International Trade
Exchange Rates and Open
Macroeconomic Models
October 17, 2006
 International trade is more complicated
than domestic trade.
 There are no national borders to be
crossed when, say, California wine is
shipped to Delaware. The consumer in
Newark pays with Dollars, just the
currency that the wine maker in
California wants.
 If that same vintner ships her wine to
Europe, however, consumers there will
have only Euros with which to pay,
rather than the Dollars the wine maker
in California wants. Thus, for
international trade to take place, there
must be some way to convert one
currency into another.
 The exchange rate states the price in
terms of one currency at which such
conversions are made. There is an
exchange rate between every pair of
currencies.
 For example the British Pound in 2002
was the equivalent of about $1.40. The
exchange rate between the Pound and
the Dollar, then, may be expressed as
roughly "$1.40 to the Pound" (meaning
that it costs $1.40 to buy a Pound) or
about "71 pence to the Dollar" (meaning
that it costs 71 British pence to buy a
Dollar).
(Currently the rate is $1.86 and .57 respectively)
 A nation’s currency is said to appreciate
when the exchange rates change so
that a unit of its currency can buy more
units of a foreign currency.
 A nation’s currency is said to depreciate
when the exchange rates change so
that a unit of its currency can buy fewer
units of a foreign currency.
 For example if the cost of a Pound rises
from $1.40 to $2.00, the cost of a U.S.
dollar in terms of pounds simultaneously
falls from 71 pence to 50 pence.
 The UK has experienced an
appreciation while the U.S. has
experienced a depreciation in its
currency.
 When an officially set exchange rate is
altered so that a unit of a nation’s
currency can buy fewer units of foreign
currency, we say that a devaluation of
that currency has taken place. When
the exchange rate is changed so that
the nation’s currency buys more units of
a foreign currency, a revaluation has
taken place.
EXCHANGE RATE
DETERMINATION IN A FREE
MARKET
 Assume that the Dollar and the Euro are
the only currencies on earth, so the
market needs to determine only one
exchange rate.
 Figure 1 depicts the determination of
this exchange rate at the point in the
figure where demand curve D1 crosses
supply curve S1.
 At this price ($0.90 per euro), the
number of Euros demanded is equal to
the number of Euros supplied.
$/Euro
Euro Market
Figure 1
S1
D shifts to the right
D shifts to the left
.90
S shifts to the right
S shifts to the left
D1
0
Q of Euros
Q1
Why does anyone demand Euros?
International trade in goods and services.
(In general, demand for Europe’s exports
leads to demand for its currency, Euros)
2. International trade in financial instruments
such as stocks and bonds. (In general
demand for Europe’s financial assets leads
to demand for it’s currency, Euros)
1.
3. Purchases of a country’s (Europe’s)
physical assets such as factories and
machinery overseas by foreigners
(e.g. U.S. citizens). (In general, direct
foreign investment leads to demand
for Europe’s currency, the Euro)
Where does the supply of Euros
come from?
Europeans want to buy U.S. goods (the
other side of 1 above)
2. Europeans want to buy U.S. stocks and
bonds (the other side of 2 above)
3. Europeans purchase physical assets in the
U.S. (the other side of 3 above)
(can use the supply and demand graphs we
have already created)
1.
 To illustrate the usefulness of even this
simple supply and demand analysis, think
about how the exchange rate between the
Dollar and the Euro should change if
Europeans become attracted by the
prospects of large gains on the U.S. stock
markets.
 To purchase U.S. stocks, foreigners will
first have to purchase U.S. Dollars,
which means selling some of their
Euros.
 In terms of the supply-demand diagram
in Figure 2, the increased desire of
Europeans to acquire U.S. stocks would
shift the supply curve for Euros out from
S1 to S2 . Equilibrium would shift from
point Q1 to point Q4, and the exchange
rate would fall: e.g. from $0.90 per Euro
to $0.80 per Euro.
