Unit 5: Mod 41 - 44 (I SKIPPED MOD 45!)

costs of fixed exchange rate

- To stabilize an exchange rate through intervention, a country must keep large quantities of foreign currency on hand, and that currency is usually a low - return investment. * AND even large reserves can be quickly exhausted when there are large capital flows out of a country. - OR using monetary policy to stabilize the exchange rate, means, it must divert monetary policy from other goals, like stabilizing the economy and managing the inflation rate!!! - foreign exchange controls, like import quotas and tariffs, distort incentives for importing and exporting goods and services. They can also create substantial costs in terms of red tape and corruption.

Benefits of a fixed exchange rate

- certainty about the future value of a currency (for example, a dollar has the same value in LA and NY, so they want the same type of affect between countries) - by committing itself to a fixed rate, a country is also committing itself not to engage in inflationary policies because such policies would destabilize the exchange rate. (COUNTRY KEEPS ITSELF ACCOUNTABLE)

Benefits of floating exchange rates

- help insulate countries from recessions originating abroad BUT In 2008, however, a financial crisis that began in the United States seemed to be producing a recession in virtually every country. In this case, it appears that the international linkages between financial markets were much stronger than any insulation from overseas disturbances provided by floating exchange rates.

What is the effect of the Fed using expansionary monetary policy, on the supply of U.S. dollars, the demand for U.S. dollars, and the equilibrium exchange rate? How does the Fed's monetary policy affect U.S. aggregate demand? Explain.

1. The supply of U.S. dollars increases. The demand for U.S. dollars decreases. The equilibrium exchange rate falls (the U.S. dollar depreciates). 2. The lower interest rates in the US means increased US exports while decreasing imports. --> This causes U.S.'s AD to INCREASE

2 purposes of Devaluations and revaluations under a fixed exchange rate regime:

1. can be used to eliminate shortages or surpluses in the foreign exchange market EX: n 2010, some economists were urging China to revalue the yuan so that it would not have to buy up so many U.S. dollars on the foreign exchange market. 2. can be used as tools of macroeconomic policy. A devaluation, by increasing exports and reducing imports, increases AD.--> So a devaluation can be used to reduce or eliminate a recessionary gap. A revaluation REDUCES AD. So it be used to reduce or eliminate an inflationary gap

Consider the country Genovia, which for some reason has decided to fix the value of its currency, the geno, at US$1.50. When there is a surplus of genos, the value of a geno gets pushed down, so it's much less than the target of $1.50. How can the Genovian government support the geno so that they can boost it and then KEEP it at the desired rate of $1.50 USD?

3 possible methods: 1. y buying its own currency in the foreign exchange market (this is called exchange market intervention, and they buy it buy using foreign exchange reserves) 2. Try to shift the supply and demand curves for the geno in the foreign exchange market. (usually done by changing monetary policy). EX: Genovian central bank can raise the Genovian interest rate. This will increase capital flows into Genovia, increasing the demand for genos, at the same time that it reduces capital flows out of Genovia, reducing the supply of genos, which increases the value of the geno. 3. reducing the supply of genos to the foreign exchange market. (like requiring domestic residents who want to buy foreign currency to get a license and giving these licenses only to people engaging in approved transactions ---> licensing systems like these are called foreign exchange controls)

Historically, fixed exchange rates haven't been permanent commitments. Sometimes countries with a fixed exchange rate switch to a floating rate. In other cases, they retain a fixed exchange rate regime but change the target exchange rate. What is a "devaluation"?

A reduction in the value of a currency that is set under a fixed exchange rate regime is called devaluation. AND it is due to a revision in a fixed exchange rate target.

. The current account includes which of the following? I. payments for goods and services II. transfer payments III. factor income

All of those

Even if a foreign currency like the peso has depreciated substantially in terms of the U.S. dollar, the real exchange rate between the peso and the U.S. dollar HAS NOT CHANGED AT ALL.

