# FLEXIBLE EXCHANGE RATES

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1 FLEXIBLE EXCHANGE RATES Along with globalization has come a high degree of interdependence. Central to this is a flexible exchange rate system, where exchange rates are determined each business day by supply and demand for currencies. Bilateral Exchange Rate: amount of one currency that exchanges for a unit of another examples: \$1.50 per 1 (British Pound) \$1 per 80 (Japanese Yen) Exchange Rate Index: the value of a currency indexed (relative to) those of major trading partners Example: US Dollar Index = 82.0 Currencies can: Appreciate: one unit of that currency buys more foreign currency - if now \$1.50 per 1 appreciation \$1.40 per 1 Depreciate: one unit of that currency buys less foreign currency - in 1985: \$1.04 per 1 (almost dollar - pound parity) - in 2013: \$1.50 per 1 To clarify exchange rates (for some): If Euro US \$ exchange rate = 1.30 => 1 Euro = \$ this can also be stated as Euro/US\$ = think of this as the US \$ cost of 1 Euro, or the cost of the currency in the numerator (or listed first) in terms of the denominator currency (or that listed second), so: Euro US \$ = 1.3 => 1Euro costs 1.3 US\$ The US \$ is not always listed second (or in the denominator), for example: US \$ - Japanese Yen = 80 - this gives the Yen price of 1 US\$: 80 Japanese Yen exchange for 1 US\$ For appreciation/depreciation, you can treat these as ratios and deduce which currency is improving relative to the other. (1) If Euro US \$ is rising => Euro/US\$ is rising, so the numerator is rising relative to the denominator, and the Euro is appreciating relative to the US\$. This means the US\$ cost of 1 Euro is now higher (2) If Euro US\$ is falling, the US\$ is appreciating relative to the Euro, so it now takes fewer US \$ to purchase 1 Euro.

2 Balance of Trade (Net Exports) = Exports (from US) - Imports (to US) Exports = f(exchange rate, foreign income) Imports = f(exchange rate, US income) Intuition: A strong economy will bring surpluses in key measures (federal budget AND balance of trade) if US grows faster than its trading partners, US Balance of Trade should improve, resulting in a surplus, but imports are subtracted from this measure (\$ go overseas) Reality: rapid US income large imports Slower foreign income growth small exports larger deficit as imports grow relative to exports How to eliminate/reverse Balance of Trade Deficit: Need to stimulate exports BUT we can't manipulate foreign income Alter our exchange rate ILLUSTRATION OF DOLLAR DEPRECIATION - show effects of strong and weak \$ on exports/imports IMPORTS: British Auto costing 10,000 - cost in US \$ depends on exchange rate Strong \$: \$1.50 per 1: 10,000 x \$1.50 = \$15,000 1 Weak \$: \$2.00 per 1: 10,000 x \$2.00 = \$20,000 1 \$ Depreciation: P imports Q D imports (other things being equal like US income) DOLLAR DEPRECIATION AFFECTS DOMESTIC INFLATION DOLLAR DEPRECIATION CAN DO THIS (other things being equal)

3 \$ Depreciation tends to make US inflation worse Imports become more expensive, and US producers are more able to raise their prices It also tends to raise global commodity prices (ex: oil, gold, silver, copper) Commodities are priced in US \$ As the US \$ depreciates, commodities become less expensive in terms of appreciating currencies, raising their demand and pushing up their dollar prices EXPORTS: US Personal Computer - cost \$1,000 - cost in Britain ( )depends on exchange rate strong \$: \$1.50 per 1:\$1,000 x = 667 \$1 (note: to get 0.667, divide 1.50 into 1) weak \$: \$2.00 per 1:\$1,000 x 0.5 = 500 \$1 \$ Depreciation: P exports Q D exports (other things being equal like foreign income) - How much Q rises is another question Depreciation lowers the cost of US labor, given US wages (its foreign currency value falls) Putting this together: DOLLAR DEPRECIATION P imports Q D imports P exports Q D exports IMPROVED BALANCE OF TRADE

