchange rate target works best for small countries with flexible economies, strong trading links to the currency partner, and low exposure to external shocks.  Countries that do not want to use an exchange rate in the long run can use an exchange rate target temporarily to stop inflation, but then they should have an exit strategy. Introduction to Economics (Combined Version) 5th Edition Mexico has maintained a fixed exchange rate for the peso at some times in the past, but not recently.

Exchange Rate Management in China (1)  Until 2005, the People’s Bank of China (PBoC) held the exchange rate of the Chinese yuan at a fixed value relative to the U.S. dollar. From 2005 to 2008, it allowed the yuan to appreciate gradually. During the global financial crisis that began in 2008, it returned to a fixed exchange rate policy. Starting in mid-2010, it once again allowed gradual appreciation. Introduction to Economics (Combined Version) 5th Edition

Exchange Rate Management in China (2)  Part (a) shows that the PBoC’s efforts to resist appreciation of the yuan led to steady growth of foreign exchange reserves from 2004 through the end of The central bank paid for those reserves with newly issued Chinese yuan, which added to the country’s money stock. Part (b) shows that as a result, in part, of the growing money stock, China experienced repeated episodes of inflation during the period. Introduction to Economics (Combined Version) 5th Edition

Currency Unions  Currency Union takes place when two or more countries share a common currency.  There are four conditions of being favorable or unfavorable to a common currency:  Patterns of Trade: If a group of countries trade mostly with one an- other, the case for a common currency is stronger because the re- duction in costs and risks of trade will be greater.  Structural Similarities: If a group of countries share a similar eco- nomic structure, so that external shocks affect them similarly, they are more suited to form a currency union.  Flexibility of Labor Markets: If labor markets are flexible, unemployed workers from one part of a currency union may be able to find jobs in other regions where conditions are better.  Fiscal Policy: Fiscal policy means government policy regarding spending, taxes, and government debt. Introduction to Economics (Combined Version) 5th Edition

Currency Unions  Currency Union takes place when two or more countries share a common currency.  The Eurozone is the most important currency area in the world today.  Some other countries share currencies, too. For example, Panama and Ecuador, and some other small countries use the U.S. dollar. Introduction to Economics (Combined Version) 5th Edition Headquarters of the European Central Bank, central bank of the Eurozone

The Current Crisis of the Euro Area  This chart shows the divergence of competitiveness, as measured by unit labor costs, among members of the euro area. Relatively rapid growth of unit labor costs in countries like Greece and Italy has been due in part to slow growth of labor productivity and higher rates of inflation. With a single currency, countries that have lost competitiveness have not been able to restore it through depreciation of their currencies. Introduction to Economics (Combined Version) 5th Edition

More Slideshows Introduction to Economics (Combined Version) 5th Edition More classroom-ready slideshows on foreign exchange rates and currency areas: Estonia Joins the Euro: What can we Learn? This slideshow examines how well Estonia fits the criteria for membership in a currency union.Estonia Joins the Euro: What can we Learn? The Breakup of the Ruble Area: Lessons for the Euro For a brief period after the breakup of the Soviet Union, the 15 successor states shared the ruble as their currency. This slideshow explains why the ruble area collapsed and compares it to the euro area. The Breakup of the Ruble Area: Lessons for the Euro If you have trouble with the links on this slide, check the index of slideshows on Ed Dolan’s Econ Blog, (dolanecon.blogspot.com)