MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 19

Dollars HOW EXCHANGE RATES ARE DETERMINED cont’d 19.1 Market equilibrium occurs where the demand for U.S.. An increase in the supply of dollars will decrease depreciate the dollar ex

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C H A P T E R 19

The World of

International Finance

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The World of

Today, the world currency markets are always open When foreign

exchange traders in New York City are sound asleep at 3:00 A.M.,

their counterparts in London are already on their phones and

computers at 8:00 A.M.

CHAPTER

19

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The Chinese Yuan and Big Macs

What factors may allow the United States to continue running large trade deficits with the rest of the world?

World Savings and U.S Current Account Deficits

How did the 2008 financial crisis lead to problems for some countries in the Euro-zone?

1

2

3

A P P L Y I N G T H E C O N C E P T S

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is called an appreciation of a currency.

•A decrease in the value of a currency relative to the currency of another nation

is called a depreciation of a currency.

HOW EXCHANGE RATES ARE DETERMINED

19.1

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The Demand for and

Supply of U.S Dollars

HOW EXCHANGE RATES ARE DETERMINED (cont’d)

19.1

Market equilibrium

occurs where the

demand for U.S

dollars equals the

supply.

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demand for dollars will

increase (appreciate) the

dollar’s exchange rate

Higher U.S interest rates

or lower U.S prices will

increase the demand for

dollars.

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An increase in the supply

of dollars will decrease

(depreciate) the dollar

exchange rate

Higher European interest

rates or lower European

prices will increase the

supply of dollars.

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C H A P T E R 19

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Changes in Demand or Supply

Let’s summarize the key facts about the foreign exchange market, using euros

as our example:

1 The demand curve for dollars represents the demand for dollars in

exchange for euros The curve slopes downward As the dollar depreciates, there will be an increase in the quantity of dollars demanded

in exchange for euros

2 The supply curve for dollars is the supply of dollars in exchange for euros

The curve slopes upward As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros

3 Increases in U.S interest rates and decreases in U.S prices will increase the demand for dollars, leading to an appreciation of the dollar

4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar

HOW EXCHANGE RATES ARE DETERMINED (cont’d)

19.1

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C H A P T E R 19

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• real exchange rate

The price of U.S goods and services relative to foreign goods and services, expressed

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C H A P T E R 19

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 FIGURE 19.4

Real Exchange Rate and

Net Exports as Percent of

GDP, 1980–2009

REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont’d)

19.2

The figure shows the real

exchange rate for the

United States compared

to its net exports as a

share of GDP

Notice that, in general,

when the real

(multilateral) exchange

rate increased, U.S net

exports fell.

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C H A P T E R 19

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THE CHINESE YUAN AND BIG MACS

APPLYING THE CONCEPTS #1: How can the price of a Big Mac in China shed light on the

U.S.-Chinese currency tensions?

•The U.S and China are at odds about the appropriate exchange rate between the yuan and the dollar

•Economist magazine checks the price of Big Macs around the world and

determines the appropriate exchange rate based on the differences in prices

•A Big Mac in China is $1.83, but should be $3.49

A P P L I C A T I O N 1

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C H A P T E R 19

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• law of one price

The theory that goods easily tradable across countries should sell at the same price expressed in a common currency

• purchasing power parity

A theory of exchange rates whereby aunit of any given currency should beable to buy the same quantity ofgoods in all countries

REAL EXCHANGE RATES AND PURCHASING POWER PARITY (cont’d)

19.2

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governments and residents of the rest of the world during a specific time period.

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THE CURRENT ACCOUNT, THE FINANCIAL ACCOUNT, AND THE CAPITAL ACCOUNT (cont’d)

19.3

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•Here is a simple rule for understanding transactions on the current,

financial, and capital accounts: Any action that gives rise to a

demand for foreign currency is a deficit item Any action that gives

rise to a supply of foreign currency is a surplus item.

•The current, financial, and capital accounts of a country are linked

by a very important relationship:

current account + financial account + capital account = 0

19.3

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19.3

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• net international investment position

Domestic holding of foreign assetsminus foreign holdings of domestic assets

• sovereign investment fund

Assets accumulated by foreign governments that are invested abroad

19.3

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C H A P T E R 19

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WORLD SAVINGS AND U.S CURRENT ACCOUNT DEFICITS

APPLYING THE CONCEPTS #2: What factors may allow the United States to continue running large trade deficits with

the rest of the world?

