The big picture marcoeconomics 12e parkin chapter 09

The Demand for One Money is the Supply of Another Money The exchange rate is determined by demand and supply in the competitive foreign exchange market.. same, the higher the exchange r

W H AT I S E C O N O M I C S ? 7 5

T h e B i g P i c t u r e

Where we have been:

Chapter 9 is the last of four that examine the long-run trends of the economy

It uses the quantity theory result from Chapter 8 that in the long run, the price level is determined by the quantity of money This result is used to show that

in the long run, the nominal exchange rate is determined by the quantities of money in the two countries Chapter 9 also uses the national income

accounting identities introduced in Chapter 4 when explaining the balance of payments and, quite importantly, the demand and supply model of Chapter 3 when explaining short-run fluctuations in the exchange rate

Where we are going:

Chapter 9 is the last of the “long-run chapters.” The next section looks at short-run fluctuations Chapter 10, with its introduction of the aggregate supply/aggregate demand model, is key to understanding short run business cycle fluctuations The material in this chapter is not prominently featured in future chapters, though it makes a slight recurrence in Chapter 14 when monetary policy is covered Chapter 15, on International Trade, does not use the material in this chapter directly However, the global loanable funds market can be used to motivate the models for the global market in goods and services

N e w i n t h e Tw e l f t h E d i t i o n

This chapter has some sections that have been modified, especially the section on exchange rate expectations It is mostly a modest reorganization of content, so there are no new items to call to your attention However, there is now a section

on the Global Loanable Funds Market that was moved from chapter 7 Data in tables and graphs have been updated to 2014 The Economics In The News

feature has a 2014 article on the rising value of the dollar The Worked Problem

RATE AND THE BALANCE OF

75

presents a scenario in which the Fed and Bank of Japan announce their interest rate policies The students are asked to analyze the announcements using the foreign exchange market and the supply and demand for U.S dollars To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are

in the MyEconLab and are called Extra Problems

76

L e c t u r e N o t e s

The Exchange Rate and the Balance of Payments

currencies and the foreign exchange value of the dollar is determined in the foreign exchange market

foreign exchange market

the transactions

I The Foreign Exchange Market

Trading Currencies

currencies Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits The foreign exchange

market is the market in which the currency of one country is exchanged for the

currency of another The price at which one currency exchanges for another is called

the exchange rate.

Exchange rates: Exchange rates are always somewhat confusing The problem is that

there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S dollars (84 yen per U.S dollar) or as U.S dollars per unit of foreign

currency (1.28 U.S dollars per Euro) Tell this fact to the students But, because the

textbook is consistent in using the exchange rate as the units of foreign currency per U.S dollars, stick to the “84 yen per dollar” format in your lectures This also makes it easier for graphing and for the discussion about appreciation or depreciation A change from 84 to

94 yen per dollar is dollar appreciation and shown by an increase along the vertical axis

as the Japanese yen or European euro Currency depreciation is the fall in the value

of one currency in terms of another currency Currency appreciation is the rise in the

value of one currency in terms of another currency

 A rise in the U.S exchange rate is called an appreciation of the dollar; a fall in the U.S exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money

The exchange rate is determined by demand and supply in the (competitive) foreign

exchange market When people holding the money of some other country want to exchange

it for U.S dollars, they supply the other currency and demand dollars When people holding U.S dollars want to buy the currency of some other country, they supply U.S dollars and demand the other currency

Demand in the Foreign Exchange Market

The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S exports, interest rates in the United States and other countries, and the expected future exchange rate

same, the higher the exchange rate, the smaller is the quantity of dollars demanded

in the foreign exchange market There are two reasons for the law of demand:

 Exports Effect: Dollars are used to buy U.S exports The lower the exchange rate, with everything else the same, the cheaper are U.S exports so the greater the

quantity of dollars demanded on the foreign exchange market to pay for the exports

 Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market

sloping, as illustrated in the figure below

Supply in the Foreign Exchange Market

The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S demand for imports, interest rates in the United States and other countries, and the expected future exchange rate

same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market There are two reasons for the law of supply:

rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports

 Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market

shown in the figure

Market Equilibrium

exchange market determine the

exchange rate In the figure, the

dollar, where the demand and supply

curves intersect

dollars drives the exchange rate

down

equilibrium exchange rate, a

shortage of dollars drives the

exchange rate up

equilibrium exchange rate at which there is neither a shortage nor a surplus

Changes in the Demand for U.S Dollars

for dollars and shifts the demand curve for dollars

increases the demand for U.S dollars because U.S producers must be paid in U.S dollars The demand curve for U.S dollars shifts rightward

 U.S Interest Rate Differential: The U.S interest rate differential is the U.S

interest rate minus the foreign interest rate The larger the U.S interest rate differential, the greater is the demand for U.S assets and the greater is the

demand for U.S dollars on the foreign exchange market An increase in the U.S interest rate differential shifts the demand curve for U.S dollars rightward

the greater is the expected profit from holding U.S dollars As a result, the

demand for U.S dollars increases and the demand curve shifts rightward

Changes in the Supply of U.S Dollars

dollars and shifts the supply curve of dollars

the supply of U.S dollars because U.S importers offer U.S dollars in order to buy the foreign currency necessary to pay foreign producers The supply curve of U.S dollars shifts rightward

