Ch. 10: The Exchange Rate and the
Balance of Payments.
 Exchange rates
• Definition
• Determinants
• Short run
• Long run
• Purchasing power parity
• Interest rate parity
 Balance of payments accounts
 Causes of an international deficit
 Alternative exchange rate policies and their long-run
effects
Currencies and Exchange Rates
U.S. Citizens sell dollars in the foreign exchange
market in order to purchase foreign currency to
• purchase imports
• purchase foreign assets (stocks, bonds, real estate, etc.)
Foreign citizens buy dollars in the foreign exchange
market with foreign currency in order to
• Purchase U.S. exports
• Purchase U.S. assets.
Currencies and Exchange Rates
Foreign Exchange Rates
•The price at which one currency exchanges for another is.
Currency depreciation
• A fall in the value of one currency in terms of another currency
• Makes country’s imports more expensive
• Makes country’s exports more affordable to trading partners
Currency appreciation
•A rise in value of one currency in terms of another currency.
•Opposite effect of depreciation on imports/exports.
Suppose that the exchange rate is 7 pesos per dollar. If
you are in Mexico and must pay 120 pesos for a round of
golf, it will cost you $_____ (give your answer to nearest
dollar, no dollar sign – e.g. 37)
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If the exchange changes from 8 yuan per
dollar to 10 yuan per dollar, relative to the
yuan, the dollar has _____ and the cost of
U.S. imports from China _____.
a) Appreciated; increased
b) Depreciated; increased
c) Appreciated; decreased.
d) Depreciated; decreased.
d.
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Current exchange rates: http://finance.yahoo.com/currency-investing
Between 2008 and 2009, the dollar
appreciated relative to the Mexican peso.
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The trade-weighted index is the average exchange rate
of the U.S. dollar against other currencies, with individual
currencies weighted by their importance in U.S.
international trade.
The Foreign Exchange Market
The Demand for One Money Is the Supply of Another
Money
When people who are holding one money want to
exchange it for U.S. dollars, they demand U.S. dollars and
they supply that other country’s money.
Factors that influence the demand for U.S. dollars also
influence the supply of foreign currencies.
Factors that influence the demand for another country’s
currency also influence the supply of U.S. dollars.
The Foreign Exchange Market
The Law of Demand for Foreign Exchange
• The demand for dollars is a derived demand.
• People buy U.S. dollars so that they can buy U.S.produced goods and services or U.S. assets.
• Other things remaining the same, the higher the
exchange rate, the smaller is the quantity of U.S. dollars
demanded in the foreign exchange market.
The Foreign Exchange Market
The exchange rate influences the quantity of U.S. dollars
demanded for two reasons:
 Exports effect
 As P of $ drops, foreign citizens wish to purchase more U.S.
exports and more $.
 Expected profit effect
The lower today’s exchange rate, other things remaining the same,
the larger is the expected profit from buying U.S. assets and the
greater is the quantity of $ demanded today
The Foreign Exchange Market
Supply of $ in the Foreign Exchange Market
The quantity $ supplied in the foreign exchange market
is the amount that traders plan to sell during a given time
period at a given exchange rate.
The Foreign Exchange Market
The Law of Supply of Foreign Exchange
Other things remaining the same, the higher the
exchange rate, the greater is the quantity of $ supplied in
the foreign exchange market.
Imports effect
• As P of $ rises, U.S. citizens increase imports and sell more $ to
purchase more imports.
 Expected profit effect
• As P of $ rises, U.S. citizens see greater potential for profits in
foreign assets and sell more $ to purchase more foreign assets.
The Foreign Exchange Market
Market Equilibrium
If $ is “too strong”,
surplus of $
If $ is “too weak”,
shortage of $
Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
• Changes in exchange rate cause movement along the demand
curve, NOT a change in demand.