Market for Euros
$/Euro
S1
D shifts to the right
D shifts to the left
.90
S shifts to the right
S shifts to the left
D1
0
Q of Euros
Q1
Market for Euros
$/Euro
S1
D shifts to the right
S2
.90
S shifts to the right
.80
0
D shifts to the left
S shifts to the left
D1
Q1
Q4
Q of
Euros
 Thus the increased supply of Euros by
European citizens would cause the Euro
to depreciate relative to the dollar. This
is what happened during the U.S. stock
market boom of the late 1990s.
Summary: Suppose that Europeans
have an interest in investing in the
U.S. stock market.
(straight forward supply and demand)
 To purchase stocks, Europeans need to
purchase $ => selling Euros.
 (supply curve for Euros shifts to the right =>
causing the $ price of the Euro to fall)
Interest Rates and Exchange Rates:
The Short Run
 Main determinant in the short run:
interest rates, in particular interest
rate differentials, and financial flows.
 As an example, suppose the Italian
government bonds pay a 5 percent rate
when yields on equally safe U.S.
government securities rise to 7 percent.
 Italian investors will be attracted by the higher
interest rates in the United States and will
offer Euros for sale.
 Why?
 To buy Dollars and use those Dollars to buy
U.S. securities.
 At the same time, U.S. investors will find it
more attractive to keep their money at home,
so fewer Euros will be demanded by
Americans.
$/Euro
Euro Market
Figure 3
S1
D shifts to the right
D shifts to the left
P1
S shifts to the right
S shifts to the left
D1
0
Q of Euros
Q1
Figure 3
Euro Market
$/Euro
S1
D shifts to the right
S2
D shifts to the left
P1
S shifts to the right
P4
S shifts to the left
0
D1
Q1
Q4
Q of Euros
Figure 3
Euro Market
$/Euro
S1
D shifts to the right
S2
P1 =
1.20
D shifts to the left
S shifts to the right
S shifts to the left
D1
P2=
1.10
0
D2
Q1
Q2
Q of Euros
 When the demand schedule shifts
inward and the supply curve shifts
outward, the effect on price is
predictable.
 The Euro will depreciate, as Figure 3
shows. In the figure, the supply curve of
Euros shifts outward from S1 to S2
when Italian investors seek to sell Euros
in order to purchase more U.S.
securities.
 At the same time, American investors
wish to buy fewer Euros because they
no longer desire to invest as much in
Italian securities. Thus, the demand
curve shifts inward from D1 to D2.
The Result:
 In our example, there is a depreciation of
the Euro from $1.20 to $1.10.
 Exercise: Suppose that interest rates are
higher in Europe than in the U.S.
Demonstrate using supply and demand
curves that this would cause the Euro to
appreciate.
In general
 Other things equal, countries that offer
investors higher rates of return attract
more capital than countries that offer
lower rates.
 Thus, a rise in interest rates often will
lead to an appreciation of the currency,
and a drop in interest rates will lead to a
depreciation of the currency.
 Interest rate differentials certainly played a
predominant role in the stunning movements
of the U.S. Dollar in the 1980s.
 In the early 1980s, American interest rates
rose well above comparable interest rates
abroad.
 As a result, foreign capital was attracted to
the U.S. American capital stayed at home,
and the Dollar soared. That is, the Dollar
appreciated.
 Similarly, a nation that suffers from
capital flight, as did Argentina in 2001,
must offer extremely high interest rates
to attract foreign capital.
Interest Rates and Exchange
Rates: The Medium Run
 The medium run is where the theory of
exchange rate determination is most
unsettled.
 Economists once reasoned as follows:
Because consumer spending increases
when income rises and decreases when
income falls, the same thing is likely to
happen to spending on imported goods.
 So a country's imports will rise quickly
when its economy booms and rise only
slowly when its economy stagnates.