 U.S Interest Rate Differential: The larger the U.S interest rate differential, the

greater is the demand for U.S assets and the smaller is the supply of U.S dollars

on the foreign exchange market An increase in the U.S interest rate differential shifts the supply curve for U.S dollars leftward

the greater is the expected profit from holding U.S dollars As a result, the supply

of U.S dollars decreases and the supply curve shifts leftward

Emphasize that the quantity of dollars measured on the horizontal axis are only dollars

that are being offered for foreign exchange, not the entire quantity of money as we learned

in Chapter 8

Changes in the Exchange Rate

The exchange rate changes when the demand

for and/or the supply of foreign exchange

change

rate increases, the demand for U.S

dollars increases and the supply

decreases As the figure shows, the

D1, and the supply curve shifts leftward,

from S0 to S1 The exchange rate rises, in

the figure from 77 yen per dollar to 102

yen per dollar, and quantity traded does

does not change at all Such changes

took place between 2012 and 2014 when

traders started to expect that the Federal Reserve would raise the interest rate in the United States while the Japanese interest rate would not change

II Arbitrage, Speculation, and Market Fundamentals

Exchange rate expectations depend on deeper economic forces that influence the value of money

 Arbitrage is the practice of seeking to profit by buying in one market and selling for

a higher price in another related market Arbitrage in the foreign exchange market

and international loans markets and goods markets achieves four outcomes:

 The law of one price: If an item is traded in more than one place, the price will be the same in all locations An example of this law is that the exchange rate

T H E E XC H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S 8 9

between the U.S dollar and the U.K pound is the same in New York as it is in London

 No round-trip profit: A round trip is using currency A to buy currency B, and then using B to buy A A round trip might involve more stages, using B to buy C and then using C to buy A Regardless, arbitrage removes the profit made from a round trip

denominate their assets and debts Interest rate parity, which means equal rates

of return across currencies, means that for risk-free transactions, there is no gain from choosing one currency over another

 Purchasing power parity: Purchasing power parity, which means equal value

of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries Purchasing power parity is an important force affecting prices and exchange rates in the long run and

influences exchange rate expectations

Interest Rate Parity Be sure that your students appreciate interest rate parity There are

many horror stories of people losing their shirts by misunderstanding interest rate parity One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates When the Australian dollar nosedived against the Japanese yen, the church

struggled to repay its loans Interest rate parity always holds Interest rates might look

unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates It is a foolish person (or organization) that acts as if it can beat the market

If one U.S dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S dollar buys the same quantity goods and services in the United States as 1.33 Canadian dollars buys in Canada

Canadian dollars buy in Canada, people will expect that the U.S dollar will eventually appreciate

 Similarly, if one U.S dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S dollar will eventually depreciate

The Economics in Action detail discusses the “Big Mac Index.” The Economist reports a Big

Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on

a plane from, say, Japan to the United States However, it is easier to arbitrage the inputs into Big Macs such as beef Thus, one might still expect some convergence of Big Mac

prices over time The Economist claims some success in its exchange rate predictions.

Speculation

Speculation is trading on the expectation of making a profit Speculation contrasts with

arbitrage, which is trading on the certainty of making a profit Most foreign exchange transactions are based on speculation, which explains why the expected future exchange rate plays such a central role in the foreign exchange market Changes in the expected future exchange rate instantly change the current exchange rate

Market Fundamentals

The fundamentals underlying the exchange rate are the demand for U.S dollars, which

depends on world demand for U.S exports, and the supply of U.S dollars, which depends

on U.S demand for imports Both demand and supply depend on the U.S interest rate

differential

The Real Exchange Rate

foreign currency per U.S dollar It tells how many units of a foreign currency one U.S

dollar buys The real exchange rate is the relative price of U.S-produced goods

and services to foreign-produced goods and services It tells how many units of

foreign GDP one unit of U.S GDP buys The real exchange rate, RER, is equal to

RER = (E  P)/P*

where E is the nominal exchange rate, P is the U.S price level, and P* is the foreign

price level

 Short Run: In the short run, this equation determines the real exchange rate The nominal exchange rate is determined in the foreign exchange market by the

supply and demand for dollars Price levels do not change rapidly and so any

change in the nominal exchange rate translates into a change in the real

exchange rate

 Long Run: In the long run, rewrite the equation as E = RER  (P*/P) In the long

run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of

money in that nation So in the long run, a change in the quantity of money

changes the price level and thereby changes the nominal exchange rate This

result means that in the long run, the nominal exchange rate is a monetary

phenomenon Chapter 8 showed that in the long run, the quantity of money

determines a nation’s price level, so the nominal exchange rate is determined by the quantities of money in the two countries

