Exchange Rates and Macroeconomic Policy

Exchange Rates and Macroeconomic Policy If you’ve ever traveled to a foreign country, you were a direct participant in the foreign exchange market Market in which one country’s currency is traded for that of another Even if you haven’t traveled abroad, you’ve been involved indirectly in all kinds of foreign exchange dealings In this chapter, we’ll look at the markets in which dollars are exchanged for foreign currency Also expand our macroeconomic analysis to consider effects of changes in exchange rates

Foreign Exchange Markets and Exchange Rates Every day more than a hundred different national currencies are exchanged for one another In banks, hotels, stores, and kiosks in airports and train stations How can we hope to make sense of these markets—how they operate and how they affect us? Basic approach is to treat each pair of currencies as a separate market In any foreign exchange market, rate at which one currency is traded for another is called the exchange rate between those two currencies

Dollars Per Pound or Pounds Per Dollar? Can think of any exchange rate in two ways As so many units of foreign currency per dollar Or so many dollars per unit of foreign currency We’ll always define exchange rate as “dollars per unit of foreign currency” Exchange rate is price of foreign currency in dollars How are all these exchange rates determined? In most cases, they are determined by familiar forces of supply and demand Each foreign exchange market reaches an equilibrium at which quantity of foreign exchange demanded is equal to quantity supplied We’ll build a model of supply and demand for a representative foreign exchange market One in which U.S. dollars are exchanged for British pounds

The Demand for British Pounds To analyze demand for pounds, start with a very basic question Who is demanding them? Anyone who has dollars and wants to exchange them for pounds In our model of market for pounds, we assume that American households and businesses are the only buyers Why do Americans want to buy pounds? To buy goods and services from British firms To buy British assets

Figure 1a: The Demand For British Pounds Dollars per Pound Millions of British Pounds A drop in the price of the pound moves us rightward along demand for pounds curve A $2.25 E 1.50 D£ 200 300

Figure 1b: The Demand For British Pounds Dollars per Pound Millions of British Pounds The demand for pounds curve shifts rightward when: U.S. real GDP ↑ U.S. relative price level ↑ U.S. tastes shift toward British goods U.S. interest rate ↓ Pound is expected to appreciate

The Demand For Pounds Curve Curve tells us quantity of pounds Americans will want to buy in any given period, at each different exchange rate Curve slopes downward The lower the exchange rate, the greater the quantity of pounds demanded Why does a lower exchange rate—a lower price for the pound—make Americans want to buy more of them? Because the lower the price of the pound, the less expansive British goods are to American buyers As we move rightward along demand for demand for pounds curve, as in the move from point A to point E

Shifts in the Demand for Pounds Curve If any of these variables changes, entire curve will shift Keep in mind that we are assuming that only one of them changes at a time; we suppose the rest to remain constant U.S. real GDP Relative price levels Americans’ tastes for British goods Relative interest rates Expected changes in the exchange rate

The Supply of British Pounds Demand for pounds is one side of market for pounds Other side is supply of pounds In real world, pounds are supplied from many sources In our model of market for pounds, we assume that British households and firms are the only sellers British supply pounds in the dollar—pound market for only one reason They want dollars Thus, to ask why the British supply pounds is to ask why they want dollars To buy goods and services from American firms To buy American assets

The Supply of Pounds Curve Supply curve for foreign currency Curve tells us quantity of pounds British will want to sell in any given period, at each different exchange rate Curve slopes upward The higher the exchange rate, the greater is the quantity of pounds supplied Why does a higher exchange rate—a higher price for the pound—make the British want to sell more of them? Because the higher the price for the pound, the more dollars someone gets for each pound sold As we move rightward along the supply of pounds curve, such as the move from point E to point F

Figure 2a: The Supply of British Pounds Dollars per Pound Millions of British Pounds S£ F $2.25 1.50 E A rise in the price of the pound moves us rightward along supply of pounds curve 300 400

Figure 2: The Supply of British Pounds Dollars per Pound Millions of British Pounds The supply of pounds curve shifts rightward if: British real GDP↑ U.S. relative price level↓ British tastes shift toward U.S. goods U.S. interest rate↑ Pound is expected to depreciate

Shifts in the Supply of Pounds Curve When exchange rate changes, we move along supply curve for pounds But other variables can affect supply of pounds besides exchange rate Real GDP in British Relative price levels British tastes for U.S. goods Relative interest rates Expected change in the exchange rate

The Equilibrium Exchange Rate Important—and in most cases, realistic—assumption Exchange rate between dollar and pound floats Is freely determined by forces of supply and demand Without government intervention to change it or keep it from changing In come cases, however, governments do not allow exchange rate to float freely Instead manipulate its value by intervening in market, or even fix it at a particular value When exchange rate floats, price will settle at level where quantity supplied and quantity demanded are equal Intersection of demand curve and supply curve

