1. © 2008 Pearson Addison-Wesley. All rights reserved Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy Chapter 13

2. © 2008 Pearson Addison-Wesley. All rights reserved 13-2 Chapter Outline Exchange Rates –Nominal, Real, PPP, Exports How Exchange Rates Are Determined: A Supply-and-Demand Analysis [SKIP] The IS-LM Model for an Open Economy [SKIP the last two sections]

3. © 2008 Pearson Addison-Wesley. All rights reserved 13-3 Overview of the Forex Market How big? Nearly $4 trillion daily turnover (spot) –In comparison: $50 billion NYSE + NASDAQ Where? –London (34%), NY (16%), Tokyo (6%) What? –USD (86%), Euro (37%), JPY (16%), GBP (15%) Who? –Banks, Companies, Central Banks… –Deutsche Bank, UBS, Barclays

4. © 2008 Pearson Addison-Wesley. All rights reserved 13-4 Exchange Rates Nominal exchange rates –The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency 1 domestic currency = X foreign currency Denote the nominal exchange rate (or simply, exchange rate) as e nom in units of the foreign currency per unit of domestic currency USD/JPY: 96.5650 (=e nom ), EUR/USD: 1.2624 (e nom =0.7921)

5. © 2008 Pearson Addison-Wesley. All rights reserved 13-5 Exchange Rates Nominal exchange rates –Under a flexible-exchange-rate system or floating-exchange- rate system, exchange rates are determined by supply and demand and may change every day; this is the current system for major currencies –In the past, many currencies operated under a fixed- exchange-rate system, in which exchange rates were determined by governments (central banks). Some currencies are still using this system. USD/HKD=7.8, Bahamian Dollar= USD

6. © 2008 Pearson Addison-Wesley. All rights reserved 13-6 Exchange Rates Real exchange rates –The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good 1 domestic good = X units of foreign good Relative price of domestic good –If the nominal exchange rate is 100 yen per dollar, and it costs 1000 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger

7. © 2008 Pearson Addison-Wesley. All rights reserved 13-7 Exchange Rates Real exchange rates –The real exchange rate is the price of domestic goods relative to foreign goods, or e = e nom P/P For (13.1) –To simplify matters, we’ll assume that each country produces a unique good –In reality, countries produce many goods, so we must use price indexes to get P and P For –If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country

8. © 2008 Pearson Addison-Wesley. All rights reserved 13-8 Exchange Rates Appreciation and depreciation –In a flexible-exchange-rate system, when e nom falls, the domestic currency has undergone a nominal depreciation (or it has become weaker); when e nom rises, the domestic currency has become stronger and has undergone a nominal appreciation –In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a strengthening is called a revaluation –We also use the terms real appreciation and real depreciation to refer to changes in the real exchange rate (Summary 15)

9. © 2008 Pearson Addison-Wesley. All rights reserved 13-9 Exchange Rates Purchasing power parity (Law of One Price) –If there were no transportation costs, the real exchange rate would have to be e = 1, or else everyone would buy goods where they were cheaper. [no arbitrage!] –Setting e = 1 in Eq. (13.1) gives P = P For /e nom (13.2) “translate foreign price to domestic price” –This means that similar goods have the same price in terms of the same currency, a concept known as purchasing power parity, or PPP (Absolute)

10. © 2008 Pearson Addison-Wesley. All rights reserved 13-10 How does PPP change the ranking of GDP? Nominal GDP (in trillion dollars, by country, 2007) –US: 13.8 –Japan: 4.4 –Germany: 3.32 –China: 3.28 GDP (in trillion dollars, PPP, 2007) –US: 13.8 (per capita $45,725) –China: 7.0 (per capita $5,300) –Japan: 4.3 –Source: IMF

11. © 2008 Pearson Addison-Wesley. All rights reserved 13-11 Exchange Rates Purchasing power parity –Empirical evidence PPP holds in the long run but not in the short run Possible reasons: (1) Countries produce different goods (2) Some goods aren’t traded (3) Transportation costs (4) Legal barriers to trade

