Exchage Rate Deter

7/27/2019 Exchage Rate Deter

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NOTES 15 Exchange Rates and International Macro

A. How Exchange Rates are Determined

If I were going to purchase a car from Japan, I would have to pay for that car in Yen (the Japanesecurrency). That means I must be willing to trade dollars for Yen. Likewise, if someone in Japanwanted to buy a U.S. computer, they would have to pay in dollars. That means they must tradetheir Yen for dollars.

If someone in the U.S. wants to buy a Japanese product, they are simultaneously willing to demandmore Yen and willing to supply more dollars. (They must supply dollars to get Yen).

If someone in Japan wants to by a U.S. product, they are simultaneously willing to demand moredollars and willing to supply more Yen.

As a result, we can formulate a market for Yen. We will treat Yen like any other good. Supply

and demand forces will determine the price of Yen (measured in dollars). We will define the priceof Yen as how many dollars we give up for one Yen (this is the price of Yen - in terms of dollars,Dollars/Yen). In the U.S., however, we often report the price of the dollar. If the dollarappreciates, that means it costs more yen to buy one dollar. (That is, we are often interested in theamount of Yen for one dollar). If the price of yen goes up, the price of the dollar will fall. Inother words, if the price of foreign currency falls, the dollar, by definition, appreciates.

Below illustrates the market for Yen:

Demand for YenSupply of Yenollars/Yen

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We will now look at the three factors that cause movements in the exchange rate market.

a) GDP

Suppose the GDP in the US increases. As we know, as Y increases, there are more expenditures inthe U.S. U.S. consumers, businesses and governments are purchasing more goods. It is highly

likely, that some of these goods are produced abroad. That means that imports will increase. Aswe get richer, we would want to buy more imports. We need foreign currency to buy imports. Ourdemand for foreign currency increases. As a result, the demand for Yen would shift to the right.This is illustrated below.

Dy1Dy2

SyDollars/Yen

An increase in the GDP of the US, increases the demand for Yen, causes the exchange rate to riseand the dollar to depreciate. (The exact opposite happens if US GDP falls).

An increase in the GDP of Japan, increases the supply of Yen. If the Japanese have a greaterincome, they would want to buy more U.S. goods. In order to buy more U.S. stuff, they need

dollars. Their demand for dollars would increase. If they want more dollars, they must supplymore yen. Because their demand for dollars increases, the supply of Yen increases.

The increase in Japans GDP would increase the supply of Yen, cause value of the Yen to fall andthe dollar to appreciate. (The exact opposite happens if Japans GDP falls)

Notice, with a GDP change in one country, only one of the curves shift!

b) Price changes: With a price change in one country, both the supply and the demand for acurrency will be affected. Let us illustrate with an example. Suppose that prices in the US rise (Pgoes up where P is price level of all goods in the economy). This means US goods become moreexpensive (foreign goods become relatively cheaper). If US goods are more expensive, US citizenswould want less of them. In other words, we would substitute towards buying more foreign goods.

If we want to buy foreign goods, we need to have foreign currency. As a result, our demand forYen (foreign currency) will increase.

The supply of Yen will also change. Picture yourself in Japan. If the price of US goodsincrease, a person in Japan would want less US goods, compared to what they were purchasingbefore. Their demand for dollars would fall. If they want less dollars, that means they would bewilling to supply less Yen. An increase in the price of US goods (inflation in the US) causes boththe supply of Yen to fall and the demand for Yen to increase.

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Below, we graphically illustrate this point:

Dy1Dy2

Sy1Sy2

Amount of Yen

Dollars/Yen

When Prices in the US increase, the demand for Yen increases, the supply of Yen falls, the price of

Yen rises and the dollar depreciates. (The exact opposite happens when the price level in the USfalls). [REMEMBER THAT BOTH AN INCREASE IN DEMAND AND A DECREASE INSUPPLY CAUSE THE PRICE OF FOREIGN CURRENCY TO RISE].

When Prices in the Japan increase, the demand for Yen falls, the supply of Yen increases, the priceof Yen falls and the dollar appreciates. (The exact opposite happens when the price level in theJapan falls).

When prices in Japan rise - US citizens want less Japanese goods and the Japanese want moreAmerican goods.

c) The third and final factor that affects exchange rates are interest rates.

Changes in interest rates shift both the demand for Yen and the Supply of Yen. If interestrates in the US go up, US citizens will want to put more money in US banks and less money inJapanese banks. The demand for Yen will fall.

Likewise, with increased interest rates in the US, Japanese citizens will want to put moremoney in the US. Their demand for dollars will increase which means they are willing to supplymore Yen.

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This is represented graphically below:

Dy1Sy1

Amount of Yen

Dy2Sy2Dollars/Yen

When interest rates in the US rise, the demand for Yen will fall, the supply of Yen will increase,

the price of Yen will fall, and the dollar will appreciate. (The exact opposite will happen if the USinterest rates fall).

When interest rates in Japan rise, the demand for Yen will increase, the supply of Yen will fall, thevalue of the Yen will rise, and the dollar will depreciate. (The exact opposite will happen if theJapanese interest rates fall).

B. How do changes in exchange rates affect our model?

Look at this example.

Suppose a computer costs 200 Yen in Japan. Suppose further that the price of yen was $.50/yen.

