PART 9

The International Economy

CHAPTER 28

Exchange Rates and the Open Economy

What determines exchange rates in the short and long run?©Maria Toutoudaki/Getty Images

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

1. LO1Define the nominal exchange rate, fixed versus flexible exchange rates, and real exchange rates.

2. LO2Summarize the law of one price and understand how purchasing power parity determines the long-run real exchange rate.

3. LO3Use supply and demand to analyze how the nominal exchange rate is determined in the short run.

4. LO4Explain how monetary policy impacts the exchange rate.

5. LO5Detail how exchange rates can be fixed.

6. LO6Discuss the advantages and disadvantages of flexible versus fixed exchange rates.

Two Americans discussing their foreign travels were commiserating over their problems understanding foreign currency. “Euro, yuan, yen, pounds, rubles, rupees, it’s driving me crazy,” said the first American. “They all look different and have different values. When I visit a foreign country, I can never figure out how much to pay the taxi driver.”

The second American was more upbeat. “Actually,” he said, “since I adopted my new system, I haven’t had any problems at all.”

The first American looked interested. “What’s your new system?”

“Well,” replied the second, “now, whenever I take a taxi abroad, I just give the driver all the local money I have. And would you believe it, I have got the fare exactly right every time!”

Dealing with unfamiliar currencies—and translating the value of foreign money into dollars—is a problem every international traveler faces. The traveler’s problem is complicated by the fact that exchange rates—the rates at which one country’s money trades for another—may change unpredictably. Thus the number of British pounds, Russian rubles, Japanese yen, or Australian dollars that a U.S. dollar can buy may vary over time, sometimes quite a lot.

The economic consequences of variable exchange rates are much broader than their impact on travel and tourism, however. For example, the competitiveness of U.S. exports depends in part on the prices of U.S. goods in terms of foreign currencies, which in turn depend on the exchange rate between the U.S. dollar and those currencies. Likewise, the prices Americans pay for imported goods depend in part on the value of the dollar relative to the currencies of the countries that produce those goods. Exchange rates also affect the value of financial investments made across national borders. For countries that are heavily dependent on trade and international capital flows—the majority of the world’s nations—fluctuations in the exchange rate may have a significant economic impact.

Moreover, such impact has been increasing over time. One of the defining economic trends of recent decades is the “globalization” of national economies. Since the mid-1980s, the value of international trade has increased at nearly twice the rate of world GDP, and the volume of international financial transactions has expanded at many times that rate. From a long-run perspective, the rapidly increasing integration of national economies we see today is not unprecedented: Before World War I, Great Britain was the center of an international economic system that was in many ways nearly as “globalized” as our own, with extensive international trade and lending. But even the most far-seeing nineteenth-century merchant or banker would be astonished by the sense of immediacy that recent revolutionary changes in communications and transportation have imparted to international economic relations. For example, a wide variety of web-based apps that allow instant communication such as videoconferencing now permit people on opposite sides of the globe to conduct “face-to-face” business negotiations and transactions.

This chapter discusses exchange rates and the role they play in open economies. We will start by distinguishing between the nominal exchange rate—the rate at which one national currency trades for another—and the real exchange rate—the rate at which one country’s goods trade for another’s. We will show how exchange rates affect the prices of exports and imports, and thus the pattern of trade.

Next we will turn to the question of how exchange rates are determined. Exchange rates may be divided into two broad categories, flexible and fixed. The value of a flexible exchange rate is determined freely in the market for national currencies, known as the foreign exchange market. Flexible exchange rates vary continually with changes in the supply of and demand for national currencies. In contrast, the value of a fixed exchange rate is set by the government at a constant level. Because most large industrial countries, including the United States, have a flexible exchange rate, we will focus on that case first. We will see that a country’s monetary policy plays a particularly important role in determining the exchange rate. Furthermore, in an open economy with a flexible exchange rate, the exchange rate becomes a tool of monetary policy, in much the same way as the real interest rate.

Although most large industrial countries have a flexible exchange rate, many small and developing economies fix their exchange rates at least to some extent, so we will consider the case of fixed exchange rates as well. We will explain first how a country’s government (usually, its central bank) goes about maintaining a fixed exchange rate at the officially determined level. Though fixing the exchange rate generally reduces day-to-day fluctuations in the value of a nation’s currency, we will see that, at times, a fixed exchange rate can become severely unstable, with potentially serious economic consequences. We will close the chapter by discussing the relative merits of fixed and flexible exchange rates.

While this chapter focuses on the two extreme exchange-rate approaches—fixed versus flexible—in today’s world, most countries’ exchange rates lie somewhere between the two extremes, with arrangements that combine the two approaches. Moreover, many countries constantly move between more flexible and more fixed exchange rate regimes. For example, for years China used to fix its currency, the renminbi (whose unit of account is the yuan), to the U.S. dollar. Since 2005, however, China has been switching between different exchange rate arrangements. In one recent arrangement, the People’s Bank of China—China’s central bank—let the renminbi float but only within a fixed band that shifts gradually over time or that is set by the central bank.

EXCHANGE RATES

The economic benefits of trade between nations in goods, services, and assets are similar to the benefits of trade within a nation. In both cases, trade in goods and services permits greater specialization and efficiency, whereas trade in assets allows financial investors to earn higher or less volatile returns while providing funds for worthwhile capital projects. However, there is a difference between the two cases, which is that trade in goods, services, and assets within a nation normally involves a single currency—dollars, yen, pesos, or whatever the country’s official form of money happens to be—whereas trade between nations usually involves dealing in different currencies. So, for example, if an American resident wants to purchase an automobile manufactured in South Korea, she (or more likely, the automobile dealer) must first trade dollars for the Korean currency, called the won. The Korean car manufacturer is then paid in won. Similarly, an Argentine who wants to purchase shares in a U.S. company (a U.S. financial asset) must first trade his Argentine pesos for dollars and then use the dollars to purchase the shares.

NOMINAL EXCHANGE RATES

Because international transactions generally require that one currency be traded for another, the relative values of different currencies are an important factor in international economic relations. The rate at which two currencies can be traded for each other is called the nominal exchange rate, or more simply the exchange rate, between the two currencies. For example, if one U.S. dollar can be exchanged for 110 Japanese yen, the nominal exchange rate between the U.S. and Japanese currencies is 110 yen per dollar. Each country has many nominal exchange rates, one corresponding to each currency against which its own currency is traded. Thus the dollar’s value can be quoted in terms of English pounds, Swedish kroner, Israeli shekels, Russian rubles, or dozens of other currencies. Table 28.1 gives exchange rates between the dollar and seven other important currencies as of the close of business in New York City on September 18, 2017.

As Table 28.1 shows, exchange rates can be expressed either as the amount of foreign currency needed to purchase one dollar (left column) or as the number of dollars needed to purchase one unit of the foreign currency (right column). These two ways of expressing the exchange rate are equivalent: Each is the reciprocal of the other. For example, on September 18, 2017, the U.S.–Canadian exchange rate could have been expressed either as 1.2292 Canadian dollars per U.S. dollar or as 0.8136 U.S. dollars per Canadian dollar, where 0.8136 = 1/1.2292.

EXAMPLE 28.1Nominal Exchange Rates

What is the exchange rate between the British pound and Canadian dollar?

Based on Table 28.1, find the exchange rate between the British and Canadian currencies. Express the exchange rate in both Canadian dollars per pound and pounds per Canadian dollar.

From Table 28.1, we see that 0.7411 British pounds will buy a U.S. dollar, and that 1.2292 Canadian dollars will buy a U.S. dollar. Therefore, 0.7411 British pounds and 1.2292 Canadian dollars are equal in value:

0.7411 pounds = 1.2292 Canadian dollars.

Dividing both sides of this equation by 1.2292, we get

0.6029 pounds = 1 Canadian dollar.

In other words, the British–Canadian exchange rate can be expressed as 0.6029 pounds per Canadian dollar. Alternatively, the exchange rate can be expressed as 1/0.6029 = 1.6586 Canadian dollars per pound.

CONCEPT CHECK 28.1

From the business section of the newspaper or an online source (try The Wall Street Journal, www.wsj.com), find recent quotations of the value of the U.S. dollar against the British pound, the Canadian dollar, and the Japanese yen. Based on these data, find the exchange rate (a) between the pound and the Canadian dollar and (b) between the Canadian dollar and the yen. Express the exchange rates you derive in two ways (for example, both as pounds per Canadian dollar and as Canadian dollars per pound).

Figure 28.1 shows the nominal exchange rate for the U.S. dollar for 1973 to 2017. Rather than showing the value of the dollar relative to that of an individual foreign currency, such as the Japanese yen or the British pound, the figure expresses the value of the dollar as an average of its values against other major currencies. This average value of the dollar is measured relative to a base value of 100 in 1973. So, for example, a value of 120 for the dollar in a particular year implies that the dollar was 20 percent more valuable in that year, relative to other major currencies, than it was in 1973.

FIGURE 28.1 The U.S. Nominal Exchange Rate, 1973–2017.This figure expresses the value of the dollar from 1973 to 2017 as an average of its values against other major currencies, relative to a base value of 100 in March 1973.Source: Federal Reserve Bank of St. Louis, FRED database, https://research.stlouisfed.org/fred2/series/TWEXMMTH.

You can see from Figure 28.1 that the dollar’s value has fluctuated over time, sometimes increasing (as in the periods 1980–1985 and 1995–2001) and sometimes decreasing (as in 1985–1987 and 2002–2004). An increase in the value of a currency relative to other currencies is known as an appreciation; a decline in the value of a currency relative to other currencies is called a depreciation. So we can say that the dollar appreciated in 1980–1985 and depreciated in 1985–1987. We will discuss the reasons a currency may appreciate or depreciate later in this chapter.

In this chapter, we will use the symbol e to stand for a country’s nominal exchange rate. Although the exchange rate can be expressed either as foreign currency units per unit of domestic currency or vice versa, as we saw in Table 28.1, let’s agree to define e as the number of units of the foreign currency that the domestic currency will buy. For example, if we treat the United States as the “home” or “domestic” country and Japan as the “foreign” country, e will be defined as the number of Japanese yen that one dollar will buy. Defining the nominal exchange rate this way implies that an increase in e corresponds to an appreciation, or a strengthening, of the home currency, while a decrease in e implies a depreciation, or weakening, of the home currency.

FLEXIBLE VERSUS FIXED EXCHANGE RATES

As we saw in Figure 28.1, the exchange rate between the U.S. dollar and other currencies isn’t constant but varies continually. Indeed, changes in the value of the dollar occur daily, hourly, minute by minute, and even within split seconds. Such fluctuations in the value of a currency are normal for countries like the United States, which have a flexible or floating exchange rate. The value of a flexible exchange rate is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market—the market on which currencies of various nations are traded for one another. We will discuss the factors that determine the supply and demand for currencies shortly.

