chapter 19 - international finance

two key predictions about what determines the behavior of exchange rates in the economy

1) interest differentials affect the behavior of exchange rates in the short run 2) price differentials for goods determines the behavior of exchange rates in the long run

fixed exchange rate policy

A policy in which a country maintains a fixed value of its currency in terms of other countries the government announces a fixed rate at which the central bank will exchange domestic currency for foreign currency Governments who want to tightly control the value of their currency adopt this policy

So why are so many smaller nations eager to join the Eurozone?

Because many benefits accrue to these smaller economies, including greater trade and investment flows with a common currency. Moreover, uncertainty about future appreciation and depreciation is removed, as are transaction costs from exchanging one currency for another. This enhances travel and trade across borders.

When the central bank does not have enough foreign exchange reserves, it is forced to do one of three things:

Change the fixed rate to make the currency less overvalued—so move it from 25 units of foreign currency per unit of domestic currency to a new fixed rate that is closer to 20 units of foreign currency per unit of domestic currency. This is called a devaluationWhen a fixed exchange rate is adjusted so that the domestic currency is worth less than it used to be. of the domestic currency, the fixed exchange rate analog to a depreciation. Abandon the fixed exchange rate regime and move to a flexible exchange rate regime. In this case, the exchange rate will again move closer to 20 units of foreign currency per unit of domestic currency but will no longer be fixed. Acquire more foreign exchange reserves sufficient to meet the excess demand. This approach usually is successful only if the underlying overvaluation is temporary.

Interest Rate Differentials and the Exchange Rate

In the short run, investors operating in the global foreign exchange market decide where to place their funds to get the highest return. When the interest rate in the United States rises by more than interest rate in another country (in this example, the United Kingdom), international investors will move money to the United States; this will lead to an appreciation of the dollar. Similarly, if the interest rate in the United States falls relative to the interest rate in another country, then international investors will move money out of the United States; this will lead to a depreciation of the dollar.

the _____ laid out the criteria that European Union countries would have to meet to enter the Eurozone

Maastricht Treaty

An Undervalued Fixed Exchange Rate

Suppose that the exchange rate that would prevail in the market under a flexible exchange rate regime was 20 units of foreign currency per unit of domestic currency. Now suppose that the central bank wants to fix the value of the domestic currency at a value of 15 units of foreign currency per unit of domestic currency. This implies that there is an excess demand for domestic currency (equivalent to an excess supply of foreign currency). The central bank's foreign exchange reserves will increase as a result.

An Overvalued Fixed Exchange Rate

Suppose that the exchange rate that would prevail in the market under a flexible exchange rate regime was 20 units of foreign currency per unit of domestic currency. Now suppose that the central bank wants to fix the value of the domestic currency at a value of 25 units of foreign currency per unit of domestic currency. This implies that there is an excess supply of domestic currency (equivalent to an excess demand for foreign currency). The central bank's foreign exchange reserves will decrease as a result.

supply and demand model of the foreign exchange market

The exchange rate is the price of domestic currency (expressed in terms of foreign currency). The quantity of domestic currency demanded (in exchange for foreign currency) varies inversely with the price of domestic currency (the exchange rate). The quantity of domestic currency supplied (in exchange for foreign currency) varies directly with the price of domestic currency (the exchange rate).

Exchange rates

The price of one currency in terms of another in the foreign exchange market. It is expressed as the number of units of foreign currency that can be purchased with one unit of the domestic currency If the United States is the domestic economy, then the exchange rate with the euro will be expressed as 0.80 euros per dollar rather than as $1.25 per euro.

