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Chapter 12 International Finance I --- Exchange Rate

Chapter 12 International Finance I --- Exchange Rate. Contents:. Definitions Relation between domestic price and foreign price Exchange rate system Changes in the demand for and supply of foreign currency Determinants of the equilibrium exchange rate

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Chapter 12 International Finance I --- Exchange Rate

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  1. Chapter 12 International Finance I --- Exchange Rate

  2. Contents: • Definitions • Relation between domestic price and foreign price • Exchange rate system • Changes in the demand for and supply of foreign currency • Determinants of the equilibrium exchange rate • Automatic adjustment for BOP deficits under different exchange rate systems

  3. Contents: • Government policies on eliminating BOP deficit under a fixed exchange rate system • Comparison between flexible and fixed exchange rate systems

  4. Definitions

  5. Definitions • Foreign exchange (fe) refers to • foreign currency • orclaims on foreign currency such as cheques drawn in the currency

  6. Exchange rate or exchange value of a foreign currency (e) is the price of the currency (in terms of another currency). Without specification of the currency, it is the amount of domestic currency required to exchange for a unit of foreign currency. Note: When e , exchange value of foreign currency rises while that of domestic currency drops. Effective exchange rate indexis the price index of exchange rates of the domestic currency. Note: When the index , the exchange value of the domestic currencyrises.

  7. Relation between Domestic Price and Foreign Price

  8. Relation between domestic price and foreign price Domestic price of a good is its price in domestic currency (Pd). Foreign price of a good is its price in foreign currency (Pf). Pd=e  Pfor Pf = Pd /e

  9. The slopes of the demand curve for and the supply curve of foreign currency • The demand curve for foreign currency is downward sloping. Imports: When e rises,  Qm 

  10. The slope of the supply curve (S) of foreign currency depends on the price elasticity of foreign demand for the country’s exports (E). Exports: when e rises   Qx 1. If E is elasticS is upwardsloping 2. If E is unitarily elastic S is vertical 3. If E is inelasticS isdownwardsloping

  11. Exchange Rate System

  12. Exchange rate systems Exchange between currencies • An economic agent who • demands foreign currency on the one hand • supplies domestic currency on the other hand • and vice versa.

  13. Demand for and supply offoreign currency Price of foreign currency in domestic currency (or exchange rate) S Equilibrium exchange rate Quantity of foreign currency D

  14. Demand for and supply of domestic currency Price of domestic currency in foreign currency S Equilibrium exchange rate Quantity of domestic currency D

  15. Types of exchange rate systems Flexible / Floating exchange rate systemDemand for & supply of foreign currency  determines the market exchange rate Fixed exchange rate system The monetary authority  fixes the official exchange rate (at a pre-announced value)

  16. S e* D Balance of payments under different exchange rate systems Flexible exchange rate system Price of foreign currency in domestic currency (e) • The equilibrium e* will finally be reached at which Qd = Qs Equilibrium exchange rate • As Qd = Qs, the market BOP must always be balanced. 0 Quantity of foreign currency

  17. e1 At e1, excess demand for foreign currency exists (the country suffers BOP deficit) Foreign currency is under-valued Fixed exchange rate system Price of foreign currency in domestic currency (or exchange rate ) S • At the pre-announced e, Qd may not equal Qs. Equilibrium exchange rate e* D Quantity of foreign currency

  18. Fixed exchange rate system At e1, • Excess demand for foreign currency  Central Bank / Monetary Authority has to sell foreign currency for domestic currency ( reserve assets & domestic money supply )  Exchange rate maintained at e1

  19. Excess supply of domestic currency e1^ Domestic currency is over-valued Price of domestic currency in foreign currency An alternative expression Fixed exchange rate system S Equilibrium exchange rate e*  D Quantity of domestic currency

  20. Terms describing changes in exchange rate Under a flexible exchange rate system,a rise in the price of a foreign currency is described as an appreciation of the foreign currency or a depreciation of the domestic currency (as more units of domestic currency are needed to exchange for a unit of foreign currency). Under a fixed exchange rate system,a rise in the price of a foreign currency is described as a revaluation of the foreign currency or a devaluation of the domestic currency.

