Notes 15 – Exchange Rates and International Macro A. How Exchange Rates are Determined



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NOTES 15 – Exchange Rates and International Macro
A. How Exchange Rates are Determined
If I were going to purchase a car from Japan, I would have to pay for that car in Yen (the Japanese currency). That means I must be willing to trade dollars for Yen. Likewise, if someone in Japan wanted to buy a U.S. computer, they would have to pay in dollars. That means they must trade their Yen for dollars.
If someone in the U.S. wants to buy a Japanese product, they are simultaneously willing to demand more Yen and willing to supply more dollars. (They must supply dollars to get Yen).
If someone in Japan wants to by a U.S. product, they are simultaneously willing to demand more dollars and willing to supply more Yen.
As a result, we can formulate a market for Yen. We will treat Yen like any other good. Supply and demand forces will determine the price of Yen (measured in dollars). We will define the price of Yen as how many dollars we give up for one Yen (this is the price of Yen - in terms of dollars, Dollars/Yen). In the U.S., however, we often report the price of the dollar. If the dollar appreciates, that means it costs more yen to buy one dollar. (That is, we are often interested in the amount of Yen for one dollar). If the price of yen goes up, the price of the dollar will fall. In other words, if the price of foreign currency falls, the dollar, by definition, appreciates.
Below illustrates the market for Yen:

We will now look at the three factors that cause movements in the exchange rate market.


a) GDP
Suppose the GDP in the US increases. As we know, as Y increases, there are more expenditures in the U.S. – U.S. consumers, businesses and governments are purchasing more goods. It is highly likely, that some of these goods are produced abroad. That means that imports will increase. As we get richer, we would want to buy more imports. We need foreign currency to buy imports. Our demand for foreign currency increases. As a result, the demand for Yen would shift to the right. This is illustrated below.

An increase in the GDP of the US, increases the demand for Yen, causes the exchange rate to rise and the dollar to depreciate. (The exact opposite happens if US GDP falls).
An increase in the GDP of Japan, increases the supply of Yen. If the Japanese have a greater income, they would want to buy more U.S. goods. In order to buy more U.S. stuff, they need dollars. Their demand for dollars would increase. If they want more dollars, they must supply more yen. Because their demand for dollars increases, the supply of Yen increases.
The increase in Japan’s GDP would increase the supply of Yen, cause value of the Yen to fall and the dollar to appreciate. (The exact opposite happens if Japan’s GDP falls)
Notice, with a GDP change in one country, only one of the curves shift!
b) Price changes: With a price change in one country, both the supply and the demand for a currency will be affected. Let us illustrate with an example. Suppose that prices in the US rise (P goes up – where P is price level of all goods in the economy). This means US goods become more expensive (foreign goods become relatively cheaper). If US goods are more expensive, US citizens would want less of them. In other words, we would substitute towards buying more foreign goods. If we want to buy foreign goods, we need to have foreign currency. As a result, our demand for Yen (foreign currency) will increase.
The supply of Yen will also change. Picture yourself in Japan. If the price of US goods increase, a person in Japan would want less US goods, compared to what they were purchasing before. Their demand for dollars would fall. If they want less dollars, that means they would be willing to supply less Yen. An increase in the price of US goods (inflation in the US) causes both the supply of Yen to fall and the demand for Yen to increase.
Below, we graphically illustrate this point:

When Prices in the US increase, the demand for Yen increases, the supply of Yen falls, the price of Yen rises and the dollar depreciates. (The exact opposite happens when the price level in the US falls). [REMEMBER THAT BOTH AN INCREASE IN DEMAND AND A DECREASE IN SUPPLY CAUSE THE PRICE OF FOREIGN CURRENCY TO RISE].
When Prices in the Japan increase, the demand for Yen falls, the supply of Yen increases, the price of Yen falls and the dollar appreciates. (The exact opposite happens when the price level in the Japan falls).
When prices in Japan rise - US citizens want less Japanese goods and the Japanese want more American goods.
c) The third and final factor that affects exchange rates are interest rates.
Changes in interest rates shift both the demand for Yen and the Supply of Yen. If interest rates in the US go up, US citizens will want to put more money in US banks and less money in Japanese banks. The demand for Yen will fall.
Likewise, with increased interest rates in the US, Japanese citizens will want to put more money in the US. Their demand for dollars will increase which means they are willing to supply more Yen.
This is represented graphically below:

When interest rates in the US rise, the demand for Yen will fall, the supply of Yen will increase, the price of Yen will fall, and the dollar will appreciate. (The exact opposite will happen if the US interest rates fall).
When interest rates in Japan rise, the demand for Yen will increase, the supply of Yen will fall, the value of the Yen will rise, and the dollar will depreciate. (The exact opposite will happen if the Japanese interest rates fall).