And because the real peso-U.S. dollar exchange rate hasn't changed, the nominal depreciation of the peso against the U.S. dollar will have no effect either on the quantity of goods and services exported by Mexico to the United States or on the quantity of goods and services imported by Mexico from the United States. T

5. Which of the following will happen in a country if a trading partner's economy experiences a recession? a. It will experience an expansion. b. Exports will decrease. c. The demand for the country's currency will increase. d. The country's currency will appreciate. e. All of the above will occur.

B. Exports will decrease, because consumers from that other country have less money to import stuff from THIS country. ALSo, it can't be all of the above, because obvi this country isn't going to experience an EXPANSION of all things

How do countries decide between fixed and floating exchange rates?

Different countries reach different conclusions at different times. Most European countries, except for Britain, have long believed that exchange rates among major European economies, which do most of their international trade with each other, should be fixed. But Canada seems happy with a floating exchange rate with the United States, even though the United States accounts for most of Canada's trade.

Now the opposite - imagine the geno's value is ABOVE the desired rate of $1.50 USD. Now, what can the Genovian government do to prevent this type of inflation of the geno? (AKA how can they DECREASE the value of the geno?)

Everything in the OPP direction: 1. Sell its own currency (the geno) while acquiring US dollars for its foreign exchange reserves 2. Reduce interest rates to increase the supply for the geno, while reducing demand (would caused value to go down) 3. can impose foreign exchange controls that limit the ability of foreigners to buy genos. A

How does a decline in the interest rate affect the foreign exchange market?

Foreigners have less incentive to move funds into Genovia because they will receive a lower rate of return on their loans. As a result, they have less need to exchange U.S. dollars for genos, so the demand for genos falls. At the same time, Genovians have more incentive to move funds abroad because the rate of return on loans at home has fallen, making investments outside the country more attractive. Thus, they need to exchange more genos for U.S. dollars and the supply of genos rises. The demand curve for genos shifts leftward, from D1 to D2, and the supply curve shifts rightward, from S1 to S2. The equilibrium exchange rate, as measured in U.S. dollars per geno, falls from XR1 to XR2. ***Basically, a reduction in the Genovian interest rate causes the geno to DEPRECIATE in value. This in turn INCREASES AD bc this devaluation increases exports and reduces imports.

When the U.S. dollar buys more Japanese yen, the U.S. dollar has I. become more valuable in terms of the yen. II. appreciated. III. depreciated

I and II only

The trade balance includes which of the following? I. imports and exports of goods II. imports and exports of services III. net capital flows

I only, just imports and exports of goods.

Which of the following methods can be used to fix a country's exchange rate at a predetermined level? I. using foreign exchange reserves to buy its own currency II. using monetary policy to change interest rates III. implementing foreign exchange controls

I, II, and III It's ALL of them, because these are all tools to change the exchange rate (p.s. foreign exchange CONTROLS are just the licensing systems. Remember this?)

1. Devaluation of a currency occurs when which of the following happens? I. The supply of a currency with a floating exchange rate increases. II. The demand for a currency with a floating exchange rate decreases. III. The government decreases the fixed exchange rate.

III only. We don't really think about the supply or demand about floating rates

the foreign exchange situation of China when it kept the exchange rate fixed at a target rate of $0.121 per yuan and the market equilibrium rate was higher than the target rate. How might each of the following policy changes eliminate the disequilibrium in the market? a. allowing the exchange rate to float more freely **Pretend your using the SECOND graph, but with china on the x-axis and the exchange rate in (US dollars per yuan)

If the exchange rate were allowed to float more freely, the U.S. dollar price of the exchange rate would move toward the equilibrium exchange rate. This would occur as a result of the shortage, when buyers of the yuan would bid up its U.S. dollar price. As the exchange rate increased, the quantity of yuan demanded would fall while its supply would increase. If the exchange rate were allowed to increase to the eq. exchange rate , the disequilibrium would be entirely eliminated.