•The 2006 Economic Report of the President directly addressed whether the

United States can continue to run large current account deficits and, of course, financial account surpluses In the report, the government recognized that the current account deficits would eventually be reduced However, it also highlighted

a number of factors suggesting the deficits could continue for a long period of time

•For the United States to continue to run a current account deficit, other countries

in the world need to continue to purchase U.S assets

•In recent years, four major countries experienced circumstances that encouraged them to save by purchasing assets from abroad: Japan, Germany, Russia, and China

•For the United States to continue to run trade deficits in the future, these or other

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appreciates—increases in value There are two distinct effects:

1 The increased value of the exchange rate makes imports

less expensive for the residents of the country where theexchange rate appreciated

2 The increased value of the exchange rate makes U.S

goods more expensive on world markets

FIXED AND FLEXIBLE EXCHANGE RATES

19.4

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C H A P T E R 19

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Fixing the Exchange Rate

• foreign exchange market intervention

The purchase or sale of currencies by government

to influence the market exchange rate

 FIGURE 19.5

Government Intervention to

Raise the Price of the Dollar

FIXED AND FLEXIBLE EXCHANGE RATES (cont’d)

19.4

To increase the price of

dollars, the U.S

government sells Euros in

exchange for dollars

This shifts the demand

curve for dollars to the

right.

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C H A P T E R 19

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Fixed versus Flexible Exchange Rates

• flexible exchange rate system

A currency system in which exchangerates are determined by free markets

FLEXIBLE EXCHANGE RATE SYSTEM

• fixed exchange rate system

A system in which governments peg

FIXED EXCHANGE RATES

19.4

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C H A P T E R 19

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Fixed versus Flexible Exchange Rates

• balance of payments deficit

Under a fixed exchange rate system, a situation inwhich the supply of a country’s currency exceeds thedemand for the currency at the current exchange rate

BALANCE OF PAYMENTS DEFICITS AND SURPLUSES

• balance of payments surplus

Under a fixed exchange rate system, a situation inwhich the demand of a country’s currency exceeds the supply for the currency at the current exchange rate

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Exchange Rate Systems Today

Fixed exchange rate systems provide benefits, but they require countries to maintain similar economic policies—especially to maintain similar inflation rates and interest rates.

Higher prices in the United States cause the U.S real exchange rate to rise This increase in the real exchange rate over time causes a trade deficit to emerge.

The flexible exchange rate system has worked well enough

19.4

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C H A P T E R 19

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THE DOWNSIDE TO THE EURO

APPLYING THE CONCEPTS #3: How did the 2008 financial crisis lead to problems for some countries in the Euro-

Greece were especially effected

•When the boom came to an end, their wage and price structure was out of line and they needed to make adjustments

•However, their options were limited Since they could not depreciate their currency,

so they could either cut spending or raise taxes or face a prolonged period of

unemployment to reduce wages and prices

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•Even when a country takes strong, institutional steps

to peg its currency, a collapse is still possible.

MANAGING FINANCIAL CRISES

19.5

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C H A P T E R 19

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THE ARGENTINE FINANCIAL CRISIS

APPLYING THE CONCEPTS #4: What are the causes of financial collapses that occur throughout the globe?

During the late 1980s, Argentina suffered from hyperinflation As part of its financial reforms, it pegged its currency to the U.S dollar, making pesos “convertible” into

dollars To issue pesos, the central bank had to have an equal amount of dollars, or its equivalent in other hard currencies, on hand Some economists believed this

reform would bring stability to the financial system Unfortunately, they were proved wrong

Several problems developed:

• As the dollar appreciated, Argentina began to suffer from a large trade deficit.

• Wage increases also pushed up the real exchange rate.

• Argentina had to borrow extensively in dollar-denominated loans.

Eventually, Argentina was forced to default on its international debt in 2002 and

freeze bank accounts The hopes of the reforms in the early 1990s had become a

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C H A P T E R 19

The World of

balance of payments

balance of payments deficit

balance of payments surplus

real exchange rate revaluation

sovereign investment funds

K E Y T E R M S

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