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III Exchange Rate Policy

Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate Three possible exchange rates policies are

Flexible Exchange Rate

demand and supply with no direct intervention by the central bank Even so, the exchange rate is influenced by the central bank’s actions For instance, if the Fed raises the U.S interest rate, the U.S interest rate differential increases, which

appreciates the U.S exchange rate Most countries, including the United States, have flexible exchange rates

Fixed Exchange Rate

government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market A fixed exchange rate requires direct and frequent intervention by the central bank

 If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S dollars By so doing the Fed increases the

demand for dollars and raises the exchange rate But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using

to purchase the dollars

has decreased from D0 to D1 To keep

the exchange rate fixed at 100 yen per

dollar, the Fed needs to buy 2 billion

dollars per day, the difference

between the quantity of dollars

supplied at the fixed exchange rate (7

billion dollars per day) and the [new]

quantity of dollars demanded (5 billion

dollars per day) To purchase these

dollars the Fed must use its foreign

reserves Ultimately the Fed will run

out of foreign reserves and when that

takes place the Fed can no longer peg

the exchange rate at 100 yen per

dollar

 If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise To fix the exchange rate the Fed sells U.S dollars so that it increases the supply of dollars and lowers the exchange rate But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S dollars

Crawling Peg

in the foreign exchange market to achieve that path A crawling peg works like a fixed exchange rate only the target value changes The target changes whenever the central bank changes China is now currently using a crawling peg exchange rate policy for the yuan

The People’s Bank of China in the Foreign Exchange Market (Economics In Action

Detail)

selling yuan and buying dollars to offset the effects of increases in the demand for

yuan China accumulated foreign currency reserves of almost $1 trillion by

mid-2006, and by the end of 2007 was fast approaching $2 trillion

yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S

dollars to hold the yuan/dollar exchange rate down

 China most likely fixed its exchange rate to anchor its inflation rate so that it does

not deviate much from the U.S inflation rate The Chinese inflation rate departs from the U.S inflation rate by an amount determined by the speed of the crawl

IV Financing International Trade

Balance of Payments Accounts

borrowing, and lending There are three balance of payments accounts:

abroad, receipts for exports of goods and services sold abroad, net interest

income paid abroad, and net transfers (such as foreign aid payment) The

current account balance equals exports plus net interest income plus net

transfers minus imports

investment abroad Any statistical discrepancy is included in this account

reserves, which are the government’s holdings of foreign currency An increase

in foreign reserves corresponds to a negative official settlements account

balance This occurs because holding foreign currency is like (but not the same

as) investing abroad, which is a negative entry in the capital account.

current account + capital account + official settlements account = 0

a positive capital account balance Over time, the current account balance tends to mirror the capital account balance because the official settlements account balance

is small

Borrowers and Lenders

Because of current account deficits and surpluses, countries, like individuals, can be

borrowers or lenders

 A country that is borrowing more from the rest of the world than it is lending to it is a

net borrower A net lender is a country that is lending more to the rest of the

world than it is borrowing from the rest of the world The United States currently is

net borrower Being a net borrower is not a problem provided the borrowed funds are

used to finance capital accumulation that increases income Being a net borrower is

a problem if the borrowed funds are used to finance consumption

The Global Loanable Funds Market

Demand and Supply in Global and National Markets

equilibrium real interest rate

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 A country is a net foreign borrower if the

world equilibrium real interest rate is less

than what would be the no-trade interest

rate in the country The figure shows this

situation

 In the figure, when the country is

isolated from international trade the

equilibrium real interest rate would be

6 percent and the equilibrium quantity

of loanable funds would be $1.6

trillion

 With international trade, the real

interest rate in the country becomes

the world real interest rate, 5 percent

At this lower real interest rate, the

quantity of loanable funds supplied

decreases to $1.4 trillion and the quantity of loanable funds demanded increases

to $1.8 trillion The difference, $0.4 trillion, is borrowed from abroad The country

has negative net exports, with X < M.

 A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in

the country The figure shows this

situation

 In the figure, when the country is

isolated from international trade the

equilibrium real interest rate would be

4 percent and the equilibrium quantity

of loanable funds would be $1.6

trillion

 With international trade, the real

interest rate in the country becomes

the world real interest rate, 5 percent

At this higher real interest rate, the

quantity of loanable funds supplied

increases to $1.8 trillion and the

quantity of loanable funds demanded

decreases to $1.4 trillion The difference, $0.4 trillion, is loaned abroad The

country has positive net exports, with X > M.

change the country’s international loaning or borrowing and will change the

country’s net exports

Debtors and Creditors

the rest of the world than it has lent to it A creditor nation is a country that during

its entire history has invested more in the rest of the world than other countries have invested in it The United States currently is debtor nation

 The net borrower/net lender difference refers to the current flow of borrowing or lending over a period of time The debtor nation/creditor nation refers to the stock of debt or foreign assets that exists at a moment in time

The analogy of a country being like an individual in terms of being a borrower or lender is revealing However, you may want to point out a big difference in lifespan Long periods of