Ch.9 The Exchange Rate

Expectations about the exchange rate

*the exchange rate changes when its expected to change driven by: interest rate parity, purchasing power parity

Purchasing power parity

A currency is worth the value of goods and services that it will buy. The quantity of goods and services that one unit of a particular currency will buy differs from the quantity of goods and services that one unit of another currency will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity, which means **equal value of money**

Interest rate parity

A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the rate of returns on two currencies are equal, interest rate parity prevails. **means equal interest rates when exchange rate changes are taken into account** Market forces achieve interest rate parity very quickly

Changes in the Exchange rate

If demand for US dollars increases and supply does not change, the exchange rate rises. If demand for US dollars decreases and supply does not change, the exchange rate falls. If supply of US dollars increases and demand does not change, the exchange rate falls. If supply of US dollars decreases and demand does not change, the exchange rate rises.

Market Equilibrium

If the exchange rate is too high, a surplus of US dollars drives it down. If the exchange rate is too low, a shortage if US dollars drives it up. The market is pulled (quickly) to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

The Law of Supply of Foreign Exchange

Other things remaining the same, the higher the exchange rate, the greater is the quantity of US dollars supplied in the foreign exchange rate

The Law of Demand for Foreign Exchange Rate

People buy US dollars so they can buy US produced goods and services or US assets Other things remaining the same, the higher the exchange rate, the smaller is the quantity of US dollars demanded in the foreign market

RER in the long run

RER is determined by the real forces of demand and supply in the market for goods and services. E= RER x (P*÷P) a rise in the foreign price level P* brings an appreciation of the US dollar in the long run A rise in the US price level P brings a depreciation of the US dollar in the long run

Factors that influence the supply of Dollars

US demand for imports, US interest rates relative to the foreign interest rate, the expected future exchange rate

Changes in the Supply of Dollars

a change in any influence on the quantity of US dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars

Currency depreciation

a fall in the value of one currency in terms of another currency

Currency appreciation

a rise in value of one currency in terms of another currency

Crawling peg

an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market China is a country that operates a crawling peg A crawling peg works like a fixed exchange rate except that the target value changes The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

The expected future exchange rate- demand

at a given current exchange rate, if expected future exchange rate for US dollars rises, the demand for US dollars increases and the demand curve for dollars shifts rightward

The expected future exchange rate- supply

at a given current exchange rate, if the expected future exchange rate for US dollars rises, the supply of US dollars decreases and the supply curve of US dollars shifts leftward

US demand for Imports

at a given exchange rate, if the US demand for imports increases, the supply of US dollars on the foreign exchange market increases and the supply curve of US dollars shifts rightward

World demand for US exports

at a given exchange rate, if world demand for US exports increases, the demand for US dollars increases and the demand curve for US dollars shifts rightward

2 reasons why the exchange rate influences the quantity of US dollars demanded

exports effect, expected profit effect

3 possible exchange rate policies

flexible exchange rate, fixed exchange rate, crawling peg

Expected profit effect- supply

for a given expected future US dollar exchange rate, the lower the current exchange rate, the greater is the expected profit from holding US dollars, and the smaller is the quantity of US dollars supplied on the foreign exchange market

Foreign currency

foreign bank notes, coins, and bank deposits

US interest rate relative to the foreign interest rate- demand

if the US interest differential rises, the demand for US dollars increases and the demand curve for US dollars shifts rightward

US interest rate relative to the foreign interest rate- supply

if the US interest differential rises, the supply of US dollars decreases and the supply curve of US dollars shifts leftward

RER in the short run

if the nominal exchange rate changes, P and P* do not change and the change in E brings an equivalent change in RER

2 reasons the exchange rate influences the quantity of US dollars supplied

imports effect, expected profits effect

Fixed exchange rate

policy that pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply *requires active intervention in the foreign exchange market

Flexible exchange rate

policy that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank

US interest rate differential =

the US interest rate - the foreign exchange rate

the quantity of US dollars supplied depends on

the exchange rate, US demand for imports, interest rates in the US and other countries, the expected future exchange rate

Factors that determine the quantity of US dollars that traders plan to buy

the exchange rate, world demand for US exports, interest rates in the US and other countries, the expected future exchange rate

Expected profit effect- demand

the larger the expected profit from holding US dollars, the greater is the quantity of US dollars demanded today But expected profits depends on the exchange rate

Exports effect

the larger the value of US exports, the greater is the quantity of US dollars demanded on the foreign exchange market

Imports effect

the larger the value of US imports, the larger is the quantity of US dollars supplied on the foreign exchange market

Foreign exchange market

the market in which the currency of one country is exchanged for the currency of another

Foreign exchange rate

the price at which one currency exchanges for another

Supply in the foreign market

the quantity of US dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate

Real exchange rate

the relative price of US- produced goods and services to foreign-produced goods and services measures the quantity of real GDP of other countries that a unit of US real GDP buys RER= (ExP)÷P* where E=exchange rate, P=US price level, and P*=foreign price level

Factors for change in the demand for US dollars in the foreign exchange market

world demand for US exports, US interest rate relative to the foreign interest rate, the expected future exchange rate