Ch. 9: 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
Supply of $
•Created when 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.)
Demand for $
• Created when Foreign citizens buy dollars in the foreign
exchange market with foreign currency 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.
Currency depreciation
• A fall in the value of one currency in terms of another
currency
– Makes imports more expensive
– Makes exports more affordable
Currency appreciation
•A rise in value of one currency in terms of another
currency.
1/EXUSEU = Euros/$
Current exchange rates at http://finance.yahoo.com/currency-investing
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. (Higher value implies
stronger $)
What determines exchange rates?
The Foreign Exchange Market
The Demand for One Currency Is the Supply of
Another Currency
Foreign citizens demanding U.S. dollars supply
their own 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 Law of Demand for Foreign Exchange
Ceteris paribus, as the P of $ drops, quantity of $
demanded rises
 Exports effect
 As P of $ drops
foreign citizens wish to purchase more U.S. exports
quantity of $ demanded rises.
 Expected profit effect
As P of $ drops,
the larger the expected profit from buying U.S. assets
quantity of $ demanded rises
The Law of Supply of Foreign Exchange
Ceteris paribus, as P of $ rises, 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 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 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
Exchange Rate Fluctuations
Exchange Rate Expectations
The exchange rate changes when it is expected to
change.
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
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
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
= NX + Net interest income + Net transfers
2. Capital account
=Foreign invest. in the U.S. - U.S. invest. 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 net borrower has
• current account deficit
•capital account surplus
A net lender has
•current account surplus
•Capital account deficit
The U.S. is currently a net borrower but during the
1960s and 1970s, the U.S. was a net lender.
Financing International Trade
Debtors and Creditors
•A debtor nation
–country that owes more than other countries owe to it.
•A creditor nation
–a country that owes less than other countries owe to it.
•Since 1986, the United States has been a debtor nation.
•Borrower/lender status based upon one year
•Debtor/creditor status based upon entire history of
borrowing/lending.
Financing International Trade
Is being a net borrower “bad”?
• does not reduce long term economic growth if funds are
used to finance capital accumulation
•can reduce economic growth if the borrowed funds are
used to finance consumption.
•difficult to determine whether U.S. is borrowing for
consumption or capital accumulation.
–Low savings rates in U.S. may be a concern.
Financing International Trade
Determinants of U.S. borrowing/lending from rest of world
C+S+T=C+I+G+NX (T=net taxes)
NX=(S-I) + (T-G)
• (S-I) = private sector balance
• (T-G) = public sector balance
if balance>0, surplus
if balance<0, deficit
Ceteris paribus, U.S. borrowing from rest of
world rises as public or private sector balance
decreases
Financing International Trade
For the United States in 2010,

Net exports were -$536 billion.

Government sector balance was -$1,295 billion

Private sector balance was $759 billion
Financing International Trade
The Three Sector
Balances
Private sector and
government sector
balance tend to move in
opposite directions.
Net exports is sum of
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
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?
Exchange Rate Policy
People’s Bank of
China in the Foreign
exchange Market
China’s official foreign
currency reserves were
rising until 2007. Stable
and falling since.
China will buy $ to drive
up price of $; sell $ to
drive down price of $.
Maintaining fixed exchange rates
If China wishes to maintain its exchange rate relative to
the dollar, how will each of the following affect
Chinese build-up of dollar reserves?
• An increase in inflation in China relative to U.S. inflation
• An increase in U.S. interest rates relative to China
• An increase in U.S. demand for Chinese exports.
• An increase in Chinese demand for U.S. exports