 For the reasons illustrated in Figure 4, a
boom in the United States should shift
the demand curve for Euros outward as
Americans seek to acquire more Euros
to buy more European goods and
services.
 And that, in turn, should lead to an
appreciation of the Euro (depreciation of
the Dollar). In the figure, the Euro rises
in value from P1 to P2 Dollars per Euro.
Figure 4
Euro Market
$/Euro
S1
D shifts to the right
D shifts to the left
P1
S shifts to the right
S shifts to the left
D1
0
Quantity of Euros
Q1
Figure 4
Euro Market
$/Euro
S1
D shifts to the right
P2
D shifts to the left
P1
D2
S shifts to the right
S shifts to the left
D1
0
Quantity of Euros
Q1 Q2
 However, if Europe was booming at the
same time, Europeans would be buying
more American exports, which would
shift the supply curve of Euros outward.
 Europeans must offer more Euros for
sale to get the Dollars they need for
purchasing U.S. goods and services.
Figure 4
Euro Market
$/Euro
S1
S2
D shifts to the right
D shifts to the left
P3
P1
D2
S shifts to the right
S shifts to the left
D1
0
Q1
Q3
Quantity of Euros
 On balance, the value of the Dollar
might rise or fall. It appears that what
matters is whether exports are growing
faster than imports.
 A country whose aggregate demand
grows faster than the rest of the world's
normally finds its imports growing faster
than its exports.
 Thus, its demand curve for foreign
currency shifts outward more rapidly than
its supply curve. Other things equal, that
will make its currency depreciate.
 In the context of figure 4 if the U.S. is
growing faster than Europe, D1 will shift
out by a larger amount than S1, leading to
an appreciation of the Euro.
Conclusion:
 This reasoning is sound - so far as it
goes. And it leads to the conclusion that
a "strong economy" might produce a
"weak currency."
 But the three most important words in
the preceding statement are "other
things equal."
 Usually, they are not. Specifically, a
booming economy will normally offer
more attractive prospects to investors
than a stagnating one -- higher interest
rates, rising stock market values, and so
on.
 This difference in prospective
investment returns, as we have seen,
should attract capital and boost its
currency value. So there appears to be
a kind of "tug of war."
 As we see, thinking only about trade in
goods and services leads to the
conclusion that faster growth should
weaken the currency.
 But thinking about trade in financial
assets (such as stocks and bonds)
leads to precisely the opposite
conclusion: Faster growth should
strengthen the currency. Which side will
win this "tug of war"?
 In the modern world, the evidence
seems to say that trade in financial
assets is the dominant factor.
 Rapid growth in the United States in the
second half of the 1990s led to a
sharply appreciating Dollar even though
U.S. imports soared.
 Why? Investors from all over the world
brought funds to America.
We conclude that:
 Stronger economic performance
appears to lead to currency appreciation
because it improves prospects for
investing in the country.
Purchasing Power Parity
Theory: The Long Run
 In the long run, an apparently simple principle
ought to govern exchange rates. As long as
goods can move freely across national
borders, exchange rates should eventually
adjust so that the same product costs the
same amount of money, whether measured in
Dollars in the United States, Euros in
Germany, or Yen in Japan -- except for
differences in transportation costs and the
like.
This simple statement forms the basis
of the major theory of exchange rate
determination in the long run:
 The purchasing-power parity theory
of exchange rate determination holds
that the exchange rate between any
two national currencies adjusts to
reflect differences in the price levels
in the two countries.
Example:
 Suppose German and American steel is
identical and that these two nations are
the only producers of steel for the world
market.
 Suppose further that steel is the only
tradeable good that either country
produces.
Question: If American steel costs $180
per ton and German steel costs 200
Euros per ton, what must be the
exchange rate between the dollar and
the euro?
Answer: Because 200 Euros and $180 each
buy a ton of steel, the two sums money must
be of equal value.
Hence, each Euro must be worth $0.90.