Some countries do not allow their currency values to vary with market conditions but instead maintain a fixed exchange rate. The value of a fixed exchange rate is set by official government policy. (A government that establishes a fixed exchange rate typically determines the exchange rate’s value independently, but sometimes exchange rates are set according to an agreement among a number of governments.) Some countries fix their exchange rates in terms of the U.S. dollar (Hong Kong, for example), but there are other possibilities. Some French-speaking African countries have traditionally fixed the value of their currencies in terms of the French franc and then in terms of the euro since it was introduced as a new currency on January 1, 1999. Under the gold standard, which many countries used until its collapse during the Great Depression, currency values were fixed in terms of ounces of gold. In the next part of the chapter we will focus on flexible exchange rates, but we will return later to the case of fixed rates. We will also discuss the costs and benefits of each type of exchange rate.

THE REAL EXCHANGE RATE

The nominal exchange rate tells us the price of the domestic currency in terms of a foreign currency. As we will see in this section, the real exchange rate tells us the price of the average domestic good or service in terms of the average foreign good or service. We will also see that a country’s real exchange rate has important implications for its ability to sell its exports abroad.

To provide background for discussing the real exchange rate, imagine you are in charge of purchasing for a U.S. corporation that is planning to acquire a large number of new computers. The company’s computer specialist has identified two models, one Japanese-made and one U.S.-made, that meet the necessary specifications. Since the two models are essentially equivalent, the company will buy the one with the lower price. However, since the computers are priced in the currencies of the countries of manufacture, the price comparison is not so straightforward. Your mission—should you decide to accept it—is to determine which of the two models is cheaper.

To complete your assignment you will need two pieces of information: the nominal exchange rate between the dollar and the yen and the prices of the two models in terms of the currencies of their countries of manufacture. Example 28.2 shows how you can use this information to determine which model is cheaper.

EXAMPLE 28.2Purchasing a Domestic versus Imported Good

Which computer is the better buy, the import or the domestic computer?

A U.S.-made computer costs $2,400, and a similar Japanese-made computer costs 242,000 yen. If the nominal exchange rate is 110 yen per dollar, which computer is the better buy?

To make this price comparison, we must measure the prices of both computers in terms of the same currency. To make the comparison in dollars, we first convert the Japanese computer’s price into dollars. The price in terms of Japanese yen is ¥242,000 (the symbol ¥ means “yen”), and we are told that ¥110 = $1. To find the dollar price of the computer, then, we observe that for any good or service,

Price in yen = Price in dollars × Value of dollar in terms of yen.

Note that the value of a dollar in terms of yen is just the yen–dollar exchange rate. Making this substitution and solving, we get

Notice that the yen symbol appears in both the numerator and the denominator of the ratio, so it cancels out. Our conclusion is that the Japanese computer is cheaper than the U.S. computer at $2,200, or $200 less than the price of the U.S. computer, $2,400. The Japanese computer is the better deal.

CONCEPT CHECK 28.2

Continuing Example 28.2, compare the prices of the Japanese and American computers by expressing both prices in terms of yen.

In Example 28.2, the fact that the Japanese computer was cheaper implied that your firm would choose it over the U.S.-made computer. In general, a country’s ability to compete in international markets depends in part on the prices of its goods and services relative to the prices of foreign goods and services, when the prices are measured in a common currency. In the hypothetical example of the Japanese and U.S. computers, the price of the domestic (U.S.) good relative to the price of the foreign (Japanese) good is $2,400/$2,200, or 1.09. So the U.S. computer is 9 percent more expensive than the Japanese computer, putting the U.S. product at a competitive disadvantage.

More generally, economists ask whether on average the goods and services produced by a particular country are expensive relative to the goods and services produced by other countries. This question can be answered by the country’s real exchange rate. Specifically, a country’s real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency.

To obtain a formula for the real exchange rate, recall that e equals the nominal exchange rate (the number of units of foreign currency per dollar) and that P equals the domestic price level, as measured, for example, by the consumer price index. We will use P as a measure of the price of the “average” domestic good or service. Similarly, let Pf equal the foreign price level. We will use Pf as the measure of the price of the “average” foreign good or service.

The real exchange rate equals the price of the average domestic good or service relative to the price of the average foreign good or service. It would not be correct, however, to define the real exchange rate as the ratio P/Pf because the two price levels are expressed in different currencies. As we saw in Example 28.2, to convert foreign prices into dollars, we must divide the foreign price by the exchange rate. By this rule, the price in dollars of the average foreign good or service equals Pf/e. Now we can write the real exchange rate as

To simplify this expression, multiply the numerator and denominator by e to get

(28.1)

which is the formula for the real exchange rate.

To check this formula, let’s use it to re-solve the computer example, Example 28.2. (For this exercise, we imagine that computers are the only good produced by the United States and Japan, so the real exchange rate becomes just the price of U.S. computers relative to Japanese computers.) In that example, the nominal exchange rate e was ¥110/$1, the domestic price P (of a computer) was $2,400, and the foreign price Pf was ¥242,000. Applying Equation 28.1, we get

which is the same answer we got earlier.

The real exchange rate, an overall measure of the cost of domestic goods relative to foreign goods, is an important economic variable. As Example 28.2 suggests, when the real exchange rate is high, domestic goods are—on average—more expensive than foreign goods (when priced in the same currency). A high real exchange rate implies that domestic producers will have difficulty exporting to other countries (domestic goods will be “overpriced”), while foreign goods will sell well in the home country (because imported goods are cheap relative to goods produced at home). Since a high real exchange rate tends to reduce exports and increase imports, we conclude that net exports will tend to be low when the real exchange rate is high. Conversely, if the real exchange rate is low, then the home country will find it easier to export (because its goods are priced below those of foreign competitors), while domestic residents will buy fewer imports (because imports are expensive relative to domestic goods). Thus net exports will tend to be high when the real exchange rate is low.

Equation 28.1 also shows that the real exchange rate tends to move in the same direction as the nominal exchange rate e (since e appears in the numerator of the formula for the real exchange rate). To the extent that real and nominal exchange rates move in the same direction, we can conclude that net exports will be hurt by a high nominal exchange rate and helped by a low nominal exchange rate.

The Economic Naturalist 28.1

Does a strong currency imply a strong economy?

Politicians and the public sometimes take pride in the fact that their national currency is “strong,” meaning that its value in terms of other currencies is high or rising. Likewise, policymakers sometimes view a depreciating (“weak”) currency as a sign of economic failure. Does a strong currency necessarily imply a strong economy?

Contrary to popular impression, there is no simple connection between the strength of a country’s currency and the strength of its economy. For example, Figure 28.1 shows that the value of the U.S. dollar relative to other major currencies was greater in the year 1973 than in the 1990s, though U.S. economic performance was considerably better in the 1990s than in 1973, a period of deep recession and rising inflation. Indeed, the one period shown in Figure 28.1 during which the dollar rose the most in value, 1980–1985, was a time of recession and high unemployment in the United States.

One reason a strong currency does not necessarily imply a strong economy is that an appreciating currency (an increase in e) tends to raise the real exchange rate (equal to eP/Pf), which may hurt a country’s net exports. For example, if the dollar strengthens against the yen (that is, if a dollar buys more yen than before), Japanese goods will become cheaper in terms of dollars. The result may be that Americans prefer to buy Japanese goods rather than goods produced at home. Likewise, a stronger dollar implies that each yen buys fewer dollars, so exported U.S. goods become more expensive to Japanese consumers. As U.S. goods become more expensive in terms of yen, the willingness of Japanese consumers to buy U.S. exports declines. A strong dollar may therefore imply lower sales and profits for U.S. industries that export, as well as for U.S. industries (like automobile manufacturers) that compete with foreign firms for the domestic U.S. market.

RECAP

EXCHANGE RATES

· The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. More precisely, the nominal exchange rate e for any given country is the number of units of foreign currency that can be bought for one unit of the domestic currency.

· An appreciation is an increase in the value of a currency relative to other currencies (a rise in e); a depreciation is a decline in a currency’s value (a fall in e).

· An exchange rate can be flexible—meaning that it varies freely according to supply and demand for the currency in the foreign exchange market—or fixed—meaning that its value is established by official government policy. (While not our focus in this chapter, an exchange rate can also combine the two approaches.)

· The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. A useful formula for the real exchange rate is eP/Pf, where e is the nominal exchange rate, P is the domestic price level, and Pf is the foreign price level.

· An increase in the real exchange rate implies that domestic goods are becoming more expensive relative to foreign goods, which tends to reduce exports and stimulate imports. Conversely, a decline in the real exchange rate tends to increase net exports.

THE DETERMINATION OF THE EXCHANGE RATE IN THE LONG RUN

Countries that have flexible exchange rates, such as the United States, see the international values of their currencies change continually. What determines the value of the nominal exchange rate at any point in time? In this section we will try to answer this basic economic question. Again, our focus for the moment is on flexible exchange rates, whose values are determined by the foreign exchange market. Later in the chapter we discuss the case of fixed exchange rates.

A SIMPLE THEORY OF EXCHANGE RATES: PURCHASING POWER PARITY (PPP)

The most basic theory of how nominal exchange rates are determined is called purchasing power parity, or PPP. To understand this theory, we must first discuss a fundamental economic concept, called the law of one price. The law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations. For example, if transportation costs are not too large, the price of a bushel of wheat ought to be the same in Mumbai, India, and Sydney, Australia. Suppose that were not the case—that the price of wheat in Sydney were only half the price in Mumbai. In that case, grain merchants would have a strong incentive to buy wheat in Sydney and ship it to Mumbai, where it could be sold at double the price of purchase. As wheat left Sydney, reducing the local supply, the price of wheat in Sydney would rise, while the inflow of wheat into Mumbai would reduce the price in Mumbai.

Equilibrium

According to the Equilibrium Principle, the international market for wheat would return to equilibrium only when unexploited opportunities to profit had been eliminated—specifically, only when the prices of wheat in Sydney and in Mumbai became equal or nearly equal (with the difference being less than the cost of transporting wheat from Australia to India).

If the law of one price were to hold for all goods and services (which is not a realistic assumption, as we will see shortly), then the value of the nominal exchange rate would be determined as Example 28.3 illustrates.

EXAMPLE 28.3The Law of One Price

How many Indian rupees equal one Australian dollar?

Suppose that a bushel of grain costs 5 Australian dollars in Sydney and 150 rupees in Mumbai. If the law of one price holds for grain, what is the nominal exchange rate between Australia and India?

Because the market value of a bushel of grain must be the same in both locations, we know that the Australian price of wheat must equal the Indian price of wheat, so that

5 Australian dollars = 150 Indian rupees.

Dividing by 5, we get

1 Australian dollar = 30 Indian rupees.

Thus the nominal exchange rate between Australia and India should be 30 rupees per Australian dollar.

CONCEPT CHECK 28.3

The price of gold is $900 per ounce in New York and 7,500 kronor per ounce in Stockholm, Sweden. If the law of one price holds for gold, what is the nominal exchange rate between the U.S. dollar and the Swedish krona?

Example 28.3 and Concept Check 28.3 illustrate the application of the purchasing power parity theory. According to the purchasing power parity (PPP) theory, nominal exchange rates are determined as necessary for the law of one price to hold.

A particularly useful prediction of the PPP theory is that in the long run, the currencies of countries that experience significant inflation will tend to depreciate. To see why, we will extend the analysis in Example 28.3.

EXAMPLE 28.4Purchasing Power Parity

How does inflation affect the nominal exchange rate?

