1. Exchange Rates and Macroeconomic Policy

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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)

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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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?

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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