12. © 2008 Pearson Addison-Wesley. All rights reserved 13-12 Exchange Rates Box 13.1: McParity –As a test of the PPP hypothesis, the Economist magazine periodically reports on the prices of Big Mac hamburgers in different countries –The prices, when translated into dollar terms using the nominal exchange rate, range from just over $1 in China to over $5 in Switzerland (using 2006 data), so PPP definitely doesn’t hold

13. © 2008 Pearson Addison-Wesley. All rights reserved 13-13 Box 13.1 Price of a Big Mac

14. © 2008 Pearson Addison-Wesley. All rights reserved 13-14 Exchange Rates Box 13.1: McParity –The hamburger price data forecast movements in exchange rates Hamburger prices might be expected to converge, so countries in which Big Macs are expensive may have a depreciation, while countries in which Big Macs are cheap may have an appreciation USD/CNY (2006) around 8.0 USD/CNY (2008) around 6.8

15. © 2008 Pearson Addison-Wesley. All rights reserved 13-15 Exchange Rates Purchasing Power Parity –When absolute PPP doesn’t hold, using Eq. (13.1), we can decompose changes in the real exchange rate into parts Δe/e = Δe nom /e nom + ΔP/P – ΔP For /P For –This can be rearranged as Δe nom /e nom = Δe/e + π For – π (13.3) nominal appreciation = real appreciation + (lower rate of inflation than in the foreign country) (1)Higher relative price of good, higher nominal value of currency (2)Higher domestic inflation, lower nominal value of currency

16. © 2008 Pearson Addison-Wesley. All rights reserved 13-16 Exchange Rates Purchasing Power Parity (relative) –In the special case in which the real exchange rate doesn’t change, so that Δe/e = 0, the resulting equation in Eq. (13.3) is called relative purchasing power parity, since nominal exchange-rate movements reflect only changes in inflation Relative PPP: change of nominal exchange rate Absolute PPP: nominal exchange rate itself Relative PPP works well as a description of exchange-rate movements in high-inflation countries, since in those countries, movements in relative inflation rates are much larger than movements in real exchange rates

17. © 2008 Pearson Addison-Wesley. All rights reserved 13-17 Exchange Rates The real exchange rate and net exports –The real exchange rate (also called the terms of trade) is important because it represents the rate at which domestic goods and services can be traded for those produced abroad An increase in the real exchange rate means people in a country can get more foreign goods for a given amount of domestic goods, discouraging (net) exports. Changes in net exports affect overall economic activity and are a primary channel through which business cycles and macroeconomic policy changes are transmitted internationally

18. © 2008 Pearson Addison-Wesley. All rights reserved 13-18 Exchange Rates The real exchange rate and net exports –The real exchange rate affects net exports through its effect on the demand for goods A high real exchange rate makes foreign goods cheap relative to domestic goods, so there’s a high demand for foreign goods (in both countries) With demand for foreign goods high, net exports decline Thus the higher the real exchange rate, the lower a country’s net exports –Empirical evidence confirms the relationship (see Fig13.2).

19. © 2008 Pearson Addison-Wesley. All rights reserved 13-19 Figure 13.2 The U.S. real exchange rate and net exports as a percentage of GDP, 1973-2006

20. © 2008 Pearson Addison-Wesley. All rights reserved 13-20 Exchange Rates The real exchange rate and net exports –But, does the desired change of net exports happen immediately after the change of real exchange rate? –The J curve It takes time for exports to respond to the change in exchange rate Although a fall in the real exchange rate will increase net exports in the long run, in the short run it may be difficult to quickly change imports and exports Pay more for imports and receive less for exports assuming no change in volumes of imports and exports. As industries adjust, net exports will rise eventually.