Suppose India experiences significant inflation so that the price of a bushel of grain in Mumbai rises from 150 to 300 rupees. Australia has no inflation, so the price of grain in Sydney remains unchanged at 5 Australian dollars. If the law of one price holds for grain, what will happen to the nominal exchange rate between Australia and India?

As in Example 28.3, we know that the market value of a bushel of grain must be the same in both locations. Therefore,

5 Australian dollars = 300 rupees.

Equivalently,

1 Australian dollar = 60 rupees.

The nominal exchange rate is now 60 rupees per Australian dollar. Before India’s inflation, the nominal exchange rate was 30 rupees per Australian dollar (Example 28.3). So in this example, inflation has caused the rupee to depreciate against the Australian dollar. Conversely, Australia, with no inflation, has seen its currency appreciate against the rupee.

This link between inflation and depreciation makes economic sense. Inflation implies that a nation’s currency is losing purchasing power in the domestic market. Analogously, exchange rate depreciation implies that the nation’s currency is losing purchasing power in international markets.

Figure 28.2 shows annual rates of inflation and nominal exchange rate depreciation for the 10 largest South American countries from 1995 to 2004.1 Inflation is measured as the annual rate of change in the country’s consumer price index; depreciation is measured relative to the U.S. dollar. As you can see, inflation varied greatly among South American countries during the period. For example, Chile’s inflation rate was within two percentage points of the inflation rate of the United States, while Venezuela’s inflation was 33 percent per year.

FIGURE 28.2 Inflation and Currency Depreciation in South America, 1995–2004.The annual rates of inflation and nominal exchange rate depreciation (relative to the U.S. dollar) in the 10 largest South American countries varied considerably during 1995–2004. High inflation was associated with rapid depreciation of the nominal exchange rate. (Data for Ecuador refer to the period 1995–2000.)Source: International Monetary Fund, International Financial Statistics, and authors’ calculations.

Figure 28.2 shows that, as the PPP theory implies, countries with higher inflation during the 1995–2004 period tended to experience the most rapid depreciation of their currencies.

SHORTCOMINGS OF THE PPP THEORY

Empirical studies have found that the PPP theory is useful for predicting changes in nominal exchange rates over the relatively long run. In particular, this theory helps to explain the tendency of countries with high inflation to experience depreciation of their exchange rates, as shown in Figure 28.2. However, the theory is less successful in predicting short-run movements in exchange rates.

A particularly dramatic failure of the PPP theory occurred in the United States in the early 1980s. As Figure 28.1 indicates, between 1980 and 1985, the value of the U.S. dollar rose nearly 50 percent relative to the currencies of U.S. trading partners. This strong appreciation was followed by an even more rapid depreciation during 1986 and 1987. PPP theory could explain this roller-coaster behavior only if inflation were far lower in the United States than in U.S. trading partners from 1980 to 1985 and far higher from 1986 to 1987. In fact, inflation was similar in the United States and its trading partners throughout both periods.

Why does the PPP theory work less well in the short run than the long run? Recall that this theory relies on the law of one price, which says that the price of an internationally traded commodity must be the same in all locations. The law of one price works well for goods such as grain or gold, which are standardized commodities that are traded widely. However, not all goods and services are traded internationally, and not all goods are standardized commodities.

Many goods and services are not traded internationally because the assumption underlying the law of one price—that transportation costs are relatively small—does not hold for them. For example, for Indians to export haircuts to Australia, they would need to transport an Indian barber to Australia every time a Sydney resident desired a trim. Because transportation costs prevent haircuts from being traded internationally, the law of one price does not apply to them. Thus, even if the price of haircuts in Australia were double the price of haircuts in India, market forces would not necessarily force prices toward equality in the short run. (Over the long run, some Indian barbers might emigrate to Australia.) Other examples of nontraded goods and services are agricultural land, buildings, heavy construction materials (whose value is low relative to their transportation costs), and highly perishable foods. In addition, some products use nontraded goods and services as inputs: a McDonald’s hamburger served in Moscow has both a tradable component (frozen hamburger patties) and a nontradable component (the labor of counter workers). In general, the greater the share of nontraded goods and services in a nation’s output, the less precisely the PPP theory will apply to the country’s exchange rate.2

The second reason the law of one price and the PPP theory sometimes fail to apply is that not all internationally traded goods and services are perfectly standardized commodities, like grain or gold. For example, U.S.-made automobiles and Japanese-made automobiles are not identical; they differ in styling, horsepower, reliability, and other features. As a result, some people strongly prefer one nation’s cars to the other’s. Thus if Japanese cars cost 10 percent more than American cars, U.S. automobile exports will not necessarily flood the Japanese market, since many Japanese will still prefer Japanese-made cars even at a 10 percent premium. Of course, there are limits to how far prices can diverge before people will switch to the cheaper product. But the law of one price, and hence the PPP theory, will not apply exactly to nonstandardized goods.

To summarize, the PPP theory works reasonably well as an explanation of exchange rate behavior over the long run, but not in the short run. Because transportation costs limit international trade in many goods and services, and because not all goods that are traded are standardized commodities, the law of one price (on which the PPP theory is based) works only imperfectly in the short run. To understand the short-run movements of exchange rates we need to incorporate some additional factors. In the next section, we will study a supply and demand framework for the determination of exchange rates.

RECAP

DETERMINING THE EXCHANGE RATE IN THE LONG RUN

· The most basic theory of nominal exchange rate determination, purchasing power parity (PPP), is based on the law of one price. The law of one price states that if transportation costs (and other costs and barriers to trade) are relatively small, the price of an internationally traded commodity must be the same in all locations. According to the PPP theory, the nominal exchange rate between two currencies can be found by setting the price of a traded commodity in one currency equal to the price of the same commodity expressed in the second currency.

· A useful prediction of the PPP theory is that the currencies of countries that experience significant inflation will tend to depreciate over the long run. However, the PPP theory does not work well in the short run. The fact that many goods and services are nontraded, and that not all traded goods are standardized, reduces the applicability of the law of one price, and hence of the PPP theory.

THE DETERMINATION OF THE EXCHANGE RATE IN THE SHORT RUN

Although the PPP theory helps to explain the long-run behavior of the exchange rate, supply and demand analysis is more useful for studying its short-run behavior. As we will see, dollars are demanded in the foreign exchange market by foreigners who seek to purchase U.S. goods and assets and are supplied by U.S. residents who need foreign currencies to buy foreign goods and assets. The equilibrium exchange rate is the value of the dollar that equates the number of dollars supplied and demanded in the foreign exchange market.

THE FOREIGN EXCHANGE MARKET: A SUPPLY AND DEMAND ANALYSIS

In this section, we will discuss the factors that affect the supply and demand for dollars in the foreign exchange market, and thus the U.S. exchange rate.

One note before we proceed: in Chapter 26, Stabilizing the Economy: The Role of the Fed, we described how the supply of money by the Fed and the demand for money by the public help to determine the nominal interest rate. However, the supply and demand for money in the domestic economy, as presented in that chapter, are not equivalent to the supply and demand for dollars in the foreign exchange market. As mentioned, the foreign exchange market is the market in which the currencies of various nations are traded for one another. The supply of dollars to the foreign exchange market is not the same as the money supply set by the Fed; rather, it is the number of dollars U.S. households and firms offer to trade for other currencies. Likewise, the demand for dollars in the foreign exchange market is not the same as the domestic demand for money, but the number of dollars holders of foreign currencies seek to buy. To understand the distinction, it may help to keep in mind that while the Fed determines the total supply of dollars in the U.S. economy, a dollar does not “count” as having been supplied to the foreign exchange market until some holder of dollars, such as a household or firm, tries to trade it for a foreign currency.

The Supply of Dollars

Anyone who holds dollars, from an international bank to a Russian citizen whose dollars are buried in the backyard, is a potential supplier of dollars to the foreign exchange market. In practice, however, the principal suppliers of dollars to the foreign exchange market are U.S. households and firms. Why would a U.S. household or firm want to supply dollars in exchange for foreign currency? There are two major reasons. First, a U.S. household or firm may need foreign currency to purchase foreign goods or services. For example, a U.S. automobile importer may need euros to purchase German cars, or an American tourist may need euros to make purchases in Paris, Rome, or Barcelona.3 Second, a U.S. household or firm may need foreign currency to purchase foreign assets. For example, an American mutual fund may wish to acquire stocks issued by Dutch companies, or an individual U.S. saver may want to purchase Irish government bonds. Because these assets are priced in euros, the U.S. household or firm will need to trade dollars for euros to acquire these assets.

The supply of dollars to the foreign exchange market is illustrated in Figure 28.3. We will focus on the market in which dollars are traded for euros, but bear in mind that similar markets exist for every other pair of traded currencies. The vertical axis of the figure shows the U.S.–European exchange rate as measured by the number of euros that can be purchased with each dollar. The horizontal axis shows the number of dollars being traded in the euro–dollar market.

FIGURE 28.3 The Supply and Demand for Dollars in the Euro–Dollar Market.The supply of dollars to the foreign exchange market is upward-sloping because an increase in the number of euros offered for each dollar makes European goods, services, and assets more attractive to U.S. buyers. Similarly, the demand for dollars is downward-sloping because holders of euros will be less willing to buy dollars the more expensive they are in terms of euros. The equilibrium exchange rate e*, also called the fundamental value of the exchange rate, equates the quantities of dollars supplied and demanded.

Note that the supply curve for dollars is upward-sloping. In other words, the more euros each dollar can buy, the more dollars people are willing to supply to the foreign exchange market. Why? At given prices for European goods, services, and assets, the more euros a dollar can buy, the cheaper those goods, services, and assets will be in dollar terms. For example, if a washing machine costs 200 euros in Germany and a dollar can buy 1 euro, the dollar price of the washing machine will be $200. However, if a dollar can buy 2 euros, then the dollar price of the same washing machine will be $100. Assuming that lower dollar prices will induce Americans to increase their expenditures on European goods, services, and assets, a higher euro–dollar exchange rate will increase the supply of dollars to the foreign exchange market. Thus the supply curve for dollars is upward-sloping.

The Demand for Dollars

In the euro–dollar foreign exchange market, demanders of dollars are those who wish to acquire dollars in exchange for euros. Most demanders of dollars in the euro–dollar market are European households and firms, although anyone who happens to hold euros is free to trade them for dollars. Why demand dollars? The reasons for acquiring dollars are analogous to those for acquiring euros. First, households and firms that hold euros will demand dollars so that they can purchase U.S. goods and services. For example, a Portuguese firm that wants to license U.S.-produced software needs dollars to pay the required fees, and a Portuguese student studying in an American university must pay tuition in dollars. The firm or the student can acquire the necessary dollars only by offering euros in exchange. Second, households and firms demand dollars in order to purchase U.S. assets. The purchase of Hawaiian real estate by a Finnish company or the acquisition of Google stock by an Austrian pension fund are two examples.

The demand for dollars is represented by the downward-sloping curve in Figure 28.3. The curve slopes downward because the more euros a European person must pay to acquire a dollar, the less attractive U.S. goods, services, and assets will be. Hence the demand for dollars will be low when dollars are expensive in terms of euros and high when dollars are cheap in terms of euros.