Figure 3: The Equilibrium Exchange Rate Dollars per Pound Dollars per Pound S£ S£ Higher U.S. real GDP leads to a higher price per pound C $2.00 E Equilibrium in the market for pounds $1.50 1.50 E D£ Millions of British Pounds Millions of British Pounds 300 300

What Happens When Things Change? What would cause price of pound to rise or fall? Simple answer—anything that shifts demand for pounds curve, or supply of pounds curve, or both curves together Appreciation An increase in price of a currency in a floating-rate system Depreciation A decrease in price of a currency in a floating-rate system When a floating exchange rates changes, one country’s currency will appreciate (rise in price) and other country’s currency will depreciate (fall in price)

Figure 4: Hypothetical Exchange Rate Data Over Time Dollars per Unit of Foreign Currency B A E C Years

How Exchange Rates Change Over Time When we examine actual behavior of exchange rates over time, we find three different kinds of movements Figure 4 Sharp up-and-down spikes Gradual rise and fall of exchange rate over course of several months or a year or two While price of foreign currency fluctuates in very short-run and short-run, can also discern a general long-run trend

The Very Short Run: “Hot Money” Banks and other large financial institutions collectively have trillions of dollars worth of funds that they can move from one type of investment to another at very short notice Often called “hot money” Sudden changes in relative interest rates, as well as sudden expectations of an appreciation of depreciation of a nation’s currency, occur frequently in foreign exchange markets Can cause massive shifts of hot money from assets of one country to those of another in very short periods of time Relative interest rates and expectations of future exchange rates are dominant forces moving exchange rates in very short-run

Figure 5: Hot Money In The Very Short Run Dollars per Pound $1.50 E 1.00 G Millions of British Pounds per Month Q1 Q2

The Short Run: Macroeconomic Fluctuations What explains movements in short-run rate—changes that occur over several months or a few years? In most cases, causes are economic fluctuations taking place in one or more countries In short-run, movements in exchange rates are caused largely by economic fluctuations All else equal, a country whose GDP rises relatively rapidly will experience a depreciation of its currency A country whose GDP falls more rapidly will experience an appreciation of its currency Observation contradicts a commonly-held myth That a strong (appreciating) currency is a sign of economic health, and a weak (depreciating) currency denotes a sick economy Keep in mind, though, that other variables can change over the business cycle besides real GDP Including interest rates and price levels in the two countries These changes will influence exchange rates over business cycle

Figure 6: Exchange Rates in the Short-Run (b) Dollars per Pound Dollars per Pound S£ $1.80 B $1.80 B 1.50 A 1.50 C Millions of British Pounds Millions of British Pounds

The Long Run: Purchasing Power Parity In mid-1992, you could buy about 100 Russian rubles for one dollar In mid-1998, that same dollar would get you more than 6,000 rubles—so many that the Russian government that year created a new ruble that was worth 1,000 of the old rubles Movements of hot money—which explain sudden, temporary movements of exchange rates—cannot explain this kind of long-run trend Nor can business cycles, which are, by nature, temporary In general, long-run trends in exchange rates are determined by relative price levels in two countries According to purchasing power parity (PPP) theory, exchange rate between two countries will adjust in long-run until average price of goods is roughly the same in both countries PPP theory has an important implication In long-run, currency of a country with a higher inflation rate will depreciate against currency of a country whose inflation rate is lower Why? Because in country with higher inflation rate, relative price level will be rising

Purchasing Power Parity: Some Important Caveats While purchasing power parity is a good general guideline for predicting long-run trends in exchange rates, it does not work perfectly Some goods—by their very nature—are difficult to trade High transportation costs can reduce trading possibilities even for goods that can be traded Artificial barriers to trade can hamper traders’ ability to move exchange rates toward purchasing power parity Such as special taxes or quotas on imports Still, purchasing power parity theory is useful in many circumstances Indeed, often observe that countries with very high inflation rates have currencies depreciating against dollar By roughly amount needed to preserve purchasing power parity

Government Intervention In Foreign Exchange Markets When exchange rates float, they can rise and fall for a variety of reasons But a government may not be content to let forces of supply and demand change its exchange rate If exchange rate rises, country’s goods will become much more expansive to foreigners, causing harm to its export-oriented industries If exchange rate falls, goods purchased from other countries will rise in price Since many imported goods are used as inputs by U.S. firms (such as oil from the Middle East and Mexico, or computer screens from Japan), a drop in exchange rate will cause a rise in U.S. price level If exchange rate is too volatile, it can make trading riskier or require traders to acquire special insurance against foreign currency losses Costs them money, time, and trouble For all of these reasons, governments sometimes intervene in foreign exchange markets involving their currency