Changes in Demand for $ caused by:
•
•
•
•
World demand for U.S. exports
U.S. interest rate relative to the foreign interest rate
Expected profits on U.S. assets relative to profits on foreign assets
The expected future exchange rate
Exchange Rate Fluctuations
Changes in the Supply of Dollars
•Changes in the exchange rate cause a movement along the supply
curve, NOT a change in supply
Changes in the supply of dollar are caused by:
 U.S. demand for imports
 U.S. interest rates relative to the foreign interest rate
 Expected profits on U.S. assets relative to profits on foreign assets
 The expected future exchange rate
If U.S. demand for Chinese imports falls
as a result of our recession, we should
expect the dollar to _____ relative to the
yuan because the ____ dollars will fall.
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If the Chinese become less willing to buy
U.S. bonds because of concerns about
default, the dollar will ______ because the
_______ dollars will decrease.
a) Appreciate; demand for
b) Depreciate; demand for
c) Appreciate; supply
d) Depreciate; supply of
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If everyone begins to believe that the
dollar will strengthen over the next
several months, this should cause:
a) An increase in
the demand for $
b) An increase in
the supply of $
c) A decrease in the
supply of $
d) Both A and B
e) Both A and C
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20%
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Exchange Rate Fluctuations
Exchange Rate Expectations
The exchange rate changes when it is expected to
change.
But expectations about the exchange rate are driven by
deeper forces. Two such forces are
 Interest rate parity
 Purchasing power parity
Interest Rate Parity
Expected $ return on investment in foreign currency =
interest rate on foreign currency +
expected change in value of foreign currency
Interest rate parity exists when interest rates are such that
expected returns on currencies are equal across countries.
Market forces achieve interest rate parity very quickly.
Example:
•U.S. interest rate=5%; German interest rate=8%
–What’s required for interest rate parity?
Interest Rate Parity
Example:
U.S. pays 5% interest; Japan pays 4% interest; Value of
$ expected to appreciate by 3% over next year.
•Where will U.S. citizens buy bonds?
•Japanese buy bonds?
•Effect on interest rates in U.S. and Japan
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U.S. pays 5% interest; Japan pays 8%
interest; Value of $ expected to depreciate
by 5% over next year. People should buy
their bonds from:
a) U.S.
50%
50%
b) Japan
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U.S. pays 5% interest; Japan pays 8% interest;
Value of $ expected to depreciate by 5% over
next year. Given the observed buying pattern in
prior problem, we should expect interest rates to
___ in U.S. and ___ in Japan.
25%
25%
25%
25%
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a) Rise; fall
b) Rise; rise
c) Fall; fall
d) Fall; rise
Purchasing Power Parity
Exists when the exchange rate is such that a currency
has the same “purchasing power” in all countries.
If PPP did not exist, one could take advantage of
“arbitrage” opportunities:
• buy item at low price and sell at high price
• drives up price in low price country and drives down price
in high price country.
Purchasing Power Parity
Suppose $1 = 2 francs, price of gold=$500 in U.S. and
800 francs in France.
What’s the arbitrage opportunity?
What will happen to price of gold in
U.S.
France
What will happen to price of $?
Purchasing Power Parity
In the long run, because of PPP:
Exchange rate between foreign currency and dollar =
price in foreign country / price in U.S.
% ch in price of $ (exchange rate)=
% ch in foreign price - % ch in U.S. prices
Purchasing Power Parity
Links for exercises below are on eco202 Website.
•Gold prices and exchange rates
•Big Mac Index
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Suppose exchange rate is .75 Euros per
dollar. The price of gold is $600 per
ounce in U.S.; 500 euros per ounce in
Euro-zone. Arbitrage would cause gold
prices to ____ in U.S. and ___ in Eurozone:
25% 25% 25% 25%
a) Rise; rise
b) Rise; fall
c) Fall; fall
d) Fall; rise
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Financing International Trade
Balance of Payments Accounts
Record a country’s international trading, borrowing, and
lending.
Transactions leading to an inflow of currency into the
U.S. create a + (credit) in a balance of payments account
Transactions leading to an outflow of currency from the
U.S. create a – (debit) in a balance of payments account.
Financing International Trade
Three balance of payments accounts
1. Current account
The current accounts balance equals the sum of exports minus
imports, net interest income, and net transfers.