4 The dollar cost of land and companies in US becomes less expensive in terms of foreign currencies Ex: \$10 mil building If the Japanese Yen appreciates by 10% (so US \$ depreciates relative to Yen by 10%), is as if the dollar cost of building is now \$9 mil 1. Dollar depreciation makes foreign investment in the US less expensive - This can be important at times of threats to import restrictions (like US in 1980s car imports) 2. Multinational corporations make money from their overseas sales when they convert back to dollars in countries whose currencies have appreciated relative to the dollar CURRENCY CONVERSION PROFIT 3. This tends to help the stock prices of US multinationals, since as the \$ depreciates their profits rise due to currency conversion profit APPLICATION: EFFECT OF LAGS ON THE BALANCE OF TRADE (the J-Curve) Dollar depreciation will help to decrease a balance of trade deficit, other things being equal, as exports rise and imports fall Initially, however, the balance of trade deficit will typically worsen. To see this, rewrite the balance of trade equation: NX = P x X P m M where X is the number (volume) of goods exported, M is the number (volume) of goods imported, P x is the dollar price of US exports, and P m is the dollar price of imports into the US. Note that P m = e P f, the exchange rate (e) times the foreign currency price of imports (P f ). Here, the exchange rate is \$/foreign currency (see British auto import example earlier). The NX equation can be rewritten as: e P X P x f M

5 In this equation, the coefficient of M is the real exchange rate (and e is the nominal exchange rate). The real exchange rate expresses the prices of foreign goods relative to US prices, and is one measure of US international competitiveness. If the real exchange rate equals 1.0, US goods are as expensive as foreign goods, and there is Purchasing Power Parity. If the real exchange rate exceeds 1.0, foreign prices are higher than US prices, making US goods more globally competitive. Q: How does dollar depreciation initially worsen the balance of trade deficit? A: The volume of goods imported and exported changes more slowly than the (nominal) exchange rate. As the dollar cost of foreign currency rises, the value of imports rises relative to the value of exports, worsening the trade deficit. Eventually, after about 18 months, the volume of exports and imports adjusts to the new prices, so exports rise and imports fall, and the trade balance improves. This is the J-Curve effect. SUPPLY AND DEMAND FOR DOLLARS The supply and demand for dollars is related to currency holdings by companies, speculators, central banks AND: Supply of \$: related to imports into US - To import, importers trade (supply) \$, demand foreign currency to pay for the foreign good Demand for \$: related to exports from US - Foreigners supply their currency and demand \$ to get the US goods (exports) If the exchange rate is expressed as foreign currency per \$1, get downward-sloping demand and upward sloping supply relative to the quantity of dollars R e R ( /\$1) Q e S D Q \$

6 Exercise: Using the import and export example earlier (British auto and US computer), explain why demand for \$ is downward sloping and supply for \$ is upward sloping Starting with \$1.50 per 1 (or 0.667/\$1), the dollar depreciates to \$2.00 per 1 (or 0.5/\$1), we saw that: (1) Imports fall, and: (2) Exports rise. DEMAND: Exports rise as their prices fall. The increase in exports raises the number of dollars demanded, so quantity of \$ demanded rises as the dollar depreciates (move down on R axis) SUPPLY: Imports fall as their \$ prices rise. This decrease in imports lowers the number of dollars supplied, so quantity of \$ supplied falls as the dollar depreciates (move down on R axis) APPLICATION: Relationship between exchange rates and domestic interest rates Consider foreign investment in US of a \$1,000 5% interest. At year s end, have \$1,050. If US interest rates fall relative to those in other countries (ex: easy monetary policy), or are expected to fall less investment income will be generated by the CD and fixed income (bond) prices will now be higher Investments in US - less attractive to foreigners Foreigners will buy fewer US assets D for bonds and CD's D for \$ R e (\$ depreciation) RESULT: SMALLER CAPITAL INFLOW INTO US R ( /\$1) R e R e S Q e D 1 D Q \$ Relative Interest Rates and Exchange Rates tend to move in the same direction (absent rising inflation)

