19.1 How Exchange Rates Are Determined

• Exchange Rate is the price at which currencies Trade for one another in the market.

• Euro is the common currency in Europe.

• A depreciation of a currency is a decrease in the value of a currency relative to the currency of another nation.

• If the dollar appreciates against the yen, the yen must depreciate against the dollar. You’ll get more yen in exchange for the dollar, but now when you trade your yen back, you’ll get fewer dollars.

• The exchange rate between U.S dollars and euros is determined in the foreign-exchange market.

• The exchange rate between U.S. dollars and euros is determined in th foreign-exchange market, the market in which dollars trade for euros.

• The supply curve is the quantity supplied of dollars in exchange for euros.

  • As the value of the dollar increases, more dollars will be supplied to the currency market in exchange for euros.

• The demand curve represents the quantity demanded of dollars in exchange for euros.

  • Total demand for dollars will increase as the price of the dollar falls, or depreciates, against the euro.

• Equilibrium in the market for foreign exchange occurs where the demand curve intersects the supply curve.

• Changes in demand and supply will change equilibrium exchange rates.

• The causes of shifts of the demand curve for dollars is the higher U.S interest rates will lead to an increased demand for dollars to invest in U.S assets and the lower U.S prices will lead to increased demand for dollars.

19.2 Real Exchange Rates and Purchasing Power Parity

• Prices change over time, so we need to adjust the exchange rate determined in the foreign exchange market to take into account changes in prices, which is an application called real-nominal principle.

• Real-Nominal Principle is what matters to people is the real value of money or income-its purchasing power-to the face value of money income.

• Real Exchange Rate is the price of U.S. goods and services relative to foreign goods and services, expressed in common currency. The formula is expressed as:

  • Real Exchange Rate = Exchange Rate x U.S Price Index/ Foreign Price Index

• An increase in U.S prices will raise the real exchange rate.

• An appreciation of the dollar when prices are held constant will increase the price of U.S goods relatively more expensive as well.

• Real exchange rate takes into account changes in a country's prices over time because of inflation.

  • Country’s net exports (exports minus imports) will fall when its real exchange rate increases.

• Multilateral Real Exchange Rate is based on an average of real exchange rates with all U.S trading partners.

  • A decrease in the real exchange rate increases net exports.

• Law of One Price is the theory that goods easily tradable across countries should sell at the same price expressed in a common currency.

  • If all goods were easily tradable and the law of one price held exactly, exchange rates would reflect no more than the differences in the way the price levels are expressed in the two countries.

• Purchasing Power Parity is the theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.

  • Studies confirmed that purchasing power parity does not give fully accurate predictions for exchange rates.

19.3 The Current Account, the Financial Account, and the Capital Account

• Balance of payments is a system of accounts that measures transactions of goods, services, income, and financial assets between domestic households, businesses, and governments and residents of the rest of the world during a specific time period.

• International transactions in the balance of payments are divided into three types: the current account, the financial account, and financial assets between domestic households, businesses, governments, and residents of the world during a specific time period.

  • A Current Account is the sum of net exports (exports minus imports) plus net income received from abroad plus net transfers from abroad.

    • U.S. current account surplus = U.S. exports - U.S. imports

  • A Financial Account is the value of a country’s net sales (sales minus purchases) of assets.

    • U.S. financial account surplus = foreign purchases of U.S. assets - U.S. purchases of foreign assets

  • A Capital Account is the value of the capital transfer and transactions in unproduced, nonfinancial assets in the international accounts.

  • The current, financial, and capital accounts of a country are linked by a very important relationship:

    • current account + financial account + capital account = 0

• A net international inves position is the domestic holding of foreign assets minus foreign holdings of domestic assets.

• A sovereign investment fund is the assets accumulated by foreign governments that are invested abroad.

19.4 Fixed and Flexible Exchange Rates

• A foreign exchange market intervention is the purchase or sale of currencies by the government to influence the market exchange rate.

• To influence the price at which one currency trades for another, governments have to affect the demand or supply for their currency.

• To increase the value of its currency, a government must increase the currency’s demand.

• To decrease the values of its currency, the government must increase its supply.

• A flexible exchange rate system is a currency system in which exchange rates are determined by free markets.

• A fixed-rate system is a system in which governments peg exchange rates to prevent their currencies from fluctuating.

• A balance of payments deficit is under a fixed exchange rate system, a situation in which the supply of a country’s currency exceeds the demand for the currency at the current exchange rate.

• A balance of payments surplus is under a fixed exchange rate system, a situation in which the demand of a country’s currency exceeds the supply for the currency at the current exchange rate.

• A devaluation is a decrease in the exchange rate to which a currency is pegged under a fixed exchange rate system.

• A revaluation is an increase in the exchange rate in which a currency is pegged under a fixed exchange rate system.

• As long as the differences in inflation continued and the exchange rate remained fixed, the U.S real exchange rate would continue to appreciate, and the U.S. trade deficit would grow even worse.

19.5 Managing Financial Crises

• In 1994 Mexico experienced a severe financial crisis.

  • Mexico’s goal was to signal to investors throughout the world that it was serious about controlling inflation and would take steps needed to keep its inflation rates in line with that of the U.S.

  • Mexico opened up its markets to let in foreign investors.

  • The demand for goods increased, and the prices started to rise.

  • The price rise caused an increase in Mexico’s real exchange rate which caused a large trade deficit to emerge.

  • Mexicans were importing more than they were exporting, at this point they could still obtain the dollars needed to finance the trade imbalance for foreign investors who were purchasing Mexican securities. There was no balance of payments deficit.

  • The internal political difficulties ensued and foreign investors started to pull their funds out of Mexico.

  • The Mexican government made the mistake of not trying to reduce its trade deficit by taking steps to reduce prices, instead, it allowed the trade deficit to continue.

  • Mexican borrowers were forced to borrow in dollars denominated in dollars.

  • Mexico's central bank ran out of dollars putting the peso more in line with its market value.

  • When the peso was devalued against the dollar, the burden of these debts measured in pesos and faced massive bankruptcies and the potential collapse of its economy.

  • To prevent a financial collapse that could have spread to many other countries, the U.S government arranged for Mexico to borrow dollars with an extended period for repayment.

• In 1997 the Asian economic crisis began.

• In 2002 the Argentine economy collapsed.