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1 Exchange Rates Betty C. Daniel University at Albany Daniel (University at Albany) Exchange rates 1 / 17

2 What is an exchange rate? Domestic-currency price of foreign currency Dollar price of euro is $1.46 Dollar price of Canadian dollar is $1.03 Dollar price of UK pound is $2.05 Dollar depreciation is an increase in the price of foreign currency Foreign-currency price of the dollar Euro price of dollar is 1/1.46 =.68 euros Canadian dollar price of US dollar is 1/1.03 =.97 Canadian dollars UK pound price of the dollar is 1/2.05 =.49 UK pounds Dollar depreciation is a decrease in the price of the dollar Daniel (University at Albany) Exchange rates 2 / 17

3 US Dollar Exchange Rates (foreign currency per dollar) US Dollar Exchange Rates EU UK Canada Jan 71 Jan 73 Jan 75 Jan 77 Jan 79 Jan 81 Jan 83 Jan 85 Jan 87 Jan 89 Jan 91 Jan 93 Jan 95 Jan 97 Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Daniel (University at Albany) Exchange rates 3 / 17

4 How does the falling dollar a ect you? As price of the euro rises, foreign goods become more expensive domestic consumers switch to cheaper domestic goods domestic rms see demand increase produce more and hire more workers raise prices Consumers pay more for goods Firms produce more and hire more workers Daniel (University at Albany) Exchange rates 4 / 17

5 How does the falling dollar a ect the price of oil? Oil is priced in dollars As the price of the dollar falls, the price of oil falls for everyone who buys oil with currencies other than the US dollar This increases the demand for oil raising its dollar price Daniel (University at Albany) Exchange rates 5 / 17

6 How does the falling dollar a ect the trade balance? Trade balance surplus = exports - imports Falling dollar increases the price of foreign goods relative to US goods P = price of US goods in dollars P = price of foreign goods in foreign currency E = exchange rate as dollars per unit of foreign currency E P = price of foreign goods in dollars Foreign agents switch to cheaper US goods importing more, raising US exports Domestic agents switch away from more expensive foreign goods, importing less, reducing US imports Trade balance increases Daniel (University at Albany) Exchange rates 6 / 17

7 Is a falling dollar good or bad for the US economy? Consumers face higher prices Firms produce more and hire more workers Dollar price of oil rises Trade de cit narrows Daniel (University at Albany) Exchange rates 7 / 17

8 Why is the dollar falling? Role of trade balance NX/GDP Jan 47 Jan 49 Jan 51 Jan 53 Jan 55 Jan 57 Jan 59 Jan 61 Jan 63 Jan 65 Jan 67 Jan 69 Jan 71 Jan 73 Jan 75 Jan 77 Jan 79 Jan 81 Jan 83 Jan 85 Jan 87 Jan 89 Jan 91 Jan 93 Jan 95 Jan 97 Jan 99 Jan 01 Jan 03 Jan 05 Jan Daniel (University at Albany) Exchange rates 8 / 17

9 Why is the dollar falling? Role of the trade balance Trade De cit = Imports - Exports = GDP = Consumption + Investment + Government Spending + Net Exports (Y = C + I + G + NX ) NX GDP minus Total Domestic Spending = Net Exports (Y (C + I + G ) = NX ) Daniel (University at Albany) Exchange rates 9 / 17

10 Why is the dollar falling? GDP and Domestic spending Apr 90 Oct 90 Apr 91 Oct 91 Apr 92 Oct 92 Apr 93 Oct 93 Apr 94 Oct 94 Apr 95 Oct 95 Apr 96 Oct 96 Apr 97 Oct 97 Apr 98 Oct 98 Apr 99 Oct 99 Apr 00 Oct 00 Apr 01 Oct 01 Apr 02 Oct 02 Apr 03 Oct 03 Apr 04 Oct 04 Apr 05 Oct 05 Apr 06 Oct 06 Apr 07 GDP Domestic Spending (C+I+G) Daniel (University at Albany) Exchange rates 10 / 17