CA = -FA

Means that the current account and financial account must sum to zero.

the foreign exchange situation of China when it kept the exchange rate fixed at a target rate of $0.121 per yuan and the market equilibrium rate was higher than the target rate. How might each of the following policy changes eliminate the disequilibrium in the market? b. placing restrictions on foreigners who want to invest in China

Placing restrictions on foreigners who want to invest in China would reduce the demand for the yuan, causing the demand curve to shift in the accompanying diagram from D1 to something like D2. This would cause a reduction in the shortage of the yuan. If demand fell to D3, the disequilibrium would be completely eliminated (Basically demand shifts to the left 2 times, so the target is hit)

the foreign exchange situation of China when it kept the exchange rate fixed at a target rate of $0.121 per yuan and the market equilibrium rate was higher than the target rate. How might each of the following policy changes eliminate the disequilibrium in the market? c. removing restrictions on Chinese who want to invest abroad

Removing restrictions on Chinese who wish to invest abroad would cause an INCREASE in supply of the yuan and a RIGHT shift of the supply curve. This increase in supply would reduce the size of the shortage.

How would a decrease in real income in the United States affect the U.S. current account balance? Explain.

The current account balance will increase (or move toward a surplus) The decrease in income will cause imports to decrease.

Explain how a floating exchange rate system can help insulate a country from recessions abroad.

The decrease in AD that occurs during a recession includes the demand for goods and services produced abroad AND at home. When a trading partner experiences a recession, it leads to a fall in their imports (AKA reducing THIS country's exports). --> leads to a reduction in demand for THIS country's currency. --> With a floating exchange rate, the currency depreciates. --> makes domestic goods and services cheaper, so exports don't fall by as much as they would have, and it makes imports more expensive, leading to a fall in imports. Both effects limit the decline in domestic AD

In the late 1980s, Canadian economists argued that the high interest rate policies of the Bank of Canada weren't just causing high unemployment—they were also making it hard for Canadian manufacturers to compete with U.S. manufacturers. Explain this complaint, using our analysis of how monetary policy works under floating exchange rates.

The high Canadian interest rates caused an INCREASE in capital inflows to Canada. T To get investments that yielded a relatively high interest rate in Canada, investors first had to obtain Canadian dollars, which INCREASES demand of the Canadian dollar. --> BUT this also causes it to appreciate or value to increase. --> This appreciation raises the price of Canadian goods to foreigners (measured in terms of the foreign currency). ---> This made it more difficult for Canadian firms to compete in other markets.

Suppose China decides that it needs a huge program of infrastructure spending, which it will finance by borrowing. How will this program affect the U.S. balance of payments? Explain.

The increase in infrastructure spending in China will reduce the surplus in the U.S. financial account and reduce the deficit in the U.S. current account. Because China is financing the program by borrowing, it is likely that other countries will increase their lending to China, decreasing their lending to the United States. These capital outflows from the United States will reduce the U.S. surplus in the financial account and reduce the deficit in the current account.

purchasing power parity

The purchasing power parity between 2 countries' currencies is the (THEORY? of) nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.

Suppose the United States and Australia were the only two countries in the world, and that both countries pursued a floating exchange rate regime. Note that the currency in Australia is the Australian dollar. If the Federal Reserve pursues expansionary monetary policy, what will happen to the U.S. interest rate and international capital flows?

U.S. interest rate falls. There is an increase in the capital flow into Australia and an increase in the capital flow out of the US The lower interest rate in the US reduces the incentive to invest in the US and increases the incentive to invest in Australia.

depreciates

When a currency becomes less valuable in terms of other currencies

appreciates

When a currency becomes more valuable in terms of other currencies

Why the demand for a currency is downward sloping

When the exchange rate of a currency increases, other countries will want less of that currency. When a currency appreciates (in other words, the exchange rate increases), then the price of goods in the country whose currency has appreciated are now relatively more expensive than those in other countries. Since those goods are more expensive, less is imported from those countries, and therefore less of that currency is needed.

balance of payments on the current account / Current account

a country's balance of payments on goods and services plus net international transfer payments and factor income

There are 2 main kinds of exchange rate regimes.

a fixed exchange rate a floating exchange rate

foreign exchange market.

a market in which currencies of different countries are bought and sold

exchange rate regime

a rule governing policy toward the exchange rate

balance of payments accounts

a summary of the country's transactions with other countries.