  21. Changes in the Demand for and Supply of Foreign Currency

  22. e’ D’ Demand for foreign currency increases Exchange rate S • If e is flexible, e rises • If e is fixed, Qd > Qs, i.e., BOP deficit results e D Quantity of foreign currency 0

  23. S’ Supply of foreign currency decreases Exchange rate S • If e is flexible, e rises e’ • If e is fixed, Qd > Qs, i.e., BOP deficit results e D Quantity of foreign currency 0

  24. Conclusion Demand for foreign currency  orsupply of foreign currency   The equilibrium exchange rate   Flexible e system  Fixed e system  dc depreciates  BOP deficit

  25. D’ Demand for foreign currency decreases Exchange rate • If e is fixed, Qs > Qd, i.e., BOP surplus results S e • If e is flexible, e falls e’ D Quantity of foreign currency 0

  26. e’ Supply of foreign currency increases Exchange rate • If e is fixed, Qs > Qd, i.e., BOP surplus results e • If e is flexible, e falls S D S’ Quantity of foreign currency 0

  27. Conclusion Demand for foreign currency  or supply of foreign currency   The equilibrium exchange rate   Fixed e system  Flexible e system  dc appreciates  BOP surplus

  28. Determinants of the Equilibrium Exchange Rate

  29. e’ D’ Protectionist measures Spending on imports  Exchange rate  Demand for fc  S Flexible e system: dc appreciates. Fixed e system: BOP surplus. e D Quantity of foreign currency 0

  30. S’ e’ More domestic investment opportunities Outflow of capital  & inflow of capital  Exchange rate Demand for fc  &supply of fc  S e Flexible e system: dc appreciates. Fixed e system: BOP surplus. D D’ Quantity of foreign currency 0

  31. e’ D’ National income rises National income  Exchange rate  Spending on imports   Demand for fc  S Flexible e system: dc depreciates.Fixed e system: BOP deficit. e D Quantity of foreign currency 0

  32. S’ e’ Interest rate rises Outflow of capital  & inflow of capital  Exchange rate Demand for fc  &supply of fc  S e Flexible e system: dc appreciates. Fixed e system: BOP surplus. D D’ Quantity of foreign currency 0

  33. e’ D’ Ms LM shifts rightward  r & Y Money Supply rises Exchange rate routflow of capital & inflow of capital D  &S  S’ S YSpending on imports D  e Flexible e system: dc depreciates.Fixed e system: BOP deficit. D 0 Quantity of foreign currency

  34. Inflation Inflation rate of a country  that of its trading partner 1.Competitiveness of import-competing products spending on imports  Demand for fc 

  35. S’ e’ D’ 2. Foreign prices of the country’s exports  If foreign demand for the country’s exports is elastic Exchange rate Volume of exports & receipts from exports  S Supply of fc  Flexible e system: dc depreciates.Fixed e system: BOP deficit. e D 0 Quantity of foreign currency

  36. S’ e’ Speculation upon the value of a currency A bullish speculation upon the domestic currency Outflow of capital  & inflow of capital  Exchange rate S Demand for fc  &supply of fc  e Flexible e system: dc appreciates. Fixed e system: BOP surplus. D D’ Quantity of foreign currency 0

  37. Automatic Adjustment for BOP Deficits under Different Exchange Rate Systems

  38. Imports: Exports: Automatic adjustment for BOP deficits under different exchange rate systems Under a flexible e system • BOP Deficit  excess D for fc e  Qm   Qx 

  39. If foreign demand for the country’s exports is elastic Exchange rate S Depreciation can improve the BOP deficit e’ e D Quantity of foreign currency Excess Demand 0

  40. If the demand for exports is unitarily elastic Exchange rate S Depreciation can improve the BOP deficit e’ e Excess Demand D Quantity of foreign currency 0

  41. If the demand for exports is inelastic and the M-L condition holds Exchange rate Depreciation can improve the BOP deficit e’ e Excess Demand Quantity of foreign currency S D 0

  42. Marshall-Lerner condition (M-L condition):  The sum of the price elasticities of foreign demand for the country’s exports and the country’s demand for foreign imports is greater than one.

  43. If the demand for export is inelastic but the M-L condition does not hold Exchange rate Depreciation cannot improve the BOP deficit and e rises persistently e Excess Demand Quantity of foreign currency S D 0

  44. LM’ r’ Y’ Under a fixed exchange rate system Facing a BOP deficit r Central bank sells foreign currency for domestic currency LM r  Ms Y & r IS 0 Y Y

  45. S’ D’ Y spending on imports  D Exchange rate routflow of capital  & inflow of capital  D&S S  The process continues until deficit  0 Fixed e D Quantity of foreign currency 0

  46. Government Policies on Eliminating BOP Deficit under a Fixed Exchange Rate System

  47. D’ Protectionist policy Spending on imports  Exchange rate S  Demand for fc   External deficit  Fixed e D Quantity of foreign currency 0

  48. An increase in interest rate Outflow of capital  & inflow of capital  Exchange rate Demand for fc  &supply of fc  S S’  External deficit  Fixed e D D’ 0 Quantity of foreign currency

  49. D’ Contractionary policy -- Prices are rigid Yspending on imports  Exchange rate  Demand for fc  S  External deficit  Fixed e D Quantity of foreign currency 0

  50. New fixed e Devaluation • The Marshall-Lerner condition is required. Exchange rate S Original fixed e D Quantity of foreign currency 0

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