21. © 2008 Pearson Addison-Wesley. All rights reserved 13-21 Figure 13.1 The J Curve

22. © 2008 Pearson Addison-Wesley. All rights reserved 13-22 How Exchange Rates Are Determined: A Supply-and-Demand Analysis What causes changes in the exchange rate? –To analyze this, we’ll use supply-and-demand analysis, assuming a fixed price level –Holding prices fixed means that changes in the real exchange rate are matched by changes in the nominal exchange rate – Δe nom /e nom = Δe/e + π For – π (13.3) where π For = π = 0

23. © 2008 Pearson Addison-Wesley. All rights reserved 13-23 How Exchange Rates Are Determined What causes changes in the exchange rate? –The nominal exchange rate is determined in the foreign exchange market by supply and demand for the currency –Demand and supply are plotted against the nominal exchange rate, just like demand and supply for any good (Fig. 13.3)

24. © 2008 Pearson Addison-Wesley. All rights reserved 13-24 Figure 13.3 The supply of and demand for the dollar

25. © 2008 Pearson Addison-Wesley. All rights reserved 13-25 How Exchange Rates Are Determined What causes changes in the exchange rate? –Supplying dollars means offering dollars in exchange for the foreign currency –The supply curve slopes upward, because if people can get more units of foreign currency for a dollar, they’ll supply more dollars –Demanding dollars means wanting to buy dollars in exchange for the foreign currency –The demand curve slopes downward, because if people need to give up a greater amount of foreign currency to obtain one dollar, they’ll demand fewer dollars

26. © 2008 Pearson Addison-Wesley. All rights reserved 13-26 How Exchange Rates Are Determined Why do people demand or supply dollars? –These transactions involving dollars are the two main categories in the balance of payments accounts: the current account and the capital and financial account –People need dollars for two reasons: To be able to buy U.S. goods and services (U.S. exports) To be able to buy U.S. real and financial assets (U.S. financial inflows) –People want to sell dollars for two reasons: To be able to buy foreign goods and services (U.S. imports) To be able to buy foreign real and financial assets (U.S. financial outflows)

27. © 2008 Pearson Addison-Wesley. All rights reserved 13-27 How Exchange Rates Are Determined Factors that increase demand for U.S. exports and assets will increase demand for dollars, shifting the demand curve to the right and increasing the nominal exchange rate –For example, an increase in the quality of U.S. goods relative to foreign goods will lead to an appreciation of the dollar (Fig. 13.4)

28. © 2008 Pearson Addison-Wesley. All rights reserved 13-28 Figure 13.4 The effect of increased export quality on the value of the dollar

29. © 2008 Pearson Addison-Wesley. All rights reserved 13-29 How Exchange Rates Are Determined Macroeconomic determinants of the exchange rate and net export demand –Look at how changes in real output or the real interest rate are linked to the exchange rate and net exports, to develop an open-economy IS-LM model

30. © 2008 Pearson Addison-Wesley. All rights reserved 13-30 How Exchange Rates Are Determined Macroeconomic determinants of the exchange rate and net export demand –Effects of changes in output (income) A rise in domestic output (income) raises demand for goods and services, including imports, so net exports decline To increase purchases of imports, people must sell the domestic currency to buy foreign currency, increasing the supply of foreign currency, which reduces the exchange rate The opposite occurs if foreign output (income) rises –Domestic net exports rise –The exchange rate appreciates

31. © 2008 Pearson Addison-Wesley. All rights reserved 13-31 How Exchange Rates Are Determined Macroeconomic determinants of the exchange rate and net export demand –Effects of changes in real interest rates A rise in the domestic real interest rate (with the foreign real interest rate held constant) causes foreigners to want to buy domestic assets, increasing the demand for domestic currency and raising the exchange rate The rise in the exchange rate leads to a decline in net exports (and a balance of payments) The opposite occurs if the foreign real interest rate rises –Domestic net exports rise –The exchange rate depreciates

32. © 2008 Pearson Addison-Wesley. All rights reserved 13-32 Summary 16

33. © 2008 Pearson Addison-Wesley. All rights reserved 13-33 Summary 17