CHAPTER 18  
 Exchange Rates

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I.      Foreign Exchange Market

                A.        Market where one currency is trade for another

                B.    The exchange rate enables people one country to translate the prices of foreign goods into units of their own currency.

                C.        Appreciation of a nation’s currency will make foreign goods cheaper. Depreciation will make foreign goods more expensive.

        II.        Determinants of the Exchange Rate       

                A.        Under a flexible rate system, exchange rate is determined by supply and demand.

                        1.                The dollar demand for foreign exchange originates from the demand of Americans for foreign goods, services, and assets (either real or financial).

                        2.                The supply of foreign exchange originates from sales of goods, services, and assets from Americans to foreigners.

                        3.                The foreign exchange market will bring the quantity demanded and quantity supplied into balance. As it does so, it will also bring the purchases by Americans from foreigners into equality with the sales by Americans to foreigners.

                B.        Changes in the Exchange Rate

                        1.        The following factor will cause a currency to depreciate:

                                a.        Rapid growth of income (relative to trading partners) that stimulates imports relative to exports.

b.     Higher rate of inflation than one's trading partners

                                c.        Reduction in domestic real interest rates

                        2.        The following factor will cause a currency to appreciate:

                                a.        Slow growth relative to one’s trading partners

                                b.        Lower inflation than one's trading partners

                                c.        Increase in domestic real interest rates

        III.   Balance of Payments

                A.    Any transaction that creates a demand for foreign currency (and a supply of the domestic currency) in the foreign exchange market is recorded as a debit, or minus, item. Imports are an example of a debit item.

                B.        Transactions that create a supply of foreign currency (and demand for the domestic currency) on the foreign exchange market are recorded as a credit, or plus, item. Exports are an example of a credit item.

                C.        Under a pure flexible system, the quantity demanded will equal the quantity supplied in the foreign exchange market. Thus, the total debits will equal the total credits in the balance of payments accounts

                D.        Current Account Transactions

                        1.                Current Account: All payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period.

                        2.        The four categories of current account transactions are:

                                a.        merchandise trade—import and export of goods.

                                b.         service trade—import and export of services.

                                c.         income from investments.

                                d.          unilateral transfers—gift to and from foreigners.

                E.        Capital Account Transactions

                        1.                Capital Account: transactions that involve changes in the ownership of real and financial assets.

                        2.                Both (1) direct investments by foreigners in the U.S. and by Americans abroad and (2) loans to and from foreigners are counted as capital transactions.

                F.        Under a pure flexible-rate system, official reserve transactions are zero; therefore, a current-account deficit implies a capital-account surplus. Similarly, a current-account surplus implies a capital-account deficit.

        IV.   Macroeconomic Policy in an Open Economy

                A.        Monetary Policy and the Exchange Rate

                        1.                An unanticipated shift to a more restrictive monetary policy will raise the real interest rate, reduce the rate of inflation, and, at least temporarily, reduce aggregate demand and the growth of income. These factors will all cause the nation’s currency to appreciate. In turn, the currency appreciation along with the inflow of capital will result in a current account deficit.

                        2.                In contrast, the effects of a more expansionary monetary policy will be just the opposite: lower interest rates, an outflow of capital, currency depreciation, and a shift toward a current account surplus.

                B.        Fiscal Policy and the Exchange Rate

                        1.                An unanticipated shift to a more expansionary fiscal policy will tend to increase real interest rates, lead to an inflow of capital, and cause the nation’s current account to shift toward a deficit.

                        2.                The effects of a shift to a more restrictive fiscal policy will be just the opposite: lower interest rates, an outflow of capital, and movement toward a current‑account surplus.

        V.        Macroeconomic Policy, Exchange Rates, Capital Flows, and  Current Account         Deficits

                A.    A more restrictive monetary policy coupled with expansionary fiscal policy—will cause higher real interest rates, an inflow of capital, currency appreciation, and a current‑account deficit. This is precisely what happened during the early 1980s.

        VI. How Do Current Account Deficits Affect the Economy?

                A.        Under a flexible exchange rate system, an inflow of capital implies a current account deficit. Similarly, an outflow of capital implies a current account surplus.

                B.    A trade deficit is not necessarily bad. Rapid growth will stimulate imports. A healthy growing economy that offers attractive investment opportunities will often generate an inflow of capital. Neither of these factors are bad. However, both are likely to cause a current account trade deficit.

                C.    A nation’s trade deficit or surplus is an aggregation of the voluntary choices of businesses and individuals. In contrast with a budget deficit of an individual, business, or government, there is no legal entity that is responsible for the trade deficit.

        VII. International Finance and Exchange Rate Regimes

                A.        There are three major types of exchange rate regimes: (1) flexible rates, (2) fixed- rate, unified currency, and (3) pegged exchange rates.

                B.        Examples of Fixed Rate, Unified System. Eleven nations of the European Union have recent adopted a unified currency system. Countries can also use a currency board to unified their currency with another. The currencies of Hong Kong, Argentina, and Panama are unified with the U.S. dollar.

                C.        Pegged Rate Systems

                        1.                A nation can either (a) follow an independent monetary policy and allow its exchange rate to fluctuate or (b) tie its monetary policy to the maintenance of the fixed exchange rate. It cannot, however, maintain the convertibility of its currency at the fixed exchange rate while following a monetary policy more expansionary than that of the country to which the domestic currency is tied. 

                        2.                Attempts to pegged rates and follow a monetary policy that is too expansionary have lead to several recent financial crisis—a situation where falling foreign currency reserves eventually force the country to forego the pegged exchange rate.