Which of the balance of payments accounts do the following events affect? a. Boeing, a U.S.-based company, sells a newly built airplane to China

a. current account

a revaluation

an increase in the value of a currency that is set under a fixed exchange rate regime

4. Which of the following would cause the real exchange rate between pesos and U.S. dollars (in terms of pesos per dollar) to decrease? a. an increase in net capital flows from Mexico to the United States b. an increase in the real interest rate in Mexico relative to the United States c. a doubling of prices in both Mexico and the United States d. a decrease in oil exports from Mexico to the United States e. an increase in the balance of payments on the current account in the United States

b. an increase in the real interest rate in Mexico relative to the United States

The financial account was previously known as the

capital account

The nominal exchange rate at which a given basket of goods and services would cost the same in each country describes a. the international consumer price index (ICPI). b. appreciation. c. depreciation. d. purchasing power parity. e. the balance of payments on the current account

d. purchasing power parity

Real exchange rates **** (I DONT UNDERSTAND!)

exchange rates adjusted for international differences in aggregate price levels. EX: Real exchange rate = Mexican pesos per U.S. dollar x (PUS/PMexico)

2 types of accounts:

financial accounts and current acccounts

international transfers

funds sent by residents of one country to residents of another

exchange market intervention

government purchases or sales of currency in the foreign exchange market

the foreign exchange situation of China when it kept the exchange rate fixed at a target rate of $0.121 per yuan and the market equilibrium rate was higher than the target rate. How might each of the following policy changes eliminate the disequilibrium in the market? d. imposing taxes on Chinese exports, such as clothing

increasing taxes on exports would decrease the demand for yuan with which to purchase those goods. The graphical analysis here is virtually identical to that found in the figure accompanying part b. (Demand keeps decreasing until it hits the target)

Foreign exchange controls

licensing systems that limit the right of individuals to buy foreign currency

Effects of devaluation

like depreciation: makes domestic goods cheaper in terms of foreign currency, which leads to higher exports. At the same time, it makes foreign goods more expensive in terms of domestic currency, which reduces imports. The effect is to increase the balance of payments on the current account.

Effects of revaluation

makes domestic goods more expensive in terms of foreign currency, which reduces exports, and makes foreign goods cheaper in domestic currency, which increases imports. So a revaluation reduces the balance of payments on the current account.

factor income

payments for the use of factors of production owned by residents of other countries Mostly this means investment income: interest paid on loans from overseas, the profits of foreign - owned corporations, and so on i.e. the profits the U.S. based disney company makess of off a Disney park in Paris

Foreign exchange reserves

stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market

foreign exchange reserves

stocks of foreign currency that governments maintain to buy their own currency on the foreign exchange market

balance of payments on goods and services

the difference between a country's exports and its imports during a given period.

balance of payments on the financial account / financial account,

the difference between a country's sales of assets to foreigners and its purchases of assets from foreigners during a given period. EX: - stocks , it's a basic rule of balance of payments accounting that the current account and the financial account must sum to zero: Current account (CA) + Financial account (FA) = 0

equilibrium exchange rate

the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied.

As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a currency. If the market has a surplus or a shortage, ___________

the exchange rate will adjust until an equilibrium is achieved.

A country has a fixed exchange rate when

the government keeps the exchange rate against some other currency at or near a particular target. For example, Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1

A country has a floating exchange rate when

the government lets the exchange rate go wherever the market takes it. (This is what's used in the US, B, and Canada)

exchange rates.

the prices at which currencies trade (inside the foreign exchange market)

merchandise trade balance / trade balance

the value of a country's exported goods minus the value of its imported goods during a given period