Interest rate differentials are correlated with the exchange rate

The rise of the dollar with respect to the British pound in the early 1980s and its subsequent decline in the late 1980s are highly correlated with the rise in U.S. interest rates in the early 1980s and the subsequent decline in the late 1980s.

devaluation

When a fixed exchange rate is adjusted so that the domestic currency is worth less than it used to be. Abandoned the fixed exchange rate and move to flexible exchange rate acquire foreign exchange reserves sufficient to meet excess demand

overvalued

a currency is said to be overvalued if the fixed exchange rate system makes the domestic currency artificially more valuable

undervalued

a currency is said to be undervalued if the fixed exchange rate system makes the domestic currency artificially less valuable occurs when governments want to favor certain sectors of the economy (exporters trying to sell goods abroad) over other sectors (importers and consumers who benefit from cheap goods from abroad).

depreciation

a decrease in value of a currency

flexible exchange rate policy

a policy in which exchange rates are determined in foreign exchange markets and governments do not agree to fix them

Purchasing Power Parity (PPP)

a theory that states that the exchange rate will adjust to equalize the price levels of two countries The idea that the law of one price will hold for many different products is what underlies the theory The intuition here is that if PPP did not hold, then people would buy goods and services in the country where they are cheap, transport them to the country where they are expensive, and make a profit. This can only happen if the transportation costs are low and the goods and services can in fact be shipped from one country to another. The more nontradable goods and services are, and the higher transportation costs are, the less likely it is that PPP will hold. PPP works better over long periods of time than over short periods. PPP predicts that when the domestic inflation rate exceeds the foreign inflation rate for a long period of time, then the domestic currency must depreciate over that time period so that domestic goods prices do not rise faster than foreign goods prices, when measured in the same currency. Conversely, PPP predicts that when the foreign inflation rate exceeds the domestic inflation rate, then the domestic currency must appreciate over time to ensure that foreign goods prices do not rise faster than domestic goods prices, when measured in the same currency.

The central bank will see its foreign exchange reserves grow which can have...

adverse longer-term implications

Currency unions

an arrangement whereby a group of countries adopt a common currency in place of their individual currencies the Eurozone is the most prominent example of a currency union

appreciation

an increase in value of a currency

Why would a government want to undervalue its currency?

because exporters in the economy will benefit from their goods being more attractive to foreign buyers, as a result of the domestic currency now artificially being less valuable. In contrast, consumers and importers would suffer because goods produced in other countries would cost more.

Why would a government want to overvalue its currency?

by making the domestic currency artificially more valuable, consumers and importers in the economy will benefit from having access to cheap foreign goods. Conversely, exporters will suffer because their goods will be artificially more expensive to foreign buyers.

In currency unions, individual countries ________ to a central bank for the entire region. The policy may not be appropriate for an individual country within the region

cede monetary policy

a higher rate of inflation in the foreign economy than in the domestic economy will make domestic goods ___ abroad, ____ net exports.

cheaper increasing

an appreciation of the domestic currency makes foreign goods ___ at home and domestic goods ___ abroad

cheaper more expensive We can conclude, therefore, that an appreciation of the domestic currency leads to more imports and fewer exports, that is, it decreases net exports

a decrease in the exchange rate signifies that the domestic currency has ___ and the foreign currency has ___ since it takes fewer units of foreign currency to buy a unit of domestic currency

decreased in value Increased in value

The central bank will run down its foreign exchange reserves and increase its domestic currency holdings, meaning it will be unable to maintain the fixed rate resulting in:

devaluation

When a participant in the foreign exchange market comes to the central bank and exchanges domestic currency for foreign currency, the central bank's holdings of foreign currency reserves ___ and their holdings of domestic currency ____

go down go up

When a participant in the foreign exchange market comes to the central bank and exchanges foreign currency for domestic currency, the central bank's holdings of foreign currency reserves ___ and their holdings of domestic currency ___.

go down go up

when the price of domestic currency is high, the quantity of domestic currency supplied will be ___, resulting in an ___ sloping supply curve. when the price of domestic currency is low, the quantity of domestic currency supplied will be ___, resulting in an ___ sloping supply curve.

high upward low upward

We can use the exchange rate to convert the price of goods from one currency to another. For example,

if a BMW costs 40,000 euros and the exchange rate between Germany and the United States was 0.8 euros per dollar, then the price of the BMW to someone in the United States is (40,000 euros)/(0.8 euros per dollar) = $50,000. Similarly, the price of a $2,000 Apple computer to someone in Germany would be $2,000 x 0.8 euros per dollar = 1,600 euros.