The Equilibrium Value of the Dollar

As mentioned earlier, the United States maintains a flexible, or floating, exchange rate, which means that the value of the dollar is determined by the forces of supply and demand in the foreign exchange market. In Figure 28.3 the equilibrium value of the dollar is e*, the euro–dollar exchange rate at which the quantity of dollars supplied equals the quantity of dollars demanded. The equilibrium value of the exchange rate is also called the fundamental value of the exchange rate. In general, the equilibrium value of the dollar is not constant but changes with shifts in the supply of and demand for dollars in the foreign exchange market.

CHANGES IN THE SUPPLY OF DOLLARS

Recall that people supply dollars to the euro–dollar foreign exchange market in order to purchase European goods, services, and assets. Factors that affect the desire of U.S. households and firms to acquire European goods, services, and assets will therefore affect the supply of dollars to the foreign exchange market. Some factors that will increase the supply of dollars, shifting the supply curve for dollars to the right, include:

· An increased preference for European goods. For example, suppose that European firms produce some popular new consumer electronics. To acquire the euros needed to buy these goods, American importers will increase their supply of dollars to the foreign exchange market.

· An increase in U.S. real incomes. An increase in the incomes of Americans will allow Americans to consume more goods and services (recall the consumption function, introduced in Chapter 25, Spending and Output in the Short Run). Some part of this increase in consumption will take the form of goods imported from Europe. To buy more European goods, Americans will supply more dollars to acquire the necessary euros.

· An increase in the real interest rate on European assets. Recall that U.S. households and firms acquire euros in order to purchase European assets as well as goods and services. Other factors, such as risk, held constant, the higher the real interest rate paid by European assets, the more European assets Americans will choose to hold. To purchase additional European assets, U.S. households and firms will supply more dollars to the foreign exchange market.

Conversely, reduced demand for European goods, lower real U.S. incomes, or a lower real interest rate on European assets will reduce the number of euros Americans need, in turn reducing their supply of dollars to the foreign exchange market and shifting the supply curve for dollars to the left. Of course, any shift in the supply curve for dollars will affect the equilibrium exchange rate, as Example 28.5 shows.

EXAMPLE 28.5Washing Machines and the Exchange Rate

How would increased demand for German washing machines affect the euro–dollar exchange rate?

Suppose German firms come to dominate the washing machine market, with washing machines that are more efficient and reliable than those produced in the United States. All else being equal, how will this change affect the relative value of the euro and the dollar?

The increased quality of German washing machines will increase the demand for the washing machines in the United States. To acquire the euros necessary to buy more German washing machines, U.S. importers will supply more dollars to the foreign exchange market. As Figure 28.4 shows, the increased supply of dollars will reduce the value of the dollar. In other words, a dollar will buy fewer euros than it did before. At the same time, the euro will increase in value: A given number of euros will buy more dollars than it did before.

FIGURE 28.4 An Increase in the Supply of Dollars Lowers the Value of the Dollar.Increased U.S. demand for German washing machines forces Americans to supply more dollars to the foreign exchange market to acquire the euros they need to buy the machines. The supply curve for dollars shifts from S to S′, lowering the value of the dollar in terms of euros. The fundamental value of the exchange rate falls from e* to e*′.

CONCEPT CHECK 28.4

The U.S. goes into a recession, and real GDP falls. All else equal, how is this economic weakness likely to affect the value of the dollar?

CHANGES IN THE DEMAND FOR DOLLARS

The factors that can cause a change in the demand for dollars in the foreign exchange market, and thus a shift of the dollar demand curve, are analogous to the factors that affect the supply of dollars. Factors that will increase the demand for dollars include:

· An increased preference for U.S. goods. For example, European airlines might find that U.S.-built aircraft are superior to others and decide to expand the number of American-made planes in their fleets. To buy the American planes, European airlines would demand more dollars on the foreign exchange market.

· An increase in real incomes abroad and thus more demand for imports from the United States.

· An increase in the real interest rate on U.S. assets, which would make those assets more attractive to foreign savers. To acquire U.S. assets, European savers would demand more dollars.

RECAP

DETERMINING THE EXCHANGE RATE IN THE SHORT RUN

· Supply and demand analysis is a useful tool for studying the short-run determination of the exchange rate. U.S. households and firms supply dollars to the foreign exchange market to acquire foreign currencies, which they need to purchase foreign goods, services, and assets. Foreigners demand dollars in the foreign exchange market to purchase U.S. goods, services, and assets. The equilibrium exchange rate, also called the fundamental value of the exchange rate, equates the quantities of dollars supplied and demanded in the foreign exchange market.

· An increased preference for foreign goods, an increase in U.S. real incomes, or an increase in the real interest rate on foreign assets will increase the supply of dollars on the foreign exchange market, lowering the value of the dollar. An increased preference for U.S. goods by foreigners, an increase in real incomes abroad, or an increase in the real interest rate on U.S. assets will increase the demand for dollars, raising the value of the dollar.

MONETARY POLICY AND THE EXCHANGE RATE

Of the many factors that could influence a country’s exchange rate, among the most important is the monetary policy of the country’s central bank. As we will see, monetary policy affects the exchange rate primarily through its effect on the real interest rate.

Suppose the Fed is concerned about inflation and tightens U.S. monetary policy in response. The effects of this policy change on the value of the dollar are shown in Figure 28.5. Before the policy change, the equilibrium value of the exchange rate is e*, at the intersection of supply curve S and the demand curve D (point E in the figure). The tightening of monetary policy raises the domestic U.S. real interest rate r, making U.S. assets more attractive to foreign financial investors. The increased willingness of foreign investors to buy U.S. assets increases the demand for dollars, shifting the demand curve rightward from D to D′ and the equilibrium point from E to F. As a result of this increase in demand, the equilibrium value of the dollar rises from e* to e*′.

FIGURE 28.5 A Tightening of Monetary Policy Strengthens the Dollar.Tighter monetary policy in the United States raises the domestic real interest rate, increasing the demand for U.S. assets by foreign savers. An increased demand for U.S. assets in turn increases the demand for dollars. The demand curve shifts from D to D′, leading the exchange rate to appreciate from e* to e*′.

In short, a tightening of monetary policy by the Fed raises the demand for dollars, causing the dollar to appreciate. By similar logic, an easing of monetary policy, which reduces the real interest rate, would weaken the demand for the dollar, causing it to depreciate.

The Economic Naturalist 28.2

Why did the dollar appreciate nearly 50 percent in the first half of the 1980s and nearly 40 percent in the second half of the 1990s?

Figure 28.1 showed the strong appreciation of the U.S. dollar in 1980–1985, followed by a sharp depreciation in 1986–1987. It also showed a strong appreciation in 1995–2001, followed by depreciation in 2002–2004. We saw earlier that the PPP theory cannot explain this roller-coaster behavior. What can explain it?

Tight monetary policy, and the associated high real interest rate, were important causes of the dollar’s remarkable appreciation during 1980–1985. U.S. inflation peaked at 13.5 percent in 1980. Under the leadership of Chairman Paul Volcker, the Fed responded to the surge in inflation by raising the real interest rate sharply in hopes of reducing aggregate demand and inflationary pressures. As a result, the real interest rate in the United States rose from negative values in 1979 and 1980 to more than 7 percent in 1983 and 1984. Attracted by these high real returns, foreign savers rushed to buy U.S. assets, driving the value of the dollar up significantly.

The Fed’s attempt to bring down inflation was successful. By the middle of the 1980s the Fed was able to ease U.S. monetary policy. The resulting decline in the real interest rate reduced the demand for U.S. assets, and thus for dollars, at which point the dollar fell back almost to its 1980 level.

One reason for the dollar’s appreciation in the late 1990s was the U.S. stock market boom and the generally strong pace of growth. These raised expected returns on U.S. assets, leading foreigners to want to buy these assets, increasing the demand for and thus appreciating the dollar. The relatively tight monetary policy during these years also played a role.

Stock markets peaked in the early 2000s before reversing course, and the U.S. economy was in recession during much of 2001, accompanied by a significant expansion in monetary policy starting early in 2001. While the dollar did not reverse its general upward trend until early 2002, when it eventually did, it started a long period of depreciation. By early 2004, with the federal funds rate at a historic low, the dollar fell back to its 1995 level.

THE EXCHANGE RATE AS A TOOL OF MONETARY POLICY

In a closed economy, monetary policy affects aggregate demand solely through the real interest rate. For example, by raising the real interest rate, a tight monetary policy reduces consumption and investment spending. We will see next that in an open economy with a flexible exchange rate, the exchange rate serves as another channel for monetary policy, one that reinforces the effects of the real interest rate.

To illustrate, suppose that policymakers are concerned about inflation and decide to restrain aggregate demand. To do so, they increase the real interest rate, reducing consumption and investment spending. But, as Figure 28.5 shows, the higher real interest rate also increases the demand for dollars, causing the dollar to appreciate. The stronger dollar, in turn, further reduces aggregate demand. Why? As we saw in discussing the real exchange rate, a stronger dollar reduces the cost of imported goods, increasing imports. It also makes U.S. exports more costly to foreign buyers, which tends to reduce exports. Recall that net exports—or exports minus imports—is one of the four components of aggregate demand. Thus, by reducing exports and increasing imports, a stronger dollar (more precisely, a higher real exchange rate) reduces aggregate demand.4

In sum, when the exchange rate is flexible, a tighter monetary policy reduces net exports (through a stronger dollar) as well as consumption and investment spending (through a higher real interest rate). Conversely, an easier monetary policy weakens the dollar and stimulates net exports, reinforcing the effect of the lower real interest rate on consumption and investment spending. Thus, relative to the case of a closed economy we studied earlier, monetary policy is more effective in an open economy with a flexible exchange rate.

The tightening of monetary policy under Fed Chairman Volcker in the early 1980s illustrates the effect of monetary policy on net exports (the trade balance). As we saw in Economic Naturalist 28.2, Volcker’s tight-money policies were a major reason for the 50 percent appreciation of the dollar during 1980–1985. In 1980 and 1981, imports into the United States were only slightly above exports from the U.S., and the trade deficit did not exceed 0.5 percent of GDP. Largely in response to a stronger dollar, the U.S. trade deficit increased substantially after 1981. By the end of 1985 the U.S. trade deficit was about 3 percent of GDP, a substantial shift in less than half a decade.

RECAP

MONETARY POLICY AND THE EXCHANGE RATE

A tight monetary policy raises the real interest rate, increasing the demand for dollars and strengthening the dollar. A stronger dollar reinforces the effects of tight monetary policy on aggregate spending by reducing net exports, a component of aggregate demand. Conversely, an easy monetary policy lowers the real interest rate, weakening the dollar.

FIXED EXCHANGE RATES

So far we have focused on the case of flexible exchange rates, the relevant case for most large industrial countries like the United States. However, the alternative approach, fixing the exchange rate, has been quite important historically and is still used in many countries, especially small or developing nations. Furthermore, as mentioned earlier, even China—currently the world’s second-largest economy—lets its currency float only within a fixed narrow band that shifts gradually over time or that is set by the central bank. (China kept its exchange rate fixed to the dollar throughout much of the 1990s and 2000s but has recently attempted to make its exchange rate somewhat more flexible.)

