1. © Pilot Publishing Company Ltd. 2005 Chapter 12 International Finance I --- Exchange Rate

2. © Pilot Publishing Company Ltd. 2005 Contents: Definitions Relation between domestic price and foreign priceRelation between domestic price and foreign price Exchange rate system Changes in the demand for and supply of foreign currencyChanges in the demand for and supply of foreign currency Determinants of the equilibrium exchange rate Automatic adjustment for BOP deficits under different exchange rate systemsAutomatic adjustment for BOP deficits under different exchange rate systems

3. © Pilot Publishing Company Ltd. 2005 Contents: Government policies on eliminating BOP deficit under a fixed exchange rate systemGovernment policies on eliminating BOP deficit under a fixed exchange rate system Comparison between flexible and fixed exchange rate systemsComparison between flexible and fixed exchange rate systems

4. © Pilot Publishing Company Ltd. 2005 Definitions

5. © Pilot Publishing Company Ltd. 2005 Definitions Foreign exchange (fe) refers to  foreign currency  or claims on foreign currency such as cheques drawn in the currency

6. © Pilot Publishing Company Ltd. 2005 Exchange rate or exchange value of a foreign currency (e) is the price of the currency (in terms of another currency). Without specification of the currency, it is the amount of domestic currency required to exchange for a unit of foreign currency. Note: When e , exchange value of foreign currency rises while that of domestic currency drops. Effective exchange rate index is the price index of exchange rates of the domestic currency. Note: When the index , the exchange value of the domestic currency rises.

7. © Pilot Publishing Company Ltd. 2005 Relation between Domestic Price and Foreign Price

8. © Pilot Publishing Company Ltd. 2005 Relation between domestic price and foreign price Domestic price of a good is its price in domestic currency (P d ). Foreign price of a good is its price in foreign currency (P f ). P d = e P f or P f = P d /e

9. © Pilot Publishing Company Ltd. 2005 The slopes of the demand curve for and the supply curve of foreign currency  The demand curve for foreign currency is downward sloping. Imports: When e rises, QmQm QmQm 

10. © Pilot Publishing Company Ltd. 2005 The slope of the supply curve (S) of foreign currency depends on the price elasticity of foreign demand for the country’s exports (E). 1. If E is elastic  S is upward sloping 2. If E is unitarily elastic  S is vertical 3. If E is inelastic  S is downward sloping  QxQx QxQx  Exports: when e rises

11. © Pilot Publishing Company Ltd. 2005 Exchange Rate System

12. © Pilot Publishing Company Ltd. 2005 Exchange rate systems An economic agent who demands foreign currency on the one hand supplies domestic currency on the other hand and vice versa. Exchange between currencies

13. © Pilot Publishing Company Ltd. 2005 Price of foreign currency in domestic currency (or exchange rate) Quantity of foreign currency S D Equilibrium exchange rate Demand for and supply of foreign currency

14. © Pilot Publishing Company Ltd. 2005 Price of domestic currency in foreign currency Quantity of domestic currency S D Equilibrium exchange rate Demand for and supply of domestic currency

15. © Pilot Publishing Company Ltd. 2005 Types of exchange rate systems Flexible / Floating exchange rate system  Demand for & supply of foreign currency  determines the market exchange rate Fixed exchange rate system  The monetary authority  fixes the official exchange rate (at a pre-announced value)

16. © Pilot Publishing Company Ltd. 2005 Price of foreign currency in domestic currency (e) Quantity of foreign currencyS D Equilibrium exchange rate e* Balance of payments under different exchange rate systems Flexible exchange rate system As Q d = Q s, the market BOP must always be balanced. The equilibrium e* will finally be reached at which Q d = Q s 0

17. © Pilot Publishing Company Ltd. 2005 Price of foreign currency in domestic currency (or exchange rate ) Quantity of foreign currency S D Equilibrium exchange rate At e 1, excess demand for foreign currency exists (the country suffers BOP deficit) Fixed exchange rate system e* e1e1 Foreign currency is under-valued  At the pre-announced e, Q d may not equal Q s.