Managed Float Many governments let their exchange rate float most of the time But will intervene on occasion when floating exchange rate moves in an undesired direction to become too volatile Central banks of many countries—including Federal Reserve—will sometimes intervene in this way in foreign exchange markets Under a managed float, a country’s central bank actively manages its exchange rate Buying its own currency to prevent depreciations, and selling its own currency to prevent appreciations Managed floats are used most often in very short-run To prevent large, sudden changes in exchange rates Almost every nation holds reserves of dollars—as well as euros, yen, and other key currencies Just so it can enter the foreign exchange market and sell them for its own currency when necessary Managed floats are controversial

Fixed Exchange Rates More extreme form of intervention is a fixed exchange rate Government declares a particular value for its exchange rate with another currency Government, through its central bank, then commits itself to intervene in the foreign exchange market any time equilibrium exchange rate differs from fixed rate When a country fixes its exchange rate below equilibrium value, result is an excess demand for the country’s currency To maintain fixed rate, country’s central bank must sell enough of its own currency to eliminate excess demand When a country fixes its exchange rate above the equilibrium value, result is an excess supply of country’s currency To maintain fixed rate, country’s central bank must buy enough of its own currency to eliminate excess supply Fixed exchange rates present little problem for a country as long as exchange rate is fixed at or very close to its equilibrium rate

Figure 7a: A Fixed Exchange Rate for the Baht 2. Here the supply and demand curves show the equilibrium exchange rate is $.06 per baht. Dollars per Baht Sbaht $0.06 Excess Demand 0.04 Dbaht 1. In both panels, Thailand fixes the exchange rate at $.04 per baht. 3. Thai Central Bank must sell 300 million baht to keep the baht from appreciating. 0.02 100 400 Millions of Baht per Month

Figure 7b: A Fixed Exchange Rate for the Baht Dollars per Baht 4. With these supply and demand curves, the equilibrium exchange rate is $.02 per baht. 5. Thai Central Bank must buy 300 million baht to keep the baht from depreciating $0.06 Sbaht Excess Supply 0.04 0.02 Dbaht 100 400 Millions of Baht per Month

Foreign Currency Crises, the IMF, and Moral Hazard Figure 8 shows how a fixed exchange rate can be problematic Devaluation A change in exchange rate from a higher fixed rate to a lower fixed rate A foreign currency crisis arises when people no longer believe that a country can maintain a fixed exchange rate above equilibrium rate As a consequence, supply of the currency increases, demand for it decreases Country must use up its reserves of dollars and other key currencies even faster in order to maintain fixed rate Once a foreign currency crisis arises, a country typically has no choice but to devalue its currency or let it float and watch it depreciate Because country waited for crisis to develop, exchange rate may for a time drop even lower than original equilibrium rate

Figure 8: A Foreign Currency Crisis Dollars per Baht A $0.04 Excess Supply 0.02 B 100 400 Millions of Baht per Month

Foreign Currency Crises, the IMF, and Moral Hazard Moral hazard occurs when a decision maker (such as an individual, firm, or government) expects to be rescued in event of an unfavorable outcome Then changes its behavior so that unfavorable outcome is more likely Plagues insurance industry, efforts to care for unemployed, and troubled business firms Problem of moral hazard helps explain the very different response of IMF when Argentina faced a somewhat similar foreign currency crisis as that of Thailand Bush administration—concerned about moral hazard problem—encouraged the IMF to take a tough stand There was no rescue, and Argentina was forced into devaluation and default in January 2002

The Euro One answer to problems that countries have encountered in managing their own currencies is to adopt another country’s currency or an international currency On January 1, 2002, 12 European countries—including Germany, France, Italy, and Spain—introduced their new common currency, the euro Why did these 12 European countries decide to do away with their national currencies? Single currency means that European firms—when they buy or sell across borders—no longer have to pay commissions on exchange of currency Or face risk that exchange rates might change before accounts are settled Elimination of exchange rate risk makes it easier for European firms to sell stocks and bond to residents anywhere in Euroland Adopting a single currency makes cross-country comparison shopping easier Some of these countries—such as Italy—have had a history of loose monetary policy that has generated high rates of inflation, and high expected inflation

Optimum Currency Areas Downsides to euro Some economists believe that—at least for a while—euro will create significant problems for Euroland countries Economists who worry about these problems question whether Europe is an optimum currency area Region whose economies will perform better with a single currency rather than separate national currencies Labor is highly mobile from one country to another At present, labor is much less mobile across European borders than across American states In very long-run, abolition of national currencies—and the creation of the euro—may work to increase labor mobility across Europe Especially if it changes attitudes of European firms and workers toward cross-national employment

Exchange Rates and Demand Shocks Depreciation of dollar causes net exports to rise—a positive spending shock that increases real GDP in short-run Appreciation of dollar causes net exports to drop—a negative spending shock that decreases real GDP in short-run Impact of net exports on equilibrium GDP—often caused by changes in exchange rate—helps us understand one reason why governments are often concerned about their exchange rates An unstable exchange rate can result in repeated shocks to economy