In this section, we will see how our conclusions change when the nominal exchange rate is fixed rather than flexible. One important difference is that when a country maintains a fixed exchange rate, its ability to use monetary policy as a stabilization tool is greatly reduced.

HOW TO FIX AN EXCHANGE RATE

In contrast to a flexible exchange rate, whose value is determined solely by supply and demand in the foreign exchange market, the value of a fixed exchange rate is determined by the government (in practice, usually the finance ministry or treasury department, with the cooperation of the central bank). Today, the value of a fixed exchange rate is usually set in terms of a major currency (for instance, Hong Kong pegs its currency to the U.S. dollar at an exchange rate of HK$7.8 to US$1), or relative to a “basket” of currencies, typically those of the country’s trading partners. Historically, currency values were often fixed in terms of gold or other precious metals, but in recent years, precious metals have rarely if ever been used for that purpose.

Once an exchange rate has been fixed, the government usually attempts to keep it unchanged for some time.5 However, sometimes economic circumstances force the government to change the value of the exchange rate. A reduction in the official value of a currency is called a devaluation; an increase in the official value is called a revaluation. The devaluation of a fixed exchange rate is analogous to the depreciation of a flexible exchange rate; both involve a reduction in the currency’s value. Conversely, a revaluation is analogous to an appreciation.

The supply and demand diagram we used to study flexible exchange rates can be adapted to analyze fixed exchange rates. Let’s consider the case of a country called Latinia, whose currency is called the peso. Figure 28.6 shows the supply and demand for the Latinian peso in the foreign exchange market. Pesos are supplied to the foreign exchange market by Latinian households and firms that want to acquire foreign currencies to purchase foreign goods and assets. Pesos are demanded by holders of foreign currencies who need pesos to purchase Latinian goods and assets. Figure 28.6 shows that the quantities of pesos supplied and demanded in the foreign exchange market are equal when a peso equals 0.1 dollars (10 pesos to the dollar). Hence 0.1 dollars per peso is the fundamental value of the peso. If Latinia had a flexible-exchange-rate system, the peso would trade at 10 pesos to the dollar in the foreign exchange market.

FIGURE 28.6 An Overvalued Exchange Rate.The peso’s official value (0.125 dollars) is shown as greater than its fundamental value (0.10 dollars), as determined by supply and demand in the foreign exchange market. Thus the peso is overvalued. To maintain the fixed value, the government must purchase pesos in the quantity AB each period.

But let’s suppose that Latinia has a fixed exchange rate and that the government has decreed the value of the Latinian peso to be 8 pesos to the dollar, or 0.125 dollars per peso. This official value of the peso, 0.125 dollars, is indicated by the solid horizontal line in Figure 28.6. Notice that it is greater than the fundamental value, corresponding to the intersection of the supply and demand curves. When the officially fixed value of an exchange rate is greater than its fundamental value, the exchange rate is said to be overvalued. The official value of an exchange rate can also be lower than its fundamental value, in which case the exchange rate is said to be undervalued.

In this example, Latinia’s commitment to hold the peso at 8 to the dollar is inconsistent with the fundamental value of 10 to the dollar, as determined by supply and demand in the foreign exchange market (the Latinian peso is overvalued). How could the Latinian government deal with this inconsistency? There are several possibilities. First, Latinia could simply devalue its currency, from 0.125 dollars per peso to 0.10 dollars per peso, which would bring the peso’s official value into line with its fundamental value. As we will see, devaluation is often the ultimate result of an overvaluation of a currency. However, a country with a fixed exchange rate will be reluctant to change the official value of its exchange rate every time the fundamental value changes. If a country must continuously adjust its exchange rate to market conditions, it might as well switch to a flexible exchange rate.

As a second alternative, Latinia could try to maintain its overvalued exchange rate by restricting international transactions. Imposing quotas on imports and prohibiting domestic households and firms from acquiring foreign assets would effectively reduce the supply of pesos to the foreign exchange market, raising the fundamental value of the currency. An even more extreme action would be to prohibit Latinians from exchanging the peso for other currencies without government approval, a policy that would effectively allow the government to determine directly the supply of pesos to the foreign exchange market. Such measures might help to maintain the official value of the peso. However, restrictions on trade and capital flows are extremely costly to the economy, because they reduce the gains from specialization and trade and deny domestic households and firms access to foreign capital markets. Thus, a policy of restricting international transactions to maintain a fixed exchange rate is likely to do more harm than good.

The third and most widely used approach to maintaining an overvalued exchange rate is for the government to become a demander of its own currency in the foreign exchange market. Figure 28.6 shows that at the official exchange rate of 0.125 dollars per peso, the private-sector supply of pesos (point B) exceeds the private-sector demand for pesos (point A). To keep the peso from falling below its official value, in each period the Latinian government could purchase a quantity of pesos in the foreign exchange market equal to the length of the line segment AB in Figure 28.6. If the government followed this strategy, then at the official exchange rate of 0.125 dollars per peso, the total demand for pesos (private demand at point A plus government demand AB) would equal the private supply of pesos (point B). This situation is analogous to government attempts to keep the price of a commodity, like grain or milk, above its market level. To maintain an official price of grain that is above the market-clearing price, the government must stand ready to purchase the excess supply of grain forthcoming at the official price. In the same way, to keep the “price” of its currency above the market-clearing level, the government must buy the excess pesos supplied at the official price.

To be able to purchase its own currency and maintain an overvalued exchange rate, the government (usually the central bank) must hold foreign currency assets, called international reserves, or simply reserves. For example, the Latinian central bank may hold dollar deposits in U.S. banks or U.S. government debt, which it can trade for pesos in the foreign exchange market as needed. In the situation shown in Figure 28.6, to keep the peso at its official value, in each period the Latinian central bank will have to spend an amount of international reserves equal to the length of the line segment AB.

Because a country with an overvalued exchange rate must use part of its reserves to support the value of its currency in each period, over time its available reserves will decline. The net decline in a country’s stock of international reserves over a year is called its balance-of-payments deficit. Conversely, if a country experiences a net increase in its international reserves over the year, the increase is called its balance-of-payments surplus.

EXAMPLE 28.6Latinia’s Balance-of-Payments Deficit

What is the balance-of-payments cost of keeping a currency overvalued?

The demand for and supply of Latinian pesos in the foreign exchange market are

Demand = 25,000 − 50,000e,

Supply = 17,600 + 24,000e,

where the Latinian exchange rate e is measured in dollars per peso. Officially, the value of the peso is 0.125 dollars. Find the fundamental value of the peso and the Latinian balance-of-payments deficit, measured in both pesos and dollars.

To find the fundamental value of the peso, equate the demand and supply for pesos:

25,000 − 50,000e = 17,600 + 24,000e.

Solving for e, we get

7,400 = 74,000e

e = 0.10.

So the fundamental value of the exchange rate is 0.10 dollars per peso, as in Figure 28.6.

At the official exchange rate, 0.125 dollars per peso, the demand for pesos is 25,000 − 50,000(0.125) = 18,750, and the supply of pesos is 17,600 + 24,000 (0.125) = 20,600. Thus the quantity of pesos supplied to the foreign exchange market exceeds the quantity of pesos demanded by 20,600 − 18,750 = 1,850 pesos. To maintain the fixed rate, the Latinian government must purchase 1,850 pesos per period, which is the Latinian balance-of-payments deficit. Since pesos are purchased at the official rate of 8 pesos to the dollar, the balance-of-payments deficit in dollars is (1,850 pesos) × (0.125 dollars/peso) = $(1,850/8) = $231.25.

CONCEPT CHECK 28.5

Repeat Example 28.6 under the assumption that the fixed value of the peso is 0.15 dollars per peso. What do you conclude about the relationship between the degree of currency overvaluation and the resulting balance-of-payments deficit?

Although a government can maintain an overvalued exchange rate for a time by offering to buy back its own currency at the official price, there is a limit to this strategy, since no government’s stock of international reserves is infinite. Eventually the government will run out of reserves, and the fixed exchange rate will collapse. As we will see next, the collapse of a fixed exchange rate can be quite sudden and dramatic.

CONCEPT CHECK 28.6

Diagram a case in which a fixed exchange rate is undervalued rather than overvalued. Show that to maintain the fixed exchange rate, the central bank must use domestic currency to purchase foreign currency in the foreign exchange market. With an undervalued exchange rate, is the country’s central bank in danger of running out of international reserves? (Hint: Keep in mind that a central bank is always free to print more of its own currency.)

SPECULATIVE ATTACKS

A government’s attempt to maintain an overvalued exchange rate can be ended quickly and unexpectedly by the onset of a speculative attack. A speculative attack involves massive selling of domestic currency assets by both domestic and foreign financial investors. For example, in a speculative attack on the Latinian peso, financial investors would attempt to get rid of any financial assets—stocks, bonds, deposits in banks—denominated in pesos. A speculative attack is most likely to occur when financial investors fear that an overvalued currency will soon be devalued since, in a devaluation, financial assets denominated in the domestic currency suddenly become worth much less in terms of other currencies. Ironically, speculative attacks, which are usually prompted by fear of devaluation, may turn out to be the cause of devaluation. Thus a speculative attack may actually be a self-fulfilling prophecy.

The effects of a speculative attack on the market for pesos are shown in Figure 28.7. At first, the situation is the same as in Figure 28.6: The supply and demand for Latinian pesos are indicated by the curves marked S and D, implying a fundamental value of the peso of 0.10 dollars per peso. As before, the official value of the peso is 0.125 dollars per peso—greater than the fundamental value—so the peso is overvalued. To maintain the fixed value of the peso, each period the Latinian central bank must use its international reserves to buy back pesos, in the amount corresponding to the line segment AB in the figure.

FIGURE 28.7 A Speculative Attack on the Peso.Initially, the peso is overvalued at 0.125 dollars per peso. To maintain the official rate, the central bank must buy pesos in the amount AB each period. Fearful of possible devaluation, financial investors launch a speculative attack, selling peso-denominated assets and supplying pesos to the foreign exchange market. As a result, the supply of pesos shifts from S to S′, lowering the fundamental value of the currency still further and forcing the central bank to buy pesos in the amount AC to maintain the official exchange rate. This more rapid loss of reserves may lead the central bank to devalue the peso, confirming financial investors’ fears.

Suppose, though, that financial investors fear that Latinia may soon devalue its currency, perhaps because the central bank’s reserves are getting low. If the peso were to be devalued from its official value of 8 pesos to the dollar to its fundamental value of 10 pesos per dollar, then a 1 million peso investment, worth $125,000 at the fixed exchange rate, would suddenly be worth only $100,000. To try to avoid these losses, financial investors will sell their peso-denominated assets and offer pesos on the foreign exchange market. The resulting flood of pesos into the market will shift the supply curve of pesos to the right, from S to S′ in Figure 28.7.

