Chapter 67: Floating exchange rates (3.2)
· Definition of exchange rates
Three main short run determinants of exchange rates exist:
1. The demand for other countries’ goods and services: When European tourists visit the US they will need US dollars and European citizens wanting more US goods will be met by European importers increasing their demand for US dollars in order to buy US goods.
2. The demand for FDI and portfolio investment in another country.
3. Speculative demand: When international speculators such as fund management firms and other financial institutions believe that the EURO will appreciate, they will buy EUROs in order to make a gain in selling them when the EURO rate rises.
· Floating exchange rate regime
o Appreciation and depreciation
Appreciation: When the market value of a freely floating currency increases, i.e. the market price has increased, the currency has appreciated. This can be caused by an increase in demand and/or decrease in supply of a currency on the foreign exchange market.
Depreciation: When the exchange rate (expressed in terms of another currency or a trade-weighted basket of currencies) for a freely floating currency falls, then the currency has depreciated. Increased supply and/or decreased demand will cause depreciation.
o Supply and demand
The supply curve for a currency is upward sloping and the demand curve