Exchange Rates and Monetary Policy Fed tries to keep U.S. economy on an even keel with monetary policy Central banks around world are engaged in a similar struggle, and face many of the same challenges as Fed Expansionary monetary policy causes aggregate expenditures to rise in two ways Increasing interest-sensitive spending Increasing net exports As a result, equilibrium GDP rises by more—and monetary policy is more effective—when effects on exchange rates are included

Exchange Rates and Monetary Policy Channels through which monetary policy works are summarized in the following schematic Analysis of contractionary monetary policy is the same, but in reverse Channel of monetary influence through exchange rates and volume of trade is important part of full story of monetary policy in United States In countries where exports are relatively large fractions of GDP—such as those of Europe—trade channel is even more important Main channel through which monetary policy affects economy Monetary policy has a stronger effect when we include impact on exchange rates and net exports, rather than just impact on interest-sensitive consumption and investment spending

Using the Theory: The Stubborn U.S. Trade Deficit U.S. trade deficit is often in the news Extent to which a country’s imports exceed its exports Trade deficit = imports – exports When exports exceed imports, a nation has a trade surplus Trade surplus = exports – imports United States has had large trade deficits with the rest of world since early 1980s Why? Before we analyze causes of trade deficit, need to do a little math U.S. trade deficit = U.S. net financial inflow Tells us how trade deficit is financed Trade deficit can arise because of forces that cause a financial inflow How do forces that create a financial inflow also cause a trade deficit?

Figure 9: Net Financial Flows Into the United States as a Percent of GDP Inflow (Percent of GDP) -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 2000 1985 1990 1995 1970 1980 1975 2002

Using the Theory: From A Financial Inflow to a Trade Deficit Figure 10 illustrates this process, using yen-dollar market An increase in desire of foreigners to invest in United States contributes to an appreciation of the dollar As a result, U.S. exports—which become more expensive for foreigners—decline Imports—which become cheaper to Americans—increase Result is a rise in U.S. trade deficit What explains huge financial inflow that began in 1980s, and has grown larger over the past decade? Even when U.S. interest rates are the same or lower than abroad, it seems that residents of other countries have a strong preference for holding American assets

Figure 10: How a U.S. Financial Inflow Creates a U.S. Trade Deficit Dollars per Yen A Japanese purchases of U.S. Assets $0.015 C 0.010 B Decrease in Japan's imports to U.S. Increase in Japan's exports to U.S. D¥ Billions of Yen per Year 10,000 15,000 12,000

Using the Theory: From A Financial Inflow to a Trade Deficit In late 1990s, there was another reason for the growing financial inflow American companies took lead in using opportunities offered by internet Under floating exchange rates, financial inflow equals trade deficit Thus, the story of U.S. financial inflow of 1980s, 1990s, and 2000s is also the story of U.S. trade deficit Can trace rise in trade deficit during recent decades to two important sources Relatively high interest rates in 1980s Long-held preference for American assets that grew stronger in 1990s Each of these contributed to a large financial inflow, a higher value for the dollar, and a trade deficit

Using the Theory: The Growing Trade Deficit with China In addition to a strong desire to buy U.S. assets, a trade deficit can arise from another cause A foreign currency fixed at an artificially low value Figure 11 shows U.S. imports to, and exports from, China from 1988 to 2002 U.S. trade deficit with China has been soaring for a variety of reasons Including special trade agreements during this period that gave China new access to U.S. markets Chinese trade policies that have encouraged exports and discouraged imports Figure 12 illustrates how an undervalued yuan can create a trade deficit for U.S. When a U.S. trading partner fixes dollar price of its currency below its equilibrium value, U.S. exports—which become more expensive to foreigners—decline U.S. imports—which become cheaper to Americans—increase Result is a rise in U.S. trade deficit China’s fixed exchange rate with the dollar is source of considerable tension between the two countries On the other hand, it enables Americans to purchase cheap goods from China But trade with China also disrupts production in the U.S. economy U.S. businesses that produce sandals, shoes, suits, electronic goods, toys and textiles find they are unable to compete with cheaper goods from China

Figure 11: The Growing U.S. Trade Deficit with China $ Billions 125 U.S. imports from China 100 80 60 U.S. exports to China 40 U.S. trade deficit with China 20 1988 1990 1992 1994 1996 1998 2000 2002

Figure 12: How an Undervalued Chinese Yuan Can Create a U. S Figure 12: How an Undervalued Chinese Yuan Can Create a U.S. Trade Deficit Dollars per Yuan Equilibrium value of Yuan SYUAN A $0.20 B C Increase in China's exports to U.S. 0.12 Fixed value of Yuan DYUAN Decrease in China's imports from U.S. 200 700 1,000 Billions of Yuan per Year