11 Why is the dollar falling? Gap between GDP and domestic spending Trade de cit implies that we are spending more than we are producing Foreign agents must have a trade surplus and are producing more than they are spending How do we pay for this extra spending? Borrow from abroad Sell assets (stocks, real estate, etc.) to foreign agents This continues as long as foreign agents willing to sell their goods for US assets Trade de cit does not require a falling dollar Domestic agents sell dollars to buy foreign goods Foreign agents buy dollars to buy US assets No change in demand for dollars and no need for exchange rate to change Daniel (University at Albany) Exchange rates 11 / 17

12 Why is the dollar falling? Increase in foreign spending and falling US trade de cit What happens when foreign agents decide to buy more of their own output instead of exporting it in exchange for US assets? US trade de cit must fall A falling trade de cit requires a falling dollar Dollar depreciation reduces imports and raises exports Falling trade de cit requires a falling dollar Domestic agents sell dollars to buy foreign goods Foreign agents do not want to buy those dollars to buy US assets Dollar must fall inducing domestic agents to buy fewer foreign goods and thereby sell fewer dollars Daniel (University at Albany) Exchange rates 12 / 17

13 Why is the dollar falling? Role of US in ation Purchasing Power Parity Law of One Price Extension to PPP P = E P Requires that there are no relative demand or supply shocks which would change the equilibrium relative price of domestic goods Holds if most shocks are monetary shocks If the monetary authority determines price levels Then the exchange rate is just relative prices If domestic prices are rising faster than Euro prices, then it will take more and more dollars to buy a euro Daniel (University at Albany) Exchange rates 13 / 17

14 Why is the dollar falling? US relative to foreign in ation M1 1997M5 1997M9 1998M1 1998M5 1998M9 1999M1 1999M5 1999M9 2000M1 2000M5 2000M9 2001M1 2001M5 Euro area CPI inflation 2001M9 2002M1 2002M5 2002M9 2003M1 2003M5 US CPI inflation 2003M9 2004M1 2004M5 2004M9 2005M1 2005M5 2005M9 2006M1 2006M5 2006M9 2007M1 2007M5 Daniel (University at Albany) Exchange rates 14 / 17

15 Why is the dollar falling? Role of interest rates Interest rate parity 1 + i t = (1 + i t ) E t+1 Alternative expression i t = it + E t+1 E t When the domestic interest rate exceeds the foreign interest rate, the dollar is expected to depreciate When the Fed cuts the interest rate Expansionary so expect prices to rise From PPP expect future price of foreign currency (E t+1 )to rise Therefore, current price of foreign currency (E t ) must rise more than future price (E t+1 ) for i to fall Therefore, an interest rate cut causes the price of foreign currency to rise, implying that the price of the dollar falls Portfolio e ect When US interest rates are lower, US assets are less attractive Agents less willing to buy US assets to nance the trade de cit Forces adjustment of trade de cit with depreciation of the dollar Daniel (University at Albany) Exchange rates 15 / 17 E t E t

16 China and the US dollar China has a large trade surplus This implies that Chinese are spending less than they are producing Trade surplus requires that Chinese be willing to sell goods in exchange for assets Chinese government has been willingly buying US government bonds Implies no need for trade balance to adjust With no need for trade balance to adjust, there is no pressure for the exchange rate to change Therefore, the Chinese government has been reducing pressure on dollar to fall As the Chinese diversify their portfolio of assets out of dollar assets, failure to nance US trade de cit will put pressure on dollar to fall Daniel (University at Albany) Exchange rates 16 / 17

17 Conclusions Falling dollar will Increase prices for US consumers and producers Increase demand for US goods inducing rms to produce more and hire more workers Increase the price of oil Reduce the trade de cit Dollar is falling because China Other countries are reducing their demand for US assets, as they spend more and diversify out of US assets US in ation has been relatively higher than in some other countries US interest rates have been relatively lower than in some other countries Initially supported the value of the dollar by buying US government bonds Recently has been diversifying out of US assets, allowing the dollar to fall Daniel (University at Albany) Exchange rates 17 / 17

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