The Dollar price of the Euro is $.90
Why? Any higher price for a Euro, such as
$1, would mean that steel would cost
$200 per ton (200 Euros at $1 each) in
Germany but only $180 per ton in the
United States.
 In that case, all foreign customers would buy
their steel in the United States -- which would
increase the demand for Dollars and
decrease the demand for Euros.
 In our diagram for the market for Euros the
supply of Euros would shift to the right and
the result would be a lower Dollar price of the
Euro.
Similarly, any exchange rate below $0.90
per Euro would send all the steel
business to Germany, driving the value
of the Euro up toward its purchasingpower parity level.
Exercise: Show why an exchange rate of
$0.80 per Euro is too low to lead to an
equilibrium in the international steel
market.
Exercise (continued)
Dollar price of Euro: $.80
$/Euro =.80
At this exchange rate the:
cost of steel in Germany is $160
cost of steel in the U.S. is $180
The purchasing-power parity theory is
used to make long-run predictions about
the effects of inflation on exchange
rates.
To continue our example, suppose that
steel (and other) prices in the United
States rise while prices in Europe
remain constant. The purchasing-power
parity theory predicts that the Euro will
appreciate relative to the Dollar. It also
predicts the amount of the appreciation.
 After the U.S. inflation, suppose that the
price of American steel is $220 per ton,
while German steel still costs 200 Euros
per ton.
 For these two prices to be equivalent,
200 Euros must be worth $220, or one
Euro must be worth $1.10.
 The Euro, therefore, must have risen
from $0.90 to $1.10.
According to the purchasing-power parity
theory

differences in domestic inflation
rates are a major cause of exchange
rate movements.

If one country has higher inflation
than another, its exchange rate
should be depreciating.
For many years, this theory seemed to
work tolerably well. Although precise
numerical predictions based on
purchasing-power parity calculations
were never very accurate (see
"Purchasing Power Parity and the Big
Mac"), nations with higher inflation did at
least experience depreciating
currencies.
But in the 1980s and 1990s, even
this rule broke down.
 For example, although the U.S. inflation rate
was consistently higher than both Germany's
and Japan's, the Dollar nonetheless rose
sharply relative to both the German Mark and
the Japanese Yen from 1980 to 1985.
 The same thing happened again between
1995 and 2000.
Clearly, the theory is missing
something. What?
 Many things. But perhaps the principal
failing of the purchasing-power parity
theory is, once again, that it focuses too
much on trade in goods and services.
 Financial assets such as stocks and
bonds are also traded actively across
national borders -- and in vastly greater
dollar volumes than goods and services.
 In fact, the astounding daily volume of
foreign exchange transactions, more
than $1.5 trillion, exceeds an entire
month’s worth of world trade in goods
and services.
The vast majority of these transactions
are financial. If investors decide that,
say, U.S. assets are a better bet than
Japanese assets, the Dollar will rise,
even if our inflation rate is well above
Japan's.
For this and other reasons:
Most economists believe that other
factors are much more important than
relative price levels for exchange rate
determination in the short run. But in the
long run, purchasing-power parity plays
an important role.
Market Determination of
Exchange Rates: Summary
You may have noticed a theme here.
International trade in financial assets:
 certainly dominates short-run exchange
rate changes,
 may dominate medium-run changes,
and
 also influences long-run changes.
We can summarize this discussion
of exchange rate determination in
free markets as follows:
1. We expect to find appreciating
currencies in countries that offer
investors higher rates of return
because these countries will attract
capital from all over the world.
2. To some extent, these are the
countries that are growing faster than
average because strong growth tends
to produce attractive investment
prospects. However, such fast-growing
countries will also be importing
relatively more than other countries,
which tends to pull their currencies
down.
3. Currency values generally will
appreciate in countries with lower
inflation rates than the rest of the
world's, because buyers in foreign
countries will demand their goods and
thus drive up their currencies.