This speculative attack creates a serious problem for the Latinian central bank. Prior to the attack, maintaining the value of the peso required the central bank to spend each period an amount of international reserves corresponding to the line segment AB. Now suddenly the central bank must spend a larger quantity of reserves, equal to the distance AC in Figure 28.7, to maintain the fixed exchange rate. These extra reserves are needed to purchase the pesos being sold by panicky financial investors. In practice, such speculative attacks often force a devaluation by reducing the central bank’s reserves to the point where further defense of the fixed exchange rate is considered hopeless. Thus a speculative attack ignited by fears of devaluation may actually end up producing the very devaluation that was feared.

MONETARY POLICY AND THE FIXED EXCHANGE RATE

We have seen that there is no truly satisfactory way of maintaining a fixed exchange rate above its fundamental value for an extended period. A central bank can maintain an overvalued exchange rate for a time by using international reserves to buy up the excess supply of its currency in the foreign exchange market. But a country’s international reserves are limited and may eventually be exhausted by the attempt to keep the exchange rate artificially high. Moreover, speculative attacks often hasten the collapse of an overvalued exchange rate.

An alternative to trying to maintain an overvalued exchange rate is to take actions that increase the fundamental value of the exchange rate. If the exchange rate’s fundamental value can be raised enough to equal its official value, then the overvaluation problem will be eliminated. The most effective way to change the exchange rate’s fundamental value is through monetary policy. As we saw earlier in the chapter, a tight monetary policy that raises the real interest rate will increase the demand for the domestic currency, as domestic assets become more attractive to foreign financial investors. Increased demand for the currency will in turn raise its fundamental value.

The use of monetary policy to support a fixed exchange rate is shown in Figure 28.8. At first, the demand and supply of the Latinian peso in the foreign exchange market are given by the curves D and S, so the fundamental value of the peso equals 0.10 dollars per peso—less than the official value of 0.125 dollars per peso. Just as before, the peso is overvalued. This time, however, the Latinian central bank uses monetary policy to eliminate the overvaluation problem. To do so, the central bank increases the domestic real interest rate, making Latinian assets more attractive to foreign financial investors and raising the demand for pesos from D to D′. After this increase in the demand for pesos, the fundamental value of the peso equals the officially fixed value, as can be seen in Figure 28.8. Because the peso is no longer overvalued, it can be maintained at its fixed value without loss of international reserves or fear of speculative attack. Conversely, an easing of monetary policy (a lower real interest rate) could be used to remedy an undervaluation, in which the official exchange rate is below the fundamental value.

FIGURE 28.8 A Tightening of Monetary Policy Eliminates an Overvaluation.With the demand for the peso given by D and the supply given by S, equilibrium occurs at point E and the fundamental value of the peso equals 0.10 dollars per peso—below the official value of 0.125 dollars per peso. The overvaluation of the peso can be eliminated by tighter monetary policy, which raises the domestic real interest rate, making domestic assets more attractive to foreign financial investors. The resulting increase in demand for the peso, from D to D′, raises the peso’s fundamental value to 0.125 dollars per peso, the official value. The peso is no longer overvalued.

Although monetary policy can be used to keep the fundamental value of the exchange rate equal to the official value, using monetary policy in this way has some drawbacks. In particular, if monetary policy is used to set the fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy. Suppose, for example, that the Latinian economy were suffering a recession due to insufficient aggregate demand at the same time that its exchange rate is overvalued. The Latinian central bank could lower the real interest rate to increase spending and output, or it could raise the real interest rate to eliminate overvaluation of the exchange rate, but it cannot do both. Hence, if Latinian officials decide to maintain the fixed exchange rate, they must give up any hope of fighting the recession using monetary policy. The fact that a fixed exchange rate limits or eliminates the use of monetary policy for the purpose of stabilizing aggregate demand is one of the most important features of a fixed exchange rate system.

The conflict monetary policymakers face, between stabilizing the exchange rate and stabilizing the domestic economy, is most severe when the exchange rate is under a speculative attack. A speculative attack lowers the fundamental value of the exchange rate still further, by increasing the supply of the currency in the foreign exchange market (see Figure 28.7). To stop a speculative attack, the central bank must raise the fundamental value of the currency a great deal, which requires a large increase in the real interest rate. (In a famous episode in 1992, the Swedish central bank responded to an attack on its currency by raising the short-term interest rate to 500 percent!) However, because the increase in the real interest rate that is necessary to stop a speculative attack reduces aggregate demand, it can cause a severe economic slowdown. Economic Naturalist 28.3 describes a real-world example of this phenomenon.

The Economic Naturalist 28.3

What were the causes and consequences of the East Asian crisis of 1997–1998?

During the last three decades of the twentieth century, the countries of East Asia enjoyed impressive economic growth and stability. But the “East Asian miracle” seemed to end in 1997, when a wave of speculative attacks hit the region’s currencies. Thailand, which had kept a constant value for its currency in terms of the U.S. dollar for more than a decade, was the first to come under attack, but the crisis spread to other countries, including South Korea, Indonesia, and Malaysia. Each of these countries was ultimately forced to devalue its currency. What caused this crisis, and what were its consequences?

Because of the impressive economic record of the East Asian countries, the speculative attacks on their currencies were unexpected by most policymakers, economists, and financial investors. With the benefit of hindsight, however, we can identify some problems in the East Asian economies that contributed to the crisis. Perhaps the most serious problems concerned their banking systems. In the decade prior to the crisis, East Asian banks received large inflows of capital from foreign financial investors hoping to profit from the East Asian miracle. Those inflows would have been a boon if they had been well invested, but unfortunately, many bankers used the funds to make loans to family members, friends, or the politically well-connected—a phenomenon that became known as crony capitalism. The results were poor returns on investment and defaults by many borrowers. Ultimately, foreign investors realized that the returns to investing in East Asia would be much lower than expected. When they began to sell off their assets, the process snowballed into a full-fledged speculative attack on the East Asian currencies.

Despite assistance by international lenders such as the International Monetary Fund (see Economic Naturalist 28.4), the effects of the speculative attacks on the East Asian economies were severe. The prices of assets such as stocks and land plummeted, and there were banking panics in several nations. (See Chapter 22, Money, Prices, and the Federal Reserve for a discussion of banking panics.) In an attempt to raise the fundamental values of their exchange rates and stave off additional devaluation, several of the countries increased their real interest rates sharply. However, the rise in real interest rates depressed aggregate demand, contributing to sharp declines in output and rising unemployment.

Fortunately, by 1999 most East Asian economies had begun to recover. Still, the crisis impressed the potential dangers of fixed exchange rates quite sharply in the minds of policymakers in developing countries. Another lesson from the crisis is that banking regulations need to be structured so as to promote economically sound lending rather than crony capitalism.

The Economic Naturalist 28.4

What is the IMF, and how has its mission evolved over the years?

The International Monetary Fund (IMF) was established after World War II. An international agency, the IMF is controlled by a 24-member executive board. Eight executive board members represent individual countries (China, France, Germany, Japan, Russia, Saudi Arabia, the United Kingdom, and the United States); the other 16 members each represent a group of countries. A managing director oversees the IMF’s operations and its approximately 2,700 staff (half of whom are economists).

The original purpose of the IMF was to help manage the system of fixed exchange rates, called the Bretton Woods system, put in place after the war. Under Bretton Woods, the IMF’s principal role was to lend international reserves to member countries that needed them so that those countries could maintain their exchange rates at the official values. However, by 1973 the United States, the United Kingdom, Germany, and most other industrial nations had abandoned fixed exchange rates for flexible rates, leaving the IMF to find a new mission. Since 1973, the IMF has been involved primarily in lending to developing countries. For example, during the currency crises of the 1990s, it lent to Mexico, Russia, Brazil, and several East Asian countries. During the 2008 crisis, it again made loans to countries that saw their currencies under pressure. More recently, the IMF joined European countries in making loans to Greece—a developed country—with the Europeans providing two-thirds of the money Greece needs to pay its government debts, and the IMF providing one-third.

The Economic Naturalist 28.5

How did policy mistakes contribute to the Great Depression?

We introduced the study of macroeconomics with the claim that policy mistakes played a major role in causing the Great Depression. Now that we are close to completing our study of macroeconomics, we can be more specific about that claim. How did policy mistakes contribute to the Great Depression?

Many policy mistakes (as well as a great deal of bad luck) contributed to the severity of the Depression. For example, U.S. policymakers, in an attempt to protect domestic industries, imposed the infamous Hawley-Smoot tariff in 1930. Other countries quickly retaliated with their own tariffs, leading to the virtual collapse of international trade.

However, the most serious mistakes by far were in the realm of monetary policy.6 As we saw in Chapter 22, Money, Prices, and the Federal Reserve, the U.S. money supply contracted by one-third between 1929 and 1933. Associated with this unprecedented decline in the money supply were sharply falling output and prices and surging unemployment.

At least three separate policy errors were responsible for the collapse of the U.S. money supply between 1929 and 1933. First, the Federal Reserve tightened monetary policy significantly in 1928 and 1929, despite the absence of inflation. Fed officials took this action primarily in an attempt to “rein in” the booming stock market, which they feared was rising too quickly. Their “success” in dampening stock market speculation was more than they bargained for, however, as rising interest rates and a slowing economy contributed to a crash in stock prices that began in October 1929.

The second critical policy error was allowing thousands of U.S. banks to fail during the banking panics of 1930 to 1933. Apparently officials believed that the failures would eliminate only the weakest banks, strengthening the banking system overall. However, the banking panics sharply reduced bank deposits and the overall money supply, for reasons discussed in Economic Naturalist 22.2.

The third policy error, related to the subject of this chapter, arose from the U.S. government’s exchange rate policies. When the Depression began, the United States, like most other major countries, was on the gold standard, with the value of the dollar officially set in terms of gold.7 By establishing a fixed value for the dollar, the United States effectively created a fixed exchange rate between the dollar and other currencies whose values were set in terms of gold. As the Depression worsened, Fed officials were urged by Congress to ease monetary policy to stop the fall in output and prices. However, as we saw earlier, under a fixed exchange rate, monetary policy cannot be used to stabilize the domestic economy. Specifically, policymakers of the early 1930s feared that if they eased monetary policy, foreign financial investors might perceive the dollar to be overvalued and launch a speculative attack, forcing a devaluation of the dollar or even the abandonment of the gold standard altogether. The Fed therefore made no serious attempt to arrest the collapse of the money supply.

With hindsight, we can see that the Fed’s decision to put a higher priority on remaining on the gold standard than on stimulating the economy was a major error. Indeed, countries that abandoned the gold standard in favor of a floating exchange rate, such as Great Britain and Sweden, or that had never been on the gold standard (Spain and China) were able to increase their money supplies and to recover much more quickly from the Depression than the United States did. The Fed evidently believed, erroneously as it turned out, that stability of the exchange rate would somehow translate into overall economic stability.

Upon taking office in March 1933, Franklin D. Roosevelt reversed several of these policy errors. He took active measures to restore the health of the banking system, and he suspended the gold standard. The money supply stopped falling and began to grow rapidly. Output, prices, and stock prices recovered rapidly during 1933 to 1937, although unemployment remained high. However, ultimate recovery from the Depression was interrupted by another recession in 1937–1938.

