Exchange Rates and the Open Economy

Chapter 18

Foreign Exchange Market

• Abbreviation: FOREX

• Over a trillion dollars worth are traded daily.

• Most trading is to finance the purchase of assets (e.g., bank deposits), not goods and services.

NEW YORK -- The dollar maintained its weaker pallor, sinking against its major rivals as "carry trade" currencies continued to take center stage.While the dollar languished in negative territory against the euro, it seesawed against the yen before ending the session weaker against the Japanese currency.Investors seem unsure as to how to react to signs of a potential reversal in China's soaring equity market, resulting in bumpy trading, particularly for carry-trade currencies.In carry trades, investors borrow low-yielding currencies such as the yen to buy higher-yielding currencies. As long as exchange rates stay in tight ranges, investors pocket the difference in interest rates as profit."It's been a whippy day, (which has) coincided with moves in the stock market," said Grant Wilson, senior currency trader at Mellon Bank.While Shanghai's benchmark stock index slipped roughly 8% Monday, it managed to gain 2.6% yesterday after slipping as much as 7.2% earlier in the Asian day.U.S. stocks fell after comments from Federal Reserve Chairman Ben Bernanke that suggested the Fed currently has little reason to lower rates."As the stock market sold off, we continually sold euro-yen," Mr. Wilson said, "we are getting some direction from the stock market."Late in New York, the euro was trading at $1.3519, up from $1.3492 late Monday, while the dollar was at 121.36 yen, down from 121.76 yen. The dollar was at 1.2180 Swiss francs, down from 1.2235 Swiss francs, while the pound traded at $1.9925, up from $1.9914 late Monday.While investors sold U.S. equities on the back of Mr. Bernanke's comments, they also sold the dollar, causing it to slip modestly in early trading.

Quantity offoreign exchange (pounds)

Q

$1.20

$1.50

$1.80

Dollar price of foreign exchange(for pounds)

Foreign Exchange Market Equilibrium

S(sales to

foreigners)

Excess demandfor pounds

Excess supplyof pounds

• The dollar price of the English pound is measured on the vertical axis. The horizontal axis indicates the flow of pounds in exchange for dollars.• The demand and supply of pounds

are in equilibrium at the exchange

rate of $1.50 = 1 English pound.• At this price, quantity demanded equals quantity supplied.• A higher price of pounds (like $1.80 = 1 pound), would lead to an excess supply of pounds ... causing the dollar price of the pound to fall (depreciate).• A lower price of pounds (like $1.20 = 1 pound), would lead to an excess demand for pounds … causing the dollar price of the pound to rise (appreciate).

D(purchases from

foreigners)

e

Depreciation caused by:

1. A rapid growth of income (relative to trading partners) that stimulates imports relative to exports

2. A higher rate of inflation than one's trading partners

3. A reduction in domestic real interest rates (relative to rates abroad)

4. A reduction in the attractiveness of the domestic investment environment that leads to an outflow of capital

Appreciation caused by:

1. A slower growth rate relative to one’s trading partners.

2. A lower inflation rate than one's trading partners.

3. An increase in domestic real interest rates (relative to rates abroad).

4. An improvement in the attractiveness of the domestic investment environment that leads to an inflow of capital.

Types of exchange rate regime

1. Flexible• Exchange rate determined by

supply and demand.• Characterized by volatility.• Creates uncertainty in

conducting international business.

• Changes in value called appreciation and depreciation.

2. Fixed • Central bank buys and sells

domestic currency at a fixed price.

• The gold standard was a fixed exchange rate regime.

• Bretton Woods was another.• Provides more certainty in the

short run but the system is susceptible to speculative attacks.

• Changes in value called revaluation and devaluation.

Types of exchange rate regimes cont.

3. Pegged • a system where the country

commits to using monetary and fiscal policy to maintain the exchange-rate value of the domestic currency at a fixed rate or within a narrow band relative to another currency (or bundle of currencies).

• Unlike the case of fixed exchange rates, countries with a pegged exchange rate continue to conduct monetary policy.

4. Unified• country adopts the

currency of another country (dollarization) or agrees on a common currency with a group of countries (Euro)

19th Century Gold Standard

1 oz of gold = $20 = £4

£1 = $5

Bretton Woods Agreement 1944

Established a system of fixed exchange rates.

Breakdown 1971-73.

Beginning of the end of fixed exchange rates …

Richard Nixon closes the Gold Window in 1971.

Speculative Attack

• Occurs under a system of fixed exchange rates.• When the official price of the currency is set above the

true price.• For example, if the Argentina peso is valued officially at

1 peso for 1 dollar but in reality is worth only 50 cents. • The Argentine central bank must keep buying pesos to

keep the price high but it will eventually run out of dollars.

• Investors predict a revaluation and sell all their pesos now.

• They will also engage in short-selling: borrow pesos, sell for dollars and buy pesos later.

Balance of Payments

Current Account

Sources of funds: exports

Uses of funds: imports

Capital Account

Sources of funds: investment by foreigners

Uses of funds: investment by Americans in foreign countries

Official Reserve Account

Changes in central bank reserves.

International Capital Flows

• Capital inflows: foreign investors buying domestic assets

• Capital outflows: domestic investors buying foreign assets.

1973 1978 1983 1988 1993 2003

- 4

- 2

0

+ 2

1998

1973 1978 1983 1988 1993 20031998

Current Account as % of GDPsurplus (+) or deficit (-)

Net Foreign Investment as % of GDPsurplus (+) or deficit (-)

0

+ 2

- 2

+ 4

Balance of Payments

NX + KI = 0

→ KI = -NX

Saving & Investment in International Economy

Y = C + I + G + NX

Y – C – G – NX = I

-NX = KI

Y – C – G = S

→ S + KI = I