 Reversing each of these arguments, we
expect to find depreciating currencies in
countries with relatively high inflation
rates, low interest rates, and poor
growth prospects.
 Some exchange rates today are truly floating,
determined by the forces of supply and
demand without government interference.
 Many others are not.
 Some people claim that exchange rate
fluctuations are so troublesome that the world
would be better off with fixed exchange rates.
 For these reasons, we turn next to a system
of fixed exchange rates, or rates that are set
by governments.
 Naturally, under such a system the exchange
rate, being fixed, is not closely watched.
 Instead, international financial specialists
focus on a country’s balance of payments to
gauge movements in the supply of and
demand for a currency.
I. Defining the Balance of
Payments in Practice
 The preceding discussion makes it look
simple to measure a nation's balance of
payments position:
 count up the private demand for and
supply of its currency
 and subtract quantity supplied from
quantity demanded.
 Go to discussion of AD
 Conceptually, that is all there is to it.
 But in practice the difficulties are great
because we never directly observe the
number of dollars demanded and
supplied.
 Actual market transactions show that
the number of, say, U.S. Dollars
purchased always equals the number of
U.S. dollars sold. Unless someone has
made a bookkeeping error, this must be
so.
 How, then, can we recognize a balance
of payments surplus or deficit?
 Easy, you say. Just look at the
transactions of the central bank, whose
purchases or sales must make up the
difference between private demand and
private supply.
 If the Federal Reserve is buying dollars,
its purchases measure our balance of
payments deficit.
 If the Fed is selling, its sales represent
our balance of payments surplus.
 Thus, the idea is to measure the
balance of payments by excluding
official transactions among
governments.
 That is, more or less, what is done.
 In practice, the balance of payments
accounts come in two main parts.
 The current account balance account
totals up exports and imports of goods
and services, cross-border payments of
interest and dividends, and cross-border
gifts.
 The United States has been running
large current account deficits for years.
 But that represents only one part of our
balance of payments, for it leaves out all
purchases and sales of assets.
 Purchases of U.S. assets by foreigners
bring foreign currency to the United
States, and
 purchases of foreign assets cost us
foreign currency.
 Netting the capital flows in each
direction gives us our surplus or deficit
on capital the account.
 In recent years, this part of our balance
of payments accounts has registered
large surpluses as foreigners have
acquired U.S. assets.
 In what sense, then does the overall
balance of payments balance?
 There are two possibilities.
 If
the exchange rate is floating, all
private transactions, that is, current
account plus capital account, must add
up to zero

(dollars purchased = dollars sold).
 But
if, instead, the exchange rate is
fixed, as shown in the Figures below,
the two accounts need not balance one
another.
 Government purchases or sales of
foreign currency make up the surplus or
deficit in the overall balance of
payments.
Equilibrium is where
Qd = Qs
S
Price of Euros
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
D
0.10
0
1
2
3
4
5
6
7
8
9
Billions of
Euros/Year
10
Price of Euros
1.00
Balance of
payments deficit
Equilibrium is where
QS = QD
S
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
D
0.10
0
1
2
3
4
5
6
7
8
9
Billions of Euros per
year
10
Equilibrium is where
Qs = Qd
S
Price of Euros
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
.33
Balance of
payments
surplus
0.20
0.10
0
1
2
3
4
5
6
D
7
8
9
Billions
of Euros
10 per year
 This simple analysis helps us
understand why the U.S. trade deficit
grew so enormously in the late 1990s.
 The international value of the Dollar
began to climb in 1995.
 According to the reasoning we have just
completed, within a few years such an
appreciation of the Dollar should have
boosted U.S. imports and damaged
U.S. exports.
 That is precisely what happened.
 In constant Dollars, American imports
soared by 40 percent between 1997
and 2000, while American exports rose
just 15 percent.
 The result was that a $113 billion
net export deficit in 1997 turned
into a monumental $399 billion
deficit by 2000.