RECAP

FIXED EXCHANGE RATES

· The value of a fixed exchange rate is set by the government. The official value of a fixed exchange rate may differ from its fundamental value, as determined by supply and demand in the foreign exchange market. An exchange rate whose officially fixed value exceeds its fundamental value is overvalued; an exchange rate whose officially fixed value is below its fundamental value is undervalued.

· For an overvalued exchange rate, the quantity of the currency supplied to the foreign exchange market at the official exchange rate exceeds the quantity demanded. The government can maintain an overvalued exchange rate for a time by using its international reserves (foreign currency assets) to purchase the excess supply of its currency. The net decline in a country’s stock of international reserves during the year is its balance-of-payments deficit.

· Because a country’s international reserves are limited, it cannot maintain an overvalued exchange rate indefinitely. Moreover, if financial investors fear an impending devaluation of the exchange rate, they may launch a speculative attack, selling domestic currency assets and supplying large amounts of the country’s currency to the foreign exchange market—an action that exhausts the country’s reserves even more quickly. Because rapid loss of reserves may force a devaluation, financial investors’ fear of devaluation may prove a self-fulfilling prophecy.

· A tight monetary policy, which increases the real interest rate, raises the demand for the currency and hence its fundamental value. By raising a currency’s fundamental value to its official value, tight monetary policies can eliminate the problem of overvaluation and stabilize the exchange rate. However, if monetary policy is used to set the fundamental value of the exchange rate, it is no longer available for stabilizing the domestic economy.

SHOULD EXCHANGE RATES BE FIXED OR FLEXIBLE?

Should countries adopt fixed or flexible exchange rates? In briefly comparing the two systems, we will focus on two major issues: (1) the effects of the exchange rate system on monetary policy and (2) the effects of the exchange rate system on trade and economic integration.

On the issue of monetary policy, we have seen that the type of exchange rate a country has strongly affects the central bank’s ability to use monetary policy to stabilize the economy. A flexible exchange rate actually strengthens the impact of monetary policy on aggregate demand. But a fixed exchange rate prevents policymakers from using monetary policy to stabilize the economy because they must instead use it to keep the exchange rate’s fundamental value at its official value (or else risk speculative attack).

In large economies like that of the United States, giving up the power to stabilize the domestic economy via monetary policy makes little sense. Thus large economies should nearly always employ a flexible exchange rate. However, in small economies, giving up this power may have some benefits. An interesting case is that of Argentina, which for the period 1991–2001 maintained a one-to-one exchange rate between its peso and the U.S. dollar. Although prior to 1991 Argentina had suffered periods of hyperinflation, while the peso was pegged to the dollar, Argentina’s inflation rate essentially equaled that of the United States. By tying its currency to the dollar and giving up the freedom to set its monetary policy, Argentina attempted to commit itself to avoiding the inflationary policies of the past, and instead placed itself under the “umbrella” of the Federal Reserve. Unfortunately, early in 2002 investors’ fears that Argentina would not be able to repay its international debts led to a speculative attack on the Argentine peso. The fixed exchange rate collapsed, the peso depreciated, and Argentina experienced an economic crisis. The lesson is that a fixed exchange rate alone cannot stop inflation in a small economy, if other policies are not sound as well. Large fiscal deficits, which were financed by foreign borrowing, ultimately pushed Argentina into crisis.

The second important issue is the effect of the exchange rate on trade and economic integration. Proponents of fixed exchange rates argue that fixed rates promote international trade and cross-border economic cooperation by reducing uncertainty about future exchange rates. For example, a firm that is considering building up its export business knows that its potential profits will depend on the future value of its own country’s currency relative to the currencies of the countries to which it exports. Under a flexible exchange rate regime, the value of the home currency fluctuates with changes in supply and demand and is therefore difficult to predict far in advance. Such uncertainty may make the firm reluctant to expand its export business. Supporters of fixed exchange rates argue that if the exchange rate is officially fixed, uncertainty about the future exchange rate is reduced or eliminated.

One problem with this argument, which has been underscored by episodes like the East Asian crisis, the Argentine crisis, and, recently, the Greek crisis (see Economic Naturalist 28.6,) is that fixed exchange rates are not guaranteed to remain fixed forever. Although they do not fluctuate from day to day as flexible rates do, a speculative attack on a fixed exchange rate, or even a change in elected politicians’ economic views, may lead suddenly and unpredictably to a large devaluation. Thus a firm that is trying to forecast the exchange rate 10 years into the future may face as much uncertainty if the exchange rate is fixed as if it is flexible.

The potential instability of fixed exchange rates caused by speculative attacks has led some countries to try a more radical solution to the problem of uncertainty about exchange rates: the adoption of a common currency. Economic Naturalist 28.6 describes an important instance of this strategy.

The Economic Naturalist 28.6

Why have 19 European countries adopted a common currency?

Effective January 1, 1999, eleven western European nations, including France, Germany, and Italy, adopted a common currency, called the euro. In several stages, the euro replaced the French franc, the German mark, the Italian lira, and other national currencies. The process was completed in early 2002 when the old currencies were completely eliminated and replaced by euros. Since then, more European nations, including eastern European ones, have joined the common currency. As of 2017, the last nation to join was Lithuania, which on January 1, 2015, became the 19th member of the euro area (or eurozone). Why have these nations adopted a common currency?

Since the end of World War II the nations of western Europe have worked to increase economic cooperation and trade among themselves. European leaders recognized that a unified and integrated European economy would be more productive and perhaps more competitive with the U.S. economy than a fragmented one. As part of this effort, these countries established fixed exchange rates under the auspices of a system called the European Monetary System (EMS). Unfortunately, the EMS did not prove stable. Numerous devaluations of the various currencies occurred, and in 1992, severe speculative attacks forced several nations, including Great Britain, to abandon the fixed exchange rate system.

In December 1991, in Maastricht in the Netherlands, the member countries of the European Community (EC) adopted a treaty popularly known as the Maastricht Treaty. One of the major provisions of the treaty, which took effect in November 1993, was that member countries would strive to adopt a common currency. This common currency, known as the euro, was formally adopted on January 1, 1999. The advent of the euro means that Europeans from eurozone countries no longer have to change currencies when trading with other eurozone countries, much as Americans from different states can trade with each other without worrying that a “New York dollar” will change in value relative to a “California dollar.” The euro has helped to promote European trade and cooperation while eliminating the problem of speculative attacks on the currencies of individual countries.

Because 19 European nations now have a single currency, they also must have a common monetary policy. The EC members agreed that European monetary policy would be put under the control of a new European Central Bank (ECB), a multinational institution located in Frankfurt, Germany. The ECB has in effect become “Europe’s Fed.” One potential problem with having a single monetary policy for so many different countries is that different countries may face different economic conditions, so a single monetary policy cannot respond to all of them. Indeed, in recent years countries in southern Europe like Spain and Italy have been in serious recessions (which requires an easing of monetary policy), while Germany has been close to full employment. With such a wide variation in economic conditions, the requirement of a single monetary policy has been creating conflicts of interest among the member nations of the European Community.

SUMMARY

· The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. A rise in the value of a currency relative to other currencies is called an appreciation; a decline in the value of a currency is called a depreciation. (LO1)

· Exchange rates can be flexible or fixed. (Approaches that combine the two are not our focus in this chapter.) The value of a flexible exchange rate is determined by the supply and demand for the currency in the foreign exchange market, the market on which currencies of various nations are traded for one another. The government sets the value of a fixed exchange rate. (LO1)

· The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. An increase in the real exchange rate implies that domestic goods and services are becoming more expensive relative to foreign goods and services, which tends to reduce exports and increase imports. Conversely, a decline in the real exchange rate tends to increase net exports. (LO1)

· A basic theory of nominal exchange rate determination, the purchasing power parity (PPP) theory, is based on the law of one price. The law of one price states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations. According to the PPP theory, we can find the nominal exchange rate between two currencies by setting the price of a commodity in one of the currencies equal to the price of the commodity in the second currency. The PPP theory correctly predicts that the currencies of countries that experience significant inflation will tend to depreciate in the long run. However, the fact that many goods and services are not traded internationally, and that not all traded goods are standardized, makes the PPP theory less useful for explaining short-run changes in exchange rates. (LO2)

· Supply and demand analysis is a useful tool for studying the determination of exchange rates in the short run. The equilibrium exchange rate, also called the fundamental value of the exchange rate, equates the quantities of the currency supplied and demanded in the foreign exchange market. A currency is supplied by domestic residents who wish to acquire foreign currencies to purchase foreign goods, services, and assets. An increased preference for foreign goods, an increase in the domestic GDP, or an increase in the real interest rate on foreign assets will all increase the supply of a currency on the foreign exchange market and thus lower its value. A currency is demanded by foreigners who wish to purchase domestic goods, services, and assets. An increased preference for domestic goods by foreigners, an increase in real GDP abroad, or an increase in the domestic real interest rate will all increase the demand for the currency on the foreign exchange market and thus increase its value. (LO3)

· If the exchange rate is flexible, a tight monetary policy (by raising the real interest rate) increases the demand for the currency and causes it to appreciate. The stronger currency reinforces the effects of the tight monetary policy on aggregate demand by reducing net exports. Conversely, easy monetary policy lowers the real interest rate and weakens the currency, which in turn stimulates net exports. (LO4)

· The value of a fixed exchange rate is officially established by the government. A fixed exchange rate whose official value exceeds its fundamental value in the foreign exchange market is said to be overvalued. An exchange rate whose official value is below its fundamental value is undervalued. A reduction in the official value of a fixed exchange rate is called a devaluation; an increase in its official value is called a revaluation. (LO5)

· For an overvalued exchange rate, the quantity of the currency supplied at the official exchange rate exceeds the quantity demanded. To maintain the official rate, the country’s central bank must use its international reserves (foreign currency assets) to purchase the excess supply of its currency in the foreign exchange market. Because a country’s international reserves are limited, it cannot maintain an overvalued exchange rate indefinitely. Moreover, if financial investors fear an impending devaluation of the exchange rate, they may launch a speculative attack, selling their domestic currency assets and supplying large quantities of the currency to the foreign exchange market. Because speculative attacks cause a country’s central bank to spend its international reserves even more quickly, they often force a devaluation. (LO5)

· A tight monetary policy, by raising the fundamental value of the exchange rate, can eliminate the problem of overvaluation. However, if monetary policy is used to set the fundamental value of the exchange rate equal to the official value, it is no longer available for stabilizing the domestic economy. Thus under fixed exchange rates, monetary policy has little or no power to affect domestic output and employment. (LO5)

· Because a fixed exchange rate implies that monetary policy can no longer be used for domestic stabilization, most large countries employ a flexible exchange rate. A fixed exchange rate may benefit a small country by forcing its central bank to follow the monetary policies of the country to which it has tied its rate. Advocates of fixed exchange rates argue that they increase trade and economic integration by making the exchange rate more predictable. However, the threat of speculative attacks greatly reduces the long-term predictability of a fixed exchange rate. (LO6)

KEY TERMS

appreciation

balance-of-payments deficit

balance-of-payments surplus

depreciation

devaluation

fixed exchange rate

flexible exchange rate

foreign exchange market

fundamental value of the exchange rate (or equilibrium exchange rate)

international reserves

law of one price

nominal exchange rate

overvalued exchange rate

purchasing power parity (PPP)

real exchange rate

revaluation

speculative attack

undervalued exchange rate

REVIEW QUESTIONS

1. 1.Japanese yen trade at 110 yen per dollar and Mexico pesos trade at 10 pesos per dollar. What is the nominal exchange rate between the yen and the peso? Express in two ways. (LO1)

2. 2.Define nominal exchange rate and real exchange rate. How are the two concepts related? Which type of exchange rate most directly affects a country’s ability to export its goods and services? (LO1)

3. 3.Would you expect the law of one price to apply to crude oil? To fresh milk? To taxi rides? To compact discs produced in different countries by local recording artists? Explain your answer in each case. (LO2)

4. 4.Why do U.S. households and firms supply dollars to the foreign exchange market? Why do foreigners demand dollars in the foreign exchange market? (LO3)

5. 5.Under a flexible exchange rate, how does an easing of monetary policy (a lower real interest rate) affect the value of the exchange rate? Does this change in the exchange rate tend to weaken or strengthen the effect of the monetary ease on output and employment? Explain. (LO4)

6. 6.Define overvalued exchange rate. Discuss four ways in which government policymakers can respond to an overvaluation. What are the drawbacks of each approach? (LO5)

7. 7.Use a supply and demand diagram to illustrate the effects of a speculative attack on an overvalued exchange rate. Why do speculative attacks often result in a devaluation? (LO5)

8. 8.Contrast fixed and flexible exchange rates in terms of how they affect (a) the ability of monetary policy to stabilize domestic output and (b) the predictability of future exchange rates. (LO6)

PROBLEMS

1. 1.Using the data in Table 28.1, find the nominal exchange rate between the Mexican peso and the Japanese yen. Express in two ways. How do your answers change if the peso appreciates by 10 percent against the dollar while the value of the yen against the dollar remains unchanged? (LO1)

2. 2.A British-made automobile is priced at £20,000 (20,000 British pounds). A comparable U.S.-made car costs $26,000. One pound trades for $1.50 in the foreign exchange market. Find the real exchange rate for automobiles from the perspective of the United States and from the perspective of Great Britain. Which country’s cars are more competitively priced? (LO1)

3. 3.Between last year and this year, the CPI in Blueland rose from 100 to 110 and the CPI in Redland rose from 100 to 105. Blueland’s currency unit, the blue, was worth $1 (U.S.) last year and is worth 90 cents (U.S.) this year. Redland’s currency unit, the red, was worth 50 cents (U.S.) last year and is worth 45 cents (U.S.) this year.

Find the percentage change from last year to this year in Blueland’s nominal exchange rate with Redland and in Blueland’s real exchange rate with Redland. (Treat Blueland as the home country.) Relative to Redland, do you expect Blueland’s exports to be helped or hurt by these changes in exchange rates? (LO1)

4. 4.The demand for U.S.-made cars in Japan is given by

Japanese demand = 10,000 − 0.001(Price of U.S. cars in yen).

Similarly, the demand for Japanese-made cars in the United States is

U.S. demand = 30,000 − 0.2(Price of Japanese cars in dollars).

The domestic price of a U.S.-made car is $20,000, and the domestic price of a Japanese-made car is ¥2,500,000. From the perspective of the United States, find the real exchange rate in terms of cars and net exports of cars to Japan, if: (LO1)

a. The nominal exchange rate is 100 yen per dollar.

b. The nominal exchange rate is 125 yen per dollar.

How does an appreciation of the dollar affect U.S. net exports of automobiles (considering only the Japanese market)?

5. 5.a. Gold is $350 per ounce in the United States and 2,800 pesos per ounce in Mexico. What nominal exchange rate between U.S. dollars and Mexican pesos is implied by the PPP theory? (LO2)

b. Mexico experiences inflation so that the price of gold rises to 4,200 pesos per ounce. Gold remains $350 per ounce in the United States. According to the PPP theory, what happens to the exchange rate? What general principle does this example illustrate? (LO2)

c. Gold is $350 per ounce in the United States and 4,200 pesos per ounce in Mexico. Crude oil (excluding taxes and transportation costs) is $30 per barrel in the United States. According to the PPP theory, what should a barrel of crude oil cost in Mexico? (LO2)

d. Gold is $350 per ounce in the United States. The exchange rate between the United States and Canada is 0.70 U.S. dollars per Canadian dollar. How much does an ounce of gold cost in Canada? (LO2)

6. 6.How would each of the following be likely to affect the value of the dollar, all else being equal? Explain. (LO3)

a. U.S. stocks are perceived as having become much riskier financial investments.

b. European computer firms switch from U.S.-produced software to software produced in India, Israel, and other nations.

c. As East Asian economies recover, international financial investors become aware of many new, high-return investment opportunities in the region.

7. 7.Suppose a French bottle of champagne costs 20 euros. (LO3)

a. If the euro–dollar exchange rate is 0.8 euros per dollar, so that a dollar can buy 0.8 euros, how much will the champagne cost in the United States?

b. If the euro–dollar exchange rate rises to 1 euro per dollar, how much will the champagne cost in the United States?

c. If an increase in the euro–dollar exchange rate leads to an increase in Americans’ dollar expenditures on French champagne, what will happen to the amount of dollars supplied to the foreign exchange market as the euro–dollar exchange rate rises?

8. 8.Consider an Apple iPod that costs $240. (LO3)

a. If the euro–dollar exchange rate is 1 euro per dollar, so that it costs a European 1 euro to buy a dollar, how much will the iPod cost in France?

b. If the euro–dollar exchange rate falls to 0.8 euros per dollar, how much will the iPod cost in France?

c. Consequently, what will happen to French purchases of iPods and the amount of dollars demanded in the foreign exchange market as the euro–dollar exchange rate falls?

9. 9.If the government follows an easy monetary policy and the exchange rate is flexible, which of the following will likely be the result? (LO4)

a. A falling real interest rate but higher net exports.

b. A higher real interest rate but lower net exports.

c. A strong currency that helps stimulate exports.

d. Increases in the demand for the currency and decreases in the supply of the currency.

10. 10.The demand for and supply of shekels in the foreign exchange market are

Demand = 30,000 − 8,000e,

Supply = 25,000 + 12,000e,

where the nominal exchange rate is expressed as U.S. dollars per shekel. (LO3, LO5)

a. What is the fundamental value of the shekel?

b. The shekel is fixed at 0.30 U.S. dollars. Is the shekel overvalued, undervalued, or neither? Find the balance-of-payments deficit or surplus in both shekels and dollars. What happens to the country’s international reserves over time?

c. Repeat part b for the case in which the shekel is fixed at 0.20 U.S. dollars.

11. 11.The annual demand for and supply of shekels in the foreign exchange market is as given in Problem 10. The shekel is fixed at 0.30 dollars per shekel. The country’s international reserves are $600. Foreign financial investors hold checking accounts in the country in the amount of 5,000 shekels. (LO3, LO5)

a. Suppose that foreign financial investors do not fear a devaluation of the shekel and, thus, do not convert their shekel checking accounts into dollars. Can the shekel be maintained at its fixed value of 0.30 U.S. dollars for the next year?

b. Now suppose that foreign financial investors come to expect a possible devaluation of the shekel to 0.25 U.S. dollars. Why should this possibility worry them?

c. In response to their concern about devaluation, foreign financial investors withdraw all funds from their checking accounts and attempt to convert those shekels into dollars. What happens?

d. Discuss why the foreign investors’ forecast of devaluation can be considered a “self-fulfilling prophecy.”

ANSWERS TO CONCEPT CHECKS

1. 28.1Answers will vary, depending on when the data are obtained. (LO1)

2. 28.2The dollar price of the U.S. computer is $2,400, and each dollar is equal to 110 yen. Therefore the yen price of the U.S. computer is (110 yen/dollar) × ($2,400), or 264,000 yen. The price of the Japanese computer is 242,000 yen. Thus the conclusion that the Japanese model is cheaper does not depend on the currency in which the comparison is made. (LO1)

3. 28.3Since the law of one price holds for gold, its price per ounce must be the same in New York and Stockholm:

$900 = 7,500 kronor.

Dividing both sides by 900, we get

$1 = 8.33 kronor.

So the exchange rate is 8.33 kronor per dollar. (LO2)

4. 28.4A decline in U.S. GDP reduces consumer incomes and hence imports. As Americans are purchasing fewer imports, they supply fewer dollars to the foreign exchange market, so the supply curve for dollars shifts to the left. Reduced supply raises the equilibrium value of the dollar. (LO3)

5. 28.5At a fixed value for the peso of 0.15 dollars, the demand for the peso equals 25,000 − 50,000(0.15) = 17,500. The supply of the peso equals 17,600 + 24,000(0.15) = 21,200. The quantity supplied at the official rate exceeds the quantity demanded by 3,700. Latinia will have to purchase 3,700 pesos each period, so its balance-of-payments deficit will equal 3,700 pesos, or 3,700 × 0.15 = 555 dollars. This balance-of-payments deficit is larger than we found in Example 28.6. We conclude that the greater the degree of overvaluation, the larger the country’s balance-of-payments deficit is likely to be. (LO5)

6. 28.6The figure shows a situation in which the official value of the currency is below the fundamental value, as determined by the supply of and demand for the currency in the foreign exchange market, so the currency is undervalued. At the official value of the exchange rate, the quantity demanded of the domestic currency (point B) exceeds the quantity supplied (point A). To maintain the official value, the central bank must supply domestic currency to the foreign exchange market each period in the amount AB. In contrast to the case of an overvalued exchange rate, here the central bank is providing its own currency to the foreign exchange market and receiving foreign currencies in return.

The central bank can print as much of its own currency as it likes, and so with an undervalued currency there is no danger of running out of international reserves. Indeed, the central bank’s stock of international reserves increases in the amount AB each period as it receives foreign currencies in exchange for the domestic currency it supplies. (LO5)

1Since Ecuador adopted the U.S. dollar as its currency in 2000, the data for Ecuador refer to the period 1995–2000.

2Trade barriers, such as tariffs and quotas, also increase the costs associated with shipping goods from one country to another. Thus trade barriers reduce the applicability of the law of one price in much the same way that physical transportation costs do.

3The following 19 countries use euros as their local currency: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. See Economic Naturalist 28.6 later in the chapter.

4We are temporarily assuming that the prices of U.S. goods in dollars and the prices of foreign goods in foreign currencies are not changing.

5There are exceptions to this statement. Some countries employ a crawling peg system, under which the exchange rate is fixed at a value that changes in a preannounced way over time. For example, the government may announce that the value of the fixed exchange rate will fall 2 percent each year. Other countries use a target zone system, in which the exchange rate is allowed to deviate by a small amount from its fixed value. To focus on the key issues, we will assume that the exchange rate is fixed at a single value for a protracted period.

6A classic 1963 book by Milton Friedman and Anna Schwartz, A Monetary History of the United States: 1867–1960 (Princeton, NJ: Princeton University Press), was the first to provide detailed support for the view that poor monetary policy helped to cause the Depression.

7The value of the dollar in 1929 was such that the price of 1 ounce of gold was fixed at $20.67.

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