In terms of dollars, how much would the computer be worth? $100. (Every $ is worth 2 Yen. If Iwanted 200 yen, I would need 100 dollars. (200 Yen * $.50/yen)).

Would if the dollar appreciated? (We know that if the dollar appreciated, the price of yen wouldfall). Say the price of yen is now $.25/yen. In terms of dollars, how much would the computer beworth? $50. (Now, every dollar is worth 4 Yen. If I wanted 200 yen, I would need $50). As thedollar appreciated, Japanese goods become cheaper (in terms of dollars). As a result, I would wantmore of them. An appreciation of the dollar (depreciation of the Yen) would cause U.S. citizens towant more Japanese goods. U.S. import of Japanese goods would increase AND U.S. purchases ofU.S. produced goods would fall.

Flipping the story around, if the dollar appreciates, U.S. goods become more expensive. As a

result, Japanese citizens will be purchasing less U.S. goods.

As the dollar appreciates, US imports will rise and US exports would fall. (The exact oppositewould hold if the dollar depreciates). i.e., NX will fall!!!!

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A. Definition:

Trade Balance: Exports Imports (X-IM). If trade balance is positive, we say there is atrade surplus. If trade balance is negative, we say there is a trade deficit.

If the dollar appreciates, we would expect the trade surplus to fall (trade deficit to rise). If the

dollar appreciates, imports will increase and exports will fall.

B. Effectiveness of Fiscal and Monetary policy in an open economy.

Fiscal Policy:

Suppose the government increases G and or decreases T. How will this affect the goods market,money market, and exchange rate market?

Goods market: As G increases, there will be an increase in AD. The increase in AD will increaseY and increase P.

This is illustrated below:

AD

AD1 AS

Y

P

Y Y1

In the money market, MME curve will shift in as prices are higher (real money balances fall). Thiswill cause interest rates to rise.

How will exchange rates respond? The increase in Y and the increase in P in the US shouldcause the dollar to depreciate relative to other currencies. The increase in r should cause the dollarto appreciate relative to other currencies.

Which one dominates? It depends on the size of the changes. But, often the interest rate effectdominates. If the interest rate effects dominate and the dollar appreciates, imports will rise andexports will fall. As a result, the AD will shift some to the left. That means: In a closed economy(with no exchange rate movements), an increase in G will cause the AD to shift out end of story.But, with exchange rate movements, an increase in G will also cause the dollar to appreciate (ifinterest rate effect dominates) and this will cause NX to fall shift the AD curve in some. In theend, Y will still increase, but not as much if exchange rates adjust.

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International crowding out- In an open economy, expansionary fiscal policy (increasing G) couldlead to the appreciation of the dollar. This causes US imports to rise and US exports to fall whichshifts the AD curve to the left and offsets some of the initial impact of the AD shifting out (in theend, the AD still shifts out, just not as much as it would have if exchange rates were fixed). In asense, the increase in imports crowds out some of the effects of expansionary fiscal policy.

If international crowding out occurs fiscal policy is less effective. A given increase in G leads to asmaller change in Y when exchange rates are allowed to result.

TWIN DEFICITS The 1980s in the U.S. : If international crowding out occurs, twin deficitscould result. By twin deficits, I mean a budget deficit and a trade deficit could occur at the sametime. Let us look at how this could happen. Suppose the government increases spending withoutincreasing taxes. A budget deficit occurs. The increase in G is expansionary fiscal policy. Fromor discussion above, if the interest rate effect dominates exchange rates, the dollar will appreciate.This will cause the imports to rise and exports to fall. In other words, a trade deficit will result.We have just shown how a budget deficit could lead to a trade deficit. This is what happened inthe 1980s (along with an appreciation of the dollar).

C. REVIEW OF MONETARY POLICY IN THE OPEN ECONOMY:

To start, let us review monetary policy in a closed economy. Suppose the Fed enacts expansionarymonetary policy (buy bonds, lower reserve ratio, etc.).

We see that when the Fed increases the money supply, interest rates fall (MME shifts out). Thedecrease in interest rates causes borrowing to become cheaper. As a result, firms would engage inmore investment. The increase in investment will shift out the AD curve in the goods market. Thisis illustrated below.

ASADAD1

Y

P

The increase in investment will lead to an increase in both P and Y. In this case, this would be theend of the story about monetary policy if exchange rates were fixed.

How would the effects of monetary policy change in an open economy? For this, we need tolook at the currency market. As we learned, the currency market is affected by Y, P and r. Withmonetary policy, r falls and P and Y rise. All of these increase the demand for foreign currencyand decrease the supply of foreign currency. This is illustrated graphically below.

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$/FC

FC

FC = Foreign Currency (ie Yen)

Dfc1 Dfc2 Sfc2

Sfc1

As we see, the price of foreign currency will conclusively rise from expansive monetary policy.This will lead the dollar to depreciate. Depreciation of the dollar will decrease imports andincrease exports. In an open economy, AD will shift out further than it does in a closed economywith expansionary monetary policy. Not only will there be an increase in investment, but there will

be an increase in exports and a decrease in imports. All of these shift out the AD curve.

As a result, we say monetary policy is more effective in an open economy. (AD shifts out more inan open economy compared to a closed economy with expansionary monetary policy because themonetary policy causes the dollar to depreciate which spurs on higher NX).

Note: The same analysis would hold with a monetary contraction. AD will shift to the left morein an open economy than a closed economy with a contractionary monetary policy.

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