7 APPLICATION: Relationship between exchange rates and the rate of economic growth If the rate of growth in a country rises or is expected to rise relative to that of other countries, investments in that country such as stocks and real estate will tend to appreciate in value, implying rising relative returns to investments in the assets of that country - This raises the demand for stocks and real estate in that country - Along with this comes an increase in the demand for that currency - The result is an appreciation in that country s currency Interest Rates and (relative) Economic Growth tend to move in the same direction NOTE: since interest rates and economic growth tend to move in the same direction (other things being equal), then, using the correct direction of causation: Higher Growth Rising Interest Rates Currency Appreciation APPLICATION: Relationship between the US\$ exchange rate and US stock prices There is not a single way that this relationship works. During the financial crisis, when the US\$ strengthened the stock market weakened. As of 2012, that reversed: a stronger US\$ was consistent with US stock gains Q: What caused this change in the relationship between the US\$ exchange rate and US stock prices? A: To establish the relationship, it is necessary to first determine why the US\$ is strengthening - If the US\$ gains strength due to a flight to safety, with economic weakness abroad and the US performing less badly than overseas, this signifies that global weakness, which hurts future profits, causing stock prices to fall. This pertains to much of the post-crisis environment - As 2012 ended, the US economy gained significant momentum, ending the less ugly scenario. Since then, the effects of flights to safety and US relative strength have reinforced each other, causing both the US\$ to strengthen and an improving US stock market, based on improved relative and absolute profit expectations for the US.

8 APPLICATION: How to Stabilize a Country s Exchange Rate To stabilize or raise its exchange rate, a country can raise interest rates BUT - This will tend to slow domestic economic activity, possibly causing the risk of a recession APPLICATION: Currency Risk of Investing in Foreign Countries APPLICATION: Relationship between exchange and inflation rates If US inflation is high relative to rates in countries we compete with, either: (1) our exports rise in \$ price, making them less competitive; or (2) the real \$ value of investment in US suffers (compared to returns in other countries) Exports + D for investments in US D for \$ R e (\$ depreciation) Inflation and Exchange Rates tend to move in opposite directions APPLICATION: If the \$ depreciates (or is expected to depreciate), given interest & inflation rates, the foreign currency value of the falls Investment in US - relatively less attractive So, when the \$ is expected to depreciate: D for \$ (investors want less US investment) S of \$ (some unload US investments) R e (\$ depreciation) Demand for US stocks and bonds falls, lowering both stock and bond prices (which raises interest rates) On days when US stock and bond prices both decline APPLICATION: How can \$ depreciation affect and the dollar s value falls, this is an indication that your the hot firm's money profit? has left the US for other venues

9 Critical elements to focus on: imports and exports Q1: Does your firm use imported inputs? If so, these are more expensive costs Q2: Does your firm export? If so, product cheaper to foreigners revenue as the amount sold rises and get currency conversion profit. Q3: Was your firm thinking of locating overseas? If so, dollar depreciation may well preserve your job. Application: Fed rate cuts in September 2007 The Fed controls a short-term interest rate (Fed funds rate). When they cut that short-term rate by 50 basis points in 9/07, long-term rates unexpectedly rose. - Lower short-term rates generally depreciate a currency - BUT the Fed s rate cut reduced the likelihood of a recession. Economic strength generally raises both interest rates and the exchange rate Q: When do long-term interest rates rise and the US \$ depreciate? A: When expected inflation rises. That was the bond market s interpretation of the likely effects of the greater-than-expected Fed rate cut. Addendum #1: The Devil s Deal Normally, the very large balance of trade deficit of the US would weaken the dollar dollar depreciation BUT The central banks of Japan and China don t want that Why? They wouldn t be able to sell as many goods to the US, causing slower growth in their countries. - To avoid this, they have purchased large amounts of US dollars and US Treasury Bonds (that help to finance our federal budget deficits) Q: What have the effects of this been? A1: When these foreign central banks buy US dollars and bonds, they trade their currencies for US dollars, which strengthens the US dollar relative to their currencies (keeping their currencies weaker than would have been) - By itself, this helps the volume of their exports to the US A2: The greater demand for US bonds by these central banks raises bond prices in the US, resulting in lower interest rates here - Their bond purchases also tend to strengthen the US dollar, while the lower interest rates have the opposite effect (as would any easing by the US Federal Reserve)