An increase in the exchange rate signifies that the domestic currency has ____ and the foreign currency has ___ because it takes more units of foreign currency to buy a unit of domestic currency.

increased in value decreased in value

When the price of domestic currency is high, the quantity of domestic currency demanded will be ___, resulting in a ___ sloping demand curve When the price of domestic currency is low, the quantity of domestic currency demanded will be ___, resulting in a ____ -sloping demand curve

low downward High downward

a depreciation of the domestic currency makes foreign goods ____ at home and domestic goods ____ abroad

more expensive cheaper a depreciation of the domestic currency leads to more exports and fewer imports, that is, it increases net exports.

a higher rate of inflation in the domestic economy than in the foreign economy will make domestic goods ____ abroad, ___ net exports.

more expensive driving down

Benefits of currency unions

prospects for greater trade and investment flows among the member countries Elimination of transaction costs from having to exchange one currency for another

law of one price

the notion that if transport costs are low, and people are not prevented from buying whatever they want, the same commodity in two countries will sell for about the same amount when measured in the same currency

revaluation

when a fixed exchange rate is adjusted so that the domestic currency is worth more than it used to be If the central bank feels that it has too many foreign exchange reserves, it will change the fixed rate to make the currency less undervalued, for example, by moving it from 15 units of foreign currency per unit of domestic currency to closer to 20 units of foreign currency.

summary pt 3

•A flexible exchange rate policy allows the exchange rate to be freely determined in the foreign exchange market. In a fixed exchange rate policy, the government sets the exchange rate at which the central bank will exchange domestic currency for foreign currency. •To implement a fixed exchange rate system, the central bank needs to have foreign currency reserves. The level of foreign reserves increases when the central bank hands out domestic currency in exchange for foreign currency and decreases when the central bank hands out foreign currency in exchange for domestic currency. •A government may choose to overvalue its currency by choosing a fixed exchange rate that makes the domestic currency artificially more valuable. Typically, this is done so that consumers and importers in the economy will benefit from having access to cheap foreign goods. •A government, instead, may choose to undervalue its currency by choosing a fixed rate that makes the domestic currency artificially less valuable. A government may want to undervalue its currency to help exporters sell more goods to foreign buyers. •A sustained overvaluation will cause a central bank to run down its foreign exchange reserves, set off a panicked rush to convert domestic currency into foreign currency, and lead to a currency crisis. •A sustained undervaluation will lead to an increase in the domestic money supply, resulting in higher inflation. Foreign economies will exert political pressure if they are unhappy with the impact of the fixed exchange rate policy on their exporters. •A currency union is an arrangement whereby a group of countries adopts a common currency in place of their individual currencies. The EMU is the most prominent example of a currency union in the world in the twenty-first century. •The EMU began in 2001 when 11 countries that had met the convergence criteria laid out by the Treaty of Maastricht adopted a common currency (the euro) in place of their individual currencies and ceded monetary policy-making authority from their national central bank to the newly formed ECB. •In a currency union, individual countries no longer have the ability to control their monetary policy. •The monetary policy appropriate for the region may not be appropriate at all for the domestic economy. This is particularly true when a smaller economy in the region has conditions that diverge from conditions for the region as a whole. •The primary benefits for a currency union are the prospects for greater trade and investment flows among the member countries because they all use the same currency. Another important change is the elimination of transaction costs from having to exchange one currency for another. •In the near future, the Eurozone will have interesting developments because some countries may want to be admitted to the EMU, and at the same time, existing member countries may want to leave the EMU.

