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1 Exchange rates are a confusing concept despite the fact that we have to deal with exchange rates whenever we travel abroad. The handout will tackle the common misconceptions with exchange rates and simplify it to the lowest common denominator. More importantly, the handout will pull together previous macroeconomic concepts (i.e. monetary policy, fiscal policy, interest rates, and GDP) with exchange rates to give you a taste of international monetary economics! If you are interested in learning more, then you should take Econ 100B (Intermediate Macroeconomics), Econ 182 (International Monetary Economics) and Econ 115 (World Economic History). By the way, William LOVES international monetary economics. Definitions and terminology What is an exchange rate (P fx )? The exchange rate is the dollar price of foreign exchange. Lets look at a specific exchange rate: The exchange rate for yen is the dollar price of yen (P yen ). The exchange rate tells me how many dollars I need to buy one yen. It also tells me how many dollars a Japanese person gets when she sells one yen. More generally, the exchange rate is the number of dollars per unit of foreign currency. What does it mean the dollar appreciates or gets stronger? If the dollar appreciates, then that means \$1 can buy more yen than before the appreciation. A strong dollar is a dollar that can buy a lot of yen. What does it mean that the dollar depreciates or gets weaker? If the dollar depreciates, then that means \$1 can buy less yen than before the depreciation. A weak dollar is a dollar that can buy very few yen. What happens to the dollar when P fx goes up? The dollar depreciates. I know this sounds confusing because the exchange rate is increasing. But remember the exchange rate (in this class) is the dollar price of yen. Hence when P yen goes up, then the price of yen goes up, which means yen is relatively MORE expensive than the dollar that implies that the dollar is relatively cheaper. What happens to the dollar when P fx goes down? The dollar appreciates. I know this sounds confusing, but just remember that P yen is the dollar price of yen. If the yen is relatively cheaper than the dollar, then the dollar MUST BE relatively more expensive than the yen. Page 1 of 7

3 Exchange Rates and GDP Why should someone who never travels even care about exchange rates? Exchange rates affect net exports that affect PAE which affect GDP! And we all care about GDP because it measures our national income! And GDP measures our economy s well being. How does the appreciation of the dollar affect GDP? If the dollar appreciates (P fx goes down), then the dollar is stronger which means that \$1 can buy more yen than before the appreciation. Imagine that you are an American with dollars that can buy a lot more yens than before. What are you going to do? If prices remain constant, then Japanese goods and services are relatively cheaper than American goods and services. Americans will buy more Japanese goods and services, which raises US imports from Japan. At the same time, American goods and services are relatively more expensive than Japanese goods and services. Japanese people will buy less American goods and services, which reduces US exports to Japan. The effect is a decline in net exports (NX). Remember that Y = C+I+G+NX. If P fx goes down, NX falls, PAE falls, and Y falls via the multiplier effect. Hence the appreciation of the dollar decreases Y! So the next time someone tells you that a strong dollar is good for America, then you should say, Well, GDP (our income) declines if the dollar becomes stronger. DO NOT FALL FOR THE TRAP THAT A STRONG DOLLAR REPRESENTS A STRONG AMERICA. THAT S NOT NECESSARILY TRUE! How does the depreciation of the dollar affect GDP? If the dollar depreciates (P fx goes up), then the dollar is weaker which means that \$1 can buy less yen than before the depreciation. If prices remain constant, then Japanese goods and services are relatively more expensive than American goods and services. Americans will buy less Japanese goods and services, which lowers US imports from Japan. At the same time, American goods and services are relatively cheaper than Japanese goods and services. Japanese people will buy more American goods and services, which increases US exports to Japan. The effect is an increase in net exports (NX). If P fx goes up, NX goes up, PAE goes up, and Y goes up via the multiplier effect. Hence the depreciation of the dollar increases Y! So the next time someone tells you that a weak dollar is bad for America, then you should say, Well, GDP increases if the dollar is weaker. Page 3 of 7

4 Interest Rates and Exchange Rates We have worked with many definitions of the interest rate: 1. Cost of borrowing 2. Opportunity cost of holding money 3. Required rate of return on an investment Now we are going to add a fourth definition that is very relevant in the foreign exchange market: the interest rate (r US ) is the rate of return of dollar assets. Conversely the foreign interest rate (r fx ) is the rate of return on foreign assets. If the Fed lowers the interest rate target, then the dollar will depreciate. If you do not remember how the Fed is able to lower the interest rate through open market transactions, then you should refer to my Demystifying Monetary Policy handout. Lets see what happens in our market for yen when the Fed lowers the interest rate. Step One. Think about American financial investors. If the interest rate falls, then the rate of return on dollar assets falls. Yen financial assets are relatively more attractive (assuming the Japanese interest rate is higher than the US interest rate). Americans want to buy MORE yen in order to take advantage of the higher rate of return in Japan. Hence demand for the yen increases (shift to the right)! Step Two. Think about Japanese financial investors. If the US interest rate falls, then the rate of return on dollar assets falls. Dollar denominated assets are relatively less attractive (assuming Japanese interest rate is higher than the US interest rate). Japanese people want to sell LESS yen in order to take advantage of a higher rate of return in Japan. Hence supply for the yen decreases (shift to the left)! P yen S2 S P yen S P2 yen P1 yen D Q yen D2 P1 yen P2 yen D2 D Q yen S2 The Fed lowers the interest rate target. The dollar depreciates. The same dollar can buy less yen. If prices are constant, then Japanese goods are relatively more expensive. American goods are relatively cheaper. NX goes up. Y goes up. The Fed raises the interest rate target. The dollar appreciates. The same dollar can buy more yen. If prices are constant, then Japanese goods are relatively cheaper. American goods are relatively more expensive. NX goes down. Y goes down. Page 4 of 7

5 Bonus Quiz 1. Assume flexible exchange rates. Argentina is currently in a recession. Suppose Argentina s central bank engages in expansionary monetary policy in an effort to bring Argentina out of its recession. Will US imports from Argentina rise or fall? Explain by describing the impact of Argentina s expansionary monetary policy on the exchange rate between dollars and pesos, and the effect of this change in exchange rate on US imports from Argentina. 2. Assume flexible exchange rates. Investors in Japan lose confidence in investing in Japan and shift their funds to the US. Assume American investors remain undeterred. Does the yen depreciate or appreciate against the dollar? Briefly explain your answer. 3. OPEC surprisingly raises oil prices against the United States by an enormous amount. Suppose the oil price hikes disproportionately affect the United States than the rest of the world. How does this affect US exports to Britain? Explain. Page 5 of 7

6 4. Explain why monetary policy could be more effective than fiscal policy in an open economy. 5. The European Central Bank buys European bonds. How does this affect US exports to Europe? Explain with words and with graphs. Page 6 of 7

7 6. Japan faces a strong Yen at its market-clearing exchange rate against the dollar. Assume inflation worldwide stays the same. How does this affect Japan s trade balance? Japan decides to fix the Yen s exchange rate below the market-clearing exchange rate. What does the Japanese Central Bank need to do in order to maintain its fixed exchange rate for the Yen? Sketch and label the following: P yen * = Initial market-clearing exchange rate for the Yen P yen f = Fixed exchange rate for the Yen P yen 2 = New market-clearing exchange rate for the Yen after Japanese monetary policy 7. Assume the Yen is initially comfortably fixed to the dollar. Japan suddenly faces a huge recession. Can the Japanese Central Bank both maintain its fixed exchange rate AND fight the recession? Why or why not? Page 7 of 7

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