2. Capital account
Foreign investment in the United States minus U.S. investment
abroad.
3. Official settlements account
•records the change in U.S. official reserves.
•U.S. official reserves are the government’s holdings of foreign
currency
•If U.S. official reserves increase, the official settlements account is
negative.
The sum of the three account balances is zero.
Financing International Trade
Borrowers and Lenders
A country that is borrowing more from the rest of the
world than it is lending to it is called a net borrower.
A country that is lending more to the rest of the world
than it is borrowing from it is called a net lender.
The United States is currently a net borrower but
during the 1960s and 1970s, the United States was a
net lender.
Financing International Trade
Debtors and Creditors
•A debtor nation is a country that during its entire history has
borrowed more from the rest of the world than it has lent to it.
•Since 1986, the United States has been a debtor nation.
•A creditor nation is a country that has invested more in the rest of
the world than other countries have invested in it.
•The difference between being a borrower/lender nation and being a
creditor/debtor nation is the difference between stocks and flows of
financial capital.
Financing International Trade
Being a net borrower does not reduce long term
economic growth provided the borrowed funds are used to
finance capital accumulation that increases income.
Being a net borrower can reduce economic growth if the
borrowed funds are used to finance consumption.
Financing International Trade
Current Account Balance
The current account balance (CAB) is
CAB = NX + Net interest income + Net transfers
The main item in the current account balance is net
exports (NX).
The other two items are much smaller and don’t fluctuate
much.
Financing International Trade
The government sector surplus or deficit is equal to
net taxes, T, minus government expenditures on goods
and services G.
The private sector surplus or deficit is saving, S,
minus investment, I.
Net exports is equal to the sum of government sector
balance and private sector balance:
NX = (T – G) + (S – I)
Financing International Trade
For the United States in 2006,
Net exports is a deficit of $784 billion, which equals the
sum of the government sector deficit of $313 billion and
the private sector deficit of $471 billion.
Financing International Trade
The Three Sector Balances
The private sector
balance and the
government sector balance
tend to move in opposite
directions.
Net exports is the sum of
the private sector and
government sector
balances.
Exchange Rate Policy
Three possible exchange rate policies are
 Flexible exchange rate
 Fixed exchange rate
 Crawling peg
Flexible Exchange Rate
A flexible exchange rate policy is one that permits the
exchange rate to be determined by demand and supply
with no direct intervention in the foreign exchange market
by the central bank.
Exchange Rate Policy
Fixed Exchange Rate
pegs the exchange rate at a value decided by the
government or central bank and that blocks the
unregulated forces of demand and supply by direct
intervention in the foreign exchange market.
A fixed exchange rate requires active intervention in the
foreign exchange market.
Exchange Rate Policy
Suppose that the target
is 100 yen per U.S. dollar.
If demand increases, the
central bank sells U.S.
dollars to increase supply.
Effect of “undervalued
dollar” and subsequent
intervention on
1. U.S. money supply?
2. U.S. Inflation?
Exchange Rate Policy
If demand decreases,
the central bank buys
U.S. dollars (with foreign
reserves) to decrease
supply.
Effect of “over-valued”
dollar and subsequent
intervention on:
1. U.S. money supply
and reserves of
foreign currency
2. U.S. inflation
Exchange Rate Policy
Crawling Peg
• selects a target path for the exchange rate with
intervention in the foreign exchange market to achieve that
path.
• China is a country that operates a crawling peg.
• Crawling peg works like a fixed exchange rate except that
the target value changes.
• Avoids wild swings in the exchange rate
Exchange Rate Policy
People’s Bank of China
in the Foreign exchange
Market
China’s official foreign
currency reserves are
piling up.
Exchange Rate Policy
The People’s bank buys
U.S. dollars to maintain the
target exchange rate.
China’s official foreign
reserves increase.
Based on diagram, is $
over- or under-valued
relative to Chinese Yuan?
If there is a fixed exchange rate system
and the dollar is “undervalued”, the U.S.
central bank will be forced to ___ dollars
which will ___ the U.S. money supply
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