key points

•An exchange rate is a rate at which one currency can be exchanged for the other. The convention used in this chapter defines the exchange rate in terms of foreign currency units per unit of domestic currency. •Because the exchange rate is the price of domestic currency (in terms of foreign currency), we can use the supply-demand framework to understand how exchange rates are determined. •When there is excess demand for the domestic currency in the foreign exchange market, the domestic currency appreciates. When there is excess supply of domestic currency in the foreign exchange market, the domestic currency depreciates. •The supply-demand framework allows us to predict that the country whose interest rate increases will see an appreciation of their currency in the short run and that the country with a higher rate of inflation will see a depreciation of their currency in the long run. •In a fixed exchange rate system, the government sets the exchange rate at which the central bank will exchange domestic currency for foreign currency using reserves of foreign and domestic currency. •If the fixed exchange rate makes the domestic currency artificially more valuable, we say that the domestic currency is overvalued; if it makes the domestic currency artificially less valuable, we say that the domestic currency is undervalued. •A government may want to overvalue its currency so that consumers and importers in the economy will benefit from having access to cheap foreign goods. Conversely, a government may want to undervalue its currency so that exporters in the economy will benefit from their goods being more attractive to foreign buyers. •A sustained overvaluation will lead to a crisis situation in which the government runs out of reserves and is forced to take drastic action. A sustained undervaluation can lead to inflation in the longer term. •A currency union is an arrangement whereby a group of countries adopts a common currency in place of their individual currencies. The primary benefits of a currency union are the prospects for greater trade and investment flows among the member countries because they all use the same currency and thus avoid transaction costs related to the exchange of currency. •In a currency union, individual countries no longer have the ability to control their monetary policy. The monetary policy appropriate for the region may not be appropriate for all the economies in the region.

summary

•An exchange rate is a rate at which one currency can be exchanged for the other. •Because the exchange rate is the price of domestic currency (in terms of foreign currency), we can use the supply-demand framework to understand how exchange rates are determined. •When there is excess demand for the domestic currency in the foreign exchange market, the domestic currency appreciates. When there is excess supply of domestic currency in the foreign exchange market, the domestic currency depreciates. •In a fixed exchange rate system, the government sets the exchange rate at which the central bank will exchange domestic currency for foreign currency using reserves of foreign and domestic currency. •In a currency union, individual countries no longer have the ability to control their monetary policy. •The monetary policy appropriate for the region may not be appropriate for all the economies in the region. •An exchange rate between two currencies is the price of one country's currency in terms of another on the foreign exchange market. The convention here is to define the exchange rate in terms of foreign currency units per unit of domestic currency. •An increase in the exchange rate signifies that the domestic currency has increased in value, also called an appreciation of the domestic currency. A decrease in the exchange rate signifies that the domestic currency has decreased in value, also known as a depreciation of the domestic currency. •All else equal, a depreciation of the domestic currency makes foreign goods more expensive at home and domestic goods cheaper abroad. This implies an increase in net exports. Conversely, an appreciation of the domestic currency leads to a decrease in net exports. •Even when the exchange rate does not change, a higher rate of inflation in the domestic economy will make domestic goods more expensive abroad, driving down net exports. Conversely, a higher rate of inflation in the foreign economy will make domestic goods cheaper abroad, increasing net exports.

summary pt 2

•Because the exchange rate is the price of domestic currency (in terms of foreign currency), we can use the supply-demand framework to understand how the exchange rate is determined. •When the demand for domestic currency rises or the supply of domestic currency falls, all else equal, the domestic currency will appreciate. •When the demand for domestic currency falls or the supply of domestic currency rises, all else equal, the domestic currency will depreciate. •The supply-demand framework predicts that interest rate differentials affect exchange rates in the short run and that price differentials for goods affect exchange rates in the long run. •International investors move their funds around the world to get the highest return. If the interest rate in the United States rose relative to the interest rate in Japan, then international investors would find financial assets in the United States more attractive, leading to an appreciation of the dollar. Conversely, a fall in U.S. interest rates would lead to a depreciation of the dollar. •PPP states that the exchange rate will adjust to equalize the price levels of two economies. PPP predicts that the domestic currency will depreciate over time when the domestic inflation rate exceeds the foreign inflation rate so that domestic goods prices do not rise faster than foreign goods prices when measured in the same currency. •Conversely, PPP predicts that the domestic currency will appreciate over time when the foreign inflation rate exceeds the domestic inflation rate.