Macro Chapter 9

How do central banks influence exchange rates?

Central banks can influence exchange rates by buying and selling assets denominated in a foreign currency. A purchase of foreign assets, other things being equal, will tend to cause the value of a country's currency to depreciate. A sale of foreign assets will tend to cause the country's exchange rate to appreciate. Some central banks commit themselves to holding their currency at an exact target value. Others intervene frequently to resist undesired appreciation or depreciation without trying to maintain a fixed rate. Still other central banks, including the US Federal Reserve, do not intervene at all in foreign exchange markets.

What has been the exchange rate policy of the Chinese central bank?

China;s central bank, the People's Bank of China (PBoC), intervenes in foreign exchange markets on a regular basis. Up to 2005, it held the value of the yuan fixed relative to the dollar. From 2005-2008, it allowed the yuan to appreciate, but not as rapidly as market forces alone would have done. During the financial crisis, from 2008 to mid-2010, the PBoC again fixed the exchange rate. From mid-2010 to present, it has again allowed a controlled appreciation. A controversy continues as to whether the yuan is undervalued.

What is the distinction between nominal and real exchange rates?

Nominal exchange rates are expressed in terms of the actual number of currency unites needed to buy another currency. Real exchange rates are adjusted for the effects of inflation. If we let H stand for the nominal exchange rate expressed as units of domestic currency per unit of foreign currency, h stand for the real exchange rate, Pd stand for the domestic price level, and Pf stand for the foreign price level, then we can express the real exchange rate using the formula h=H(Pf/Pd). We express the real exchange rate using an index with a value of 100 for a chosen base year.

How do supply and demand determine exchange rates?

Supply and demand determine the exchange rate of one currency relative to another. The market where Mexican pesos trade for US dollars is an example. The supply curve of dollars in that market reflects the activities of US importers, who sell dollars to obtain pesos they need in oder to buy Mexican goods and services, and the activities of US investors who need pesos in order to buy Mexican stocks, bonds, or other assets. The demand curve for dollars reflects the activities of Mexican buyers of exports from the US and MExican investors in dollar-dominated assets. An increase in the value of the peso relative to the dollar is an appreciation of the peso. A decrease in the value of the peso is a depreciation.

What are the benefits of the euro currency area, and what are the problems it faces?

The euro, which first came into general circulation in 2002, is now the currency of seventeen members of the European Union. The purpose of the common currency area is to improve economic integration and lower the costs and risks of trade and international finance. However, the euro area has faced a number of problems in recent years. Its member countries do not share the degree of structural similarity needed for smooth operation of a currency area. Also, some countries have experienced problems with fiscal discipline and some have needed emergency assistance from their more stable partners.

Purchasing Power Parity (PPP)

a situation in which goods cost the same in one country as in another when prices are compared using the market exchange rate

Real Effective Exchange Rate (REER)

a weighted average of the exchange rate of a country's currency relative to those of all trading partners

appreciate

an increase in value of one country's currency relative to the currency of another country

common currency

central bank loses independent control over monetary policy

depreciate

decrease in value of one country's currency relative to the currency of another country

foreign-exchange markets

markets in which the currencies of different countries are traded for one another

currency union

two or more countries that share a common currency

unit labor costs

wage rates adjusted to reflect changes in labor productivity