The International Monetary System: Order or Disorder? 19

What Are Exchange Rates? Exchange rate Price of a country’s currency in terms of another country’s currency. Appreciate A unit of a currency buys more units of foreign currency Depreciate A unit of a currency buys fewer units of foreign currency Depreciation to one country must be an appreciation to the other. 2

What Are Exchange Rates? An example: 1 pound = $1.60 or 62.5 pence = $1 If pound appreciates: 1 pound = $2 Dollar depreciates: $1 = 50 pence 3

Table 1 Exchange Rates with the U.S. Dollar 4

Devaluation and Revaluation Decrease/increase in currency set by governments Devaluation Reduction in the official value of a currency A unit of a nation’s currency buys fewer units of foreign currency Revaluation Increase in the official value of a currency A unit of a nation’s currency buys more units of foreign currency 5

Exchange Rate Determination: Free Market Floating exchange rates Rates determined in free markets by the law of supply and demand Equilibrium exchange rate occurs where the quantity demanded is equal to the quantity supplied If the market exchange rate increases in value - appreciation and if decreases in value - depreciation 6

Determination of Exchange Rates in a Free Market 7 Price of a Euro (in dollars) Number of Euros S S D D $1.50 E Supply of Euros represents demand for Dollars Demand for Euros represents supply of Dollars.

Exchange Rate Determination Demand for a country’s currency International trade in goods and services Purchases of physical assets Trade in financial assets Supply of a country’s currency Arises from its imports of goods and services Foreign investment by its own citizens 8

Exchange Rate Determination What happens to the value of the Euro if Europeans become concerned about the safety of US assets Supply less Euros since demand less dollars Euro will appreciate 9

Figure 2 The Effect of Declining Demand for U.S. Assets on the Exchange Rate 10 Price of a Euro (in dollars) Number of Euros S1S1 S1S1 D D $1.50 E $1.70 S2S2 S2S2 A

Exchange Rate Determination Non clicker-clicker question. What happens to the value of the Euro if American investors become worried about profit prospects on German stock market A boom in France leads to more French purchases of American goods Interest rates on government bonds rise in the United States but are stable in Italy 11

Exchange Rate Determination In the short run, major determinants Interest rates and interest rate differentials What happens when yields on American bonds increase relative to British bonds? US bonds become more attractive to American and British investors. 12

The Effect of a Rise in U.S. Interest Rates 13 Price of a Pound (in dollars) Number of Pounds S1S1 S1S1 D1D1 D1D1 $1.75 E1E1 $1.50 D2D2 D2D2 S2S2 S2S2 E2E2

Exchange Rate Determination In general, Countries that offer investors higher rates of return attract more capital A rise in interest rates is expected to lead to an appreciation of the currency A drop in interest rates is expected to lead to an depreciation of the currency 14

Exchange Rate Determination Medium run (it takes time for changes in GDP to occur) Want to consider affect on exchange rates of rising or falling incomes What happens to the value of the Euro if US economy booms? American have more income and the demand for British imports increases. 15

The Effect of an Economic Boom Abroad on the Exchange Rate 16 Price of a Euro (in dollars) Number of Euros S S D1D1 D1D1 $1.50 E $1.60 D2D2 D2D2 A What if Europe is also booming?

The Effect of an Economic Boom Abroad on the Exchange Rate 17 Price of a Euro (in dollars) Number of Euros S1 D1D1 D1D1 $1.50 E D2D2 D2D2 A What if Europe is also booming? C S2

Exchange Rate Determination In general in the medium run If a country grows faster than the rest of the world Imports – grow faster than exports Demand curve for foreign currency shifts outward more rapidly than the supply curve Other things equal, currency depreciates But a booming economy attract will attract investors So currency should appreciate 18

Exchange Rate Determination Which effect wins? Trade in financial assets Stronger economic performance often leads to currency appreciation because it improves prospects for investing in the country. 19

Exchange Rate Determination The Long-Run: Purchasing-power parity theory of exchange rate determination The exchange rate between any two national currencies adjusts to reflect differences in the price levels in the two countries The Steel example – American Steel cost $300 per ton and German Steel cost 200 euros per ton. The exchange rate will be $300/200 = $1.50 per euro. What happens at $1.60? What happens at $1.40? 20

Exchange Rate Determination Purchasing-power parity theory Differences in domestic inflation rates are a major cause of exchange rate movements If one country has higher inflation than another, its exchange rate should depreciate Why? Doesn’t always hold in actuality. This is “all other things constant” analysis. There more to exchange rate movements that trade in goods and services – primarily financial transactions. 21

Market(floating) Exchange Rate Determination Three main points 1.Currency appreciation in countries that offer investors higher rates of return 2.But these countries will also be importing relatively more than other countries, which tends to pull their currencies down 3.Currency values generally will appreciate in countries with lower inflation rates than the rest of the world’s 22

Fixed Rates: The Balance of Payments Fixed exchange rates Rates set by government decisions and maintained by government actions Balance of payments deficit The amount by which the quantity supplied of a country’s currency (per year) exceeds the quantity demanded Arises whenever the exchange rate is pegged at an artificially high level 23

A Balance of Payments Deficit 24 Price of a Peso (in dollars) Billions of Pesos per Year S S D D 0.50 E B A Balance of payments deficit

Fixed Rates: The Balance of Payments How does the government of Argentina maintain the peso at $1? Must buy the 4 billion peso surplus But, they need dollars to do that. Lose $4 billion in reserves 25

Fixed Rates: The Balance of Payments Balance of payments surplus The amount by which the quantity demanded of a country’s currency (per year) exceeds the quantity supplied Arises whenever the exchange rate is pegged at an artificially low level 26

A Balance of Payments Surplus 27 Price of a Yuan (in dollars) Billions of Yuan per Year S S D D 0.16 E $ ,000 B A Balance of payments surplus

Fixed Rates: The Balance of Payments How does the Chinese government maintain the yuan at $0.16? Must sell the 400 billion yuan surplus Gain $64 billion in reserves What’s the difference between the yuan and peso example The accumulation of reserves does not force a central bank to revalue in the way that sufficiently large losses of reserves can force a devaluation. 28

Fixed Rates: The Balance of Payments Two main parts to the balance of payments Current account balance International purchases and sales of goods and services Cross-border interest and dividend payments Cross-border gifts to and from private individuals and governments Approximately = Net exports U.S. has large current account deficits: IM > X 29

Fixed Rates: The Balance of Payments Capital account balance Purchases and sales of financial assets to and from citizens and companies of other countries U.S. has large capital account surplus Balance of payment = Current account + Capital account 30

Fixed Rates: The Balance of Payments Does the overall balance of payments balance? Yes, if the exchange rate is floating All private transactions must add up to zero Dollars purchased equals dollars sold Not necessarily if the exchange rate is fixed Government purchases or sales of foreign currency make up for the deficit or surplus STOP HERE! 31