18. © Pilot Publishing Company Ltd. 2005 At e 1,  Excess demand for foreign currency  Central Bank / Monetary Authority has to sell foreign currency for domestic currency (  reserve assets & domestic money supply  )  Exchange rate maintained at e 1 Fixed exchange rate system

19. © Pilot Publishing Company Ltd. 2005 Price of domestic currency in foreign currency Quantity of domestic currency S D Equilibrium exchange rate Excess supply of domestic currency Fixed exchange rate system e* e1^e1^ Domestic currency is over-valued An alternative expression

20. © Pilot Publishing Company Ltd. 2005 Terms describing changes in exchange rate Under a flexible exchange rate system, a rise in the price of a foreign currency is described as an appreciation of the foreign currency or a depreciation of the domestic currency (as more units of domestic currency are needed to exchange for a unit of foreign currency). Under a fixed exchange rate system, a rise in the price of a foreign currency is described as a revaluation of the foreign currency or a devaluation of the domestic currency.

21. © Pilot Publishing Company Ltd. 2005 Changes in the Demand for and Supply of Foreign Currency

22. © Pilot Publishing Company Ltd. 2005 S D’ Exchange rate Quantity of foreign currency 0 D Demand for foreign currency increases e’ e If e is flexible, e rises If e is fixed, Q d > Q s, i.e., BOP deficit results

23. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 Supply of foreign currency decreases S’ S D e’ e If e is flexible, e rises If e is fixed, Q d > Q s, i.e., BOP deficit results

24. © Pilot Publishing Company Ltd. 2005 Demand for foreign currency  or supply of foreign currency   The equilibrium exchange rate  Conclusion  Flexible e system  Fixed e system  dc depreciates  BOP deficit

25. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e’ e D’ D If e is flexible, e falls If e is fixed, Q s > Q d, i.e., BOP surplus results S Demand for foreign currency decreases

26. © Pilot Publishing Company Ltd. 2005 Supply of foreign currency increases Exchange rate Quantity of foreign currency 0 S D e’ e If e is flexible, e falls If e is fixed, Q s > Q d, i.e., BOP surplus results S’

27. © Pilot Publishing Company Ltd. 2005 Demand for foreign currency  or supply of foreign currency   The equilibrium exchange rate  Conclusion  Flexible e system  Fixed e system  dc appreciates  BOP surplus

28. © Pilot Publishing Company Ltd. 2005 Determinants of the Equilibrium Exchange Rate

29. © Pilot Publishing Company Ltd. 2005 Protectionist measures Spending on imports  Exchange rate Quantity of foreign currency 0 e’ e S D’ D  Demand for fc   Demand for fc  Flexible e system: dc appreciates. Fixed e system: BOP surplus.

30. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ S’ More domestic investment opportunities Outflow of capital  & inflow of capital  Outflow of capital  & inflow of capital  Demand for fc  & supply of fc  D’ Flexible e system: dc appreciates. Fixed e system: BOP surplus.

31. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ D’ National income rises  Spending on imports   Spending on imports  National income   Demand for fc   Demand for fc  Flexible e system: dc depreciates. Fixed e system: BOP deficit.

32. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ S’ Interest rate rises Outflow of capital  & inflow of capital  Outflow of capital  & inflow of capital  Demand for fc  & supply of fc  D’ Flexible e system: dc appreciates. Fixed e system: BOP surplus.

33. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ D’ Money Supply rises r   outflow of capital  & inflow of capital   D  & S  r   outflow of capital  & inflow of capital   D  & S  M s   LM shifts rightward  r  & Y  M s   LM shifts rightward  r  & Y  Y   Spending on imports   D  Flexible e system: dc depreciates. Fixed e system: BOP deficit. S’

34. © Pilot Publishing Company Ltd. 2005 Inflation Inflation rate of a country  that of its trading partner 1. Competitiveness of import-competing products   spending on imports   Demand for fc   Demand for fc 

35. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ D’ S’ 2. Foreign prices of the country’s exports  Volume of exports & receipts from exports  Supply of fc  If foreign demand for the country’s exports is elastic Flexible e system: dc depreciates. Fixed e system: BOP deficit.

36. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e S D e’ S’ Outflow of capital  & inflow of capital  Outflow of capital  & inflow of capital  Demand for fc  & supply of fc  D’ Flexible e system: dc appreciates. Fixed e system: BOP surplus. Speculation upon the value of a currency A bullish speculation upon the domestic currency

37. © Pilot Publishing Company Ltd. 2005 Automatic Adjustment for BOP Deficits under Different Exchange Rate Systems

38. © Pilot Publishing Company Ltd. 2005 Automatic adjustment for BOP deficits under different exchange rate systems Under a flexible e system BOP Deficit  excess D for fc  e  QmQm QmQm Imports: Exports:    QxQx QxQx 

39. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e’ e S D Depreciation can improve the BOP deficit Excess Demand If foreign demand for the country’s exports is elastic

40. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e’ e S D Excess Demand Depreciation can improve the BOP deficit If the demand for exports is unitarily elastic

41. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e’ e DS If the demand for exports is inelastic and the M-L condition holds Depreciation can improve the BOP deficit Excess Demand

42. © Pilot Publishing Company Ltd. 2005 Marshall-Lerner condition (M-L condition):  The sum of the price elasticities of foreign demand for the country’s exports and the country’s demand for foreign imports is greater than one.

43. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 e D S Excess Demand Depreciation cannot improve the BOP deficit and e rises persistently If the demand for export is inelastic but the M-L condition does not hold

44. © Pilot Publishing Company Ltd. 2005 Under a fixed exchange rate system r Y0 IS LM’ LM Y Y’ r’ r Facing a BOP deficit Central bank sells foreign currency for domestic currency  M s   Y  & r   M s   Y  & r 

45. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 Fixed e S’ D’ D S Y   spending on imports   D  Y   spending on imports   D   The process continues until deficit  0 r   outflow of capital  & inflow of capital   D  & S  r   outflow of capital  & inflow of capital   D  & S 

46. © Pilot Publishing Company Ltd. 2005 Government Policies on Eliminating BOP Deficit under a Fixed Exchange Rate System

47. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 Fixed e D’ D S Protectionist policy Spending on imports   Demand for fc   Demand for fc   External deficit 

48. © Pilot Publishing Company Ltd. 2005 Quantity of foreign currency 0 Exchange rate S D D’ Fixed e S’ An increase in interest rate Outflow of capital  & inflow of capital  Outflow of capital  & inflow of capital  Demand for fc  & supply of fc   External deficit 

49. © Pilot Publishing Company Ltd. 2005 Contractionary policy -- Prices are rigid Quantity of foreign currency 0 Exchange rate D S D’ Fixed e Y   spending on imports   Demand for fc   Demand for fc   External deficit 

50. © Pilot Publishing Company Ltd. 2005 Exchange rate Quantity of foreign currency 0 Original fixed e D S Devaluation New fixed e The Marshall-Lerner condition is required.

51. © Pilot Publishing Company Ltd. 2005 Comparison between Flexible and Fixed Exchange Rate Systems

52. © Pilot Publishing Company Ltd. 2005 Advantages of flexible e system (or disadvantages of fixed e system)  Allocate resources efficiently  No BOP problem  No need to hold a large amount of reserve assets  Government policies are free to achieve domestic objectives  Insulated from imported inflation

53. © Pilot Publishing Company Ltd. 2005 Disadvantages of flexible e system (or advantages of fixed e system)  Bring uncertainty to businessmen  Arouse speculation  Enhance domestic inflation

54. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. There is no BOP problem because the payments must always be balanced. 2. Some economic transactions are favourable to an economy but some are not. 3. The gain from trade is determined by the balance of payments. 4. The supply curve of foreign currency must be upward sloping.

55. © Pilot Publishing Company Ltd. 2005 5. Depreciation or devaluation can resolve the problem of payments deficit. 6. Without government intervention, a BOP deficit will persist under a fixed exchange rate system. Correcting Misconceptions: