Exchange Rates and
Macroeconomic Policy
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
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
2
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
3
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
4
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
5
Figure 1: The Demand For British
Pounds
6
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
7
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
8
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
9
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
10
Figure 2: The Supply of British
Pounds
11
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
12
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
13
Figure 3: The Equilibrium Exchange
Rate
14
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)
15
Figure 4: Hypothetical Exchange
Rate Data Over Time
16
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
17
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
18
Figure 5: Hot Money In The Very
Short Run
Dollars
per Pound
£
S1
£
S2
$1.50
1.00
E
G
£
D2
Q1 Q2
£
1
D
Millions of
British Pounds
per Month
19
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
20
Figure 6: Exchange Rates in the
Short-Run
21
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
22
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
23
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
24
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
25
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
26
Figure 7: A Fixed Exchange Rate for
the Baht
27
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
28
Figure 8: A Foreign Currency Crisis
29
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
30
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
31
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
32
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
33
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
34
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
35
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?
36
Figure 9: Net Financial Flows Into the
United States as a Percent of GDP
37
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
38
Figure 10: How a U.S. Financial
Inflow Creates a U.S. Trade Deficit
39
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
40
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
41
Figure 11: The Growing U.S. Trade
Deficit with China
42
Figure 12: How an Undervalued Chinese
Yuan Can Create a U.S. Trade Deficit
43