B. How do changes in exchange rates affect our model?
Look at this example.
Suppose a computer costs 200 Yen in Japan. Suppose further that the price of yen was $.50/yen. In terms of dollars, how much would the computer be worth? $100. (Every $ is worth 2 Yen. If I wanted 200 yen, I would need 100 dollars. (200 Yen * $.50/yen)).
Would if the dollar appreciated? (We know that if the dollar appreciated, the price of yen would fall). Say the price of yen is now $.25/yen. In terms of dollars, how much would the computer be worth? $50. (Now, every dollar is worth 4 Yen. If I wanted 200 yen, I would need $50). As the dollar appreciated, Japanese goods become cheaper (in terms of dollars). As a result, I would want more of them. An appreciation of the dollar (depreciation of the Yen) would cause U.S. citizens to want more Japanese goods. U.S. import of Japanese goods would increase AND U.S. purchases of U.S. produced goods would fall.
Flipping the story around, if the dollar appreciates, U.S. goods become more expensive. As a result, Japanese citizens will be purchasing less U.S. goods.
As the dollar appreciates, US imports will rise and US exports would fall. (The exact opposite would hold if the dollar depreciates). i.e., NX will fall!!!!
A. Definition:
Trade Balance: Exports – Imports (X-IM). If trade balance is positive, we say there is a trade surplus. If trade balance is negative, we say there is a trade deficit.
If the dollar appreciates, we would expect the trade surplus to fall (trade deficit to rise). If the dollar appreciates, imports will increase and exports will fall.
B. Effectiveness of Fiscal and Monetary policy in an open economy.
Fiscal Policy:
Suppose the government increases G and or decreases T. How will this affect the goods market, money market, and exchange rate market?
Goods market: As G increases, there will be an increase in AD. The increase in AD will increase Y and increase P.
This is illustrated below:

In the money market, MME curve will shift in as prices are higher (real money balances fall). This will cause interest rates to rise.


How will exchange rates respond? The increase in Y and the increase in P in the US should cause the dollar to depreciate relative to other currencies. The increase in r should cause the dollar to appreciate relative to other currencies.
Which one dominates? It depends on the size of the changes. But, often the interest rate effect dominates. If the interest rate effects dominate and the dollar appreciates, imports will rise and exports will fall. As a result, the AD will shift some to the left. That means: In a closed economy (with no exchange rate movements), an increase in G will cause the AD to shift out – end of story. But, with exchange rate movements, an increase in G will also cause the dollar to appreciate (if interest rate effect dominates) and this will cause NX to fall shift the AD curve in some. In the end, Y will still increase, but not as much if exchange rates adjust.
International crowding out - In an open economy, expansionary fiscal policy (increasing G) could lead to the appreciation of the dollar. This causes US imports to rise and US exports to fall which shifts the AD curve to the left and offsets some of the initial impact of the AD shifting out (in the end, the AD still shifts out, just not as much as it would have if exchange rates were fixed). In a sense, the increase in imports crowds out some of the effects of expansionary fiscal policy.
If international crowding out occurs fiscal policy is less effective. A given increase in G leads to a smaller change in Y when exchange rates are allowed to result.
TWIN DEFICITS – The 1980s in the U.S.: If international crowding out occurs, twin deficits could result. By twin deficits, I mean a budget deficit and a trade deficit could occur at the same time. Let us look at how this could happen. Suppose the government increases spending without increasing taxes. A budget deficit occurs. The increase in G is expansionary fiscal policy. From or discussion above, if the interest rate effect dominates exchange rates, the dollar will appreciate. This will cause the imports to rise and exports to fall. In other words, a trade deficit will result. We have just shown how a budget deficit could lead to a trade deficit. This is what happened in the 1980s (along with an appreciation of the dollar).
C. REVIEW OF MONETARY POLICY IN THE OPEN ECONOMY:
To start, let us review monetary policy in a closed economy. Suppose the Fed enacts expansionary monetary policy (buy bonds, lower reserve ratio, etc.).
We see that when the Fed increases the money supply, interest rates fall (MME shifts out). The decrease in interest rates causes borrowing to become cheaper. As a result, firms would engage in more investment. The increase in investment will shift out the AD curve in the goods market. This is illustrated below.

The increase in investment will lead to an increase in both P and Y. In this case, this would be the end of the story about monetary policy if exchange rates were fixed.
How would the effects of monetary policy change in an open economy? For this, we need to look at the currency market. As we learned, the currency market is affected by Y, P and r. With monetary policy, r falls and P and Y rise. All of these increase the demand for foreign currency and decrease the supply of foreign currency. This is illustrated graphically below.

As we see, the price of foreign currency will conclusively rise from expansive monetary policy. This will lead the dollar to depreciate. Depreciation of the dollar will decrease imports and increase exports. In an open economy, AD will shift out further than it does in a closed economy with expansionary monetary policy. Not only will there be an increase in investment, but there will be an increase in exports and a decrease in imports. All of these shift out the AD curve.
As a result, we say monetary policy is more effective in an open economy. (AD shifts out more in an open economy compared to a closed economy with expansionary monetary policy because the monetary policy causes the dollar to depreciate which spurs on higher NX).
Note: The same analysis would hold with a monetary contraction. AD will shift to the left more in an open economy than a closed economy with a contractionary monetary policy.






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