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Exchange Rates

Exchange Rates. Balance of payments deficit/surplus + adjustments depend on system of exchange 1) flexible/floating: demand + supply 2) fixed/pegged: gov’t determines rates + adjusts as necessary to maintain.

siobhan-crofton
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Exchange Rates

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  1. Exchange Rates

  2. Balance of payments deficit/surplus + adjustments depend on system of exchange • 1) flexible/floating: demand + supply • 2) fixed/pegged: gov’t determines rates + adjusts as necessary to maintain

  3. Currency demand down sloping: currency less expensive goods less expensive to foreigners higher demand for goods higher quantity demand for currency • Currency supply up sloping: as more expensive (dollar price of pounds rises/pound price of dollar falls) foreigners purchase more goods greater supply foreign currency (exchanging foreign currency for domestic)

  4. British Pounds S+D Dollar price of 1 pound S 2 D Q1 Q of pounds

  5. Depreciation • Dollar price of pounds increases dollar depreciation relative to the pound (more dollars to get single unit of pounds)

  6. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) $3 $2 D2 D Q1 Q2 Q of pounds

  7. Appreciation • Dollar price of pounds decreases dollar appreciation relative to the pound (fewer dollars to get one unit of pounds)

  8. British Pounds S+D Dollar price of 1 pound S $2 Dollar appreciates (pounds depreciates) $1 D D2 Q1 Q of pounds Q2

  9. Generalizations • 1) Currency demand increases (ceteris paribus) appreciation • 2) Currency supply increases depreciation • 3) If US currency depreciates/appreciates some foreign currency appreciates/depreciates relative to it

  10. Determinants • 1) Tastes: changing demand products • 2) Relative income: relative fast income growth depreciation: income up more consumption domestic + imports greater relative demand foreign currency • 3) Relative price-level: purchasing power parity theory: exchange rates equate purchasing power of currencies (dollar gets same amount of stuff) • However: exchange rates differ from PPP even over long periods, BUT relative price levels a determinant (attempt to get relatively cheaper goods)

  11. 4) Relative interest rates greater demand financial investments greater demand currency • 5) Speculation: attempt to profit from rate changes (often self-fulfilling)

  12. Flexible Rates and Balance of Payments • Rates automatically adjust to eventually eliminate balance of payment deficits/surpluses • At equilibrium no need to draw down/build up official reserves to balance payments • Suppose D for pounds increases

  13. Dollar price of 1 pound British Pounds S+D c S $3 a b $2 D2 D Q1 Q2 Q of pounds

  14. If exchange rate stays at $2 = £1, balance of payments deficit of ab US demand b pounds, Brits only supply a quantity shortage pounds Competitive market new exchange rate (say $3 = £1) + dollar depreciates

  15. Dollar price of 1 pound S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  16. Exchange rates links all domestic and foreign prices • Dollar price foreign good= foreign price x exchange rate £ 9,000 car at $2 = £1 $18,000 • At $3 = £1 $27,000 car decline US imports B goods decrease quantity demanded pounds (movement point b to point c)

  17. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  18. US goods relatively cheaper B imports more (US exports more) increase quantity supply pounds movement a to c • Combination equilibrium S and D at new exchange rate

  19. Dollar price of 1 pound British Pounds S+D S Dollar depreciates (pounds appreciates) c $3 a b $2 D2 D Q1 Q2 Q of pounds

  20. Fixed Exchange Rates • G must intervene to maintain set exchange rate: • 1) Use of reserves: central bank buys/sells currency in open-market Reserves acquired: a) diff circumstances in past (surplus/deficit), b) gold as “international money” • If deficit persistent + sizable, may be unable to maintain peg bad news

  21. 2) Trade policies • Discourage imports: Tariffs or import quotas, special taxes • Encourage exports: subsidies •  loss of efficiency, retaliation

  22. 3) Exchange Controls + Rationing • EC: require all pounds acquired through trade sold to Fed ration only this amount • 1) Distorted trade: comparative advantage distorted • 2) Favoritism • 3) Restricted choice • 4) Black markets

  23. Domestic Macroeconomic Adjustments • Contractionary policy (tax hikes, reduce G, increase interest rates) lower income fewer imports + increased foreign investment (if higher relative rates) decrease D pounds + increase S pounds new exchange rate • Price of exchange-rate stability = recession

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