10 A3: As this has allowed US interest rates to remain lower than they would otherwise have been, this has caused income in the US to be higher than it would have been - Higher US income raises the demand for goods (imports) from China and Japan, offsetting the interest rate effect in A2 to some extent A4: The artificially weak Yuan has provided incentives for US firms to construct factories and purchase equipment in China as the dollar cost is very attractive - While total investment in equipment and software for the US GDP accounts has been very weak in late 2006 and 2007, the total amounts spend by US firms in these categories has been very large it just hasn t been in the US (where it would have counted for GDP) EXERCISE 1: What if the Japanese and Chinese central banks stopped purchasing as many US dollars and Treasury Bonds? Outline the effects on the US, Japan, and China in terms of exchange rates, their balances of trade, interest rates, and economic growth EXERCISE 2: Outline the effects of China s central bank allowing the Chinese Yuan to float freely against the US dollar. Addendum #2: Misplaced Gripes by Executives When the US dollar was appreciating relative to other currencies several years ago, US manufacturing executives complained very vociferously about how this made US manufacturing exports non-competitive - Their evidence: Exports were declining Were they correct? US Exports = f(exchange rate, foreign income) Other things equal, dollar appreciation hurts US exports Q: Were other things equal? A: No. Part of the reason the US dollar was appreciating was that our economy was growing faster than those of our trading partners. So, not only was the exchange rate effect in force, but so too was the impact of declining foreign income. Recall: - As foreign income falls, US exports also fall (other things being equal) So, the perceived impact of an appreciating dollar on US exports was overstated, since falling foreign income was also at work Eventual dollar depreciation did not help exports as much as the executives had believed it would

11 Addendum #3: The Carry Trade PRACTICE QUESTIONS The relative prices of Japanese goods to Americans fall when the: A) yen appreciates. B) dollar appreciates. C) inflation rate in the United States is higher than the inflation rate in Japan, and there are flexible exchange rates. D) inflation rate in Japan is higher than the inflation rate in the United States and there are fixed exchange rates. All of the following add to the demand for U.S. dollars except: A) long-term capital inflows. B) foreign travel by United States citizens. C) exports of commodities from the United States. D) travel by foreigners on United States airlines. Dollar price of 1 euro Supply of euros.90 0 Q* Demand for euros Q of euros Refer to the above graph. If currency traders think the European economy will experience a recession and the U.S. economy will not, then this event will most likely cause the: A) euro to appreciate. C) U.S. dollar to depreciate. B) euro to depreciate. D) the supply of euros to decrease

12 If the exchange rate between the yen and the U.S. dollar is 100 yen = \$1, how much would a camera that costs 10,550 yen in Japan cost in the United States? A) \$ B) \$ C) \$ D) \$1,055. E) \$1.05. More German companies start to invest in the United States. This will lead to a(n) A) decrease in the demand for dollars and an increase in the demand for marks. B) increase in the supply of dollars and a decrease in the demand for marks. C) increase in the demand for dollars and a decrease in the supply of marks. D) increase in the demand for dollars and an increase in the supply of marks. Why does the depreciation of a country's currency tend to increase its price level? A) Domestic buyers tend to substitute imports for domestic products. B) A currency depreciation makes a country's products less competitive in world markets, so exports fall. C) A currency depreciation makes imported inputs more expensive. D) A currency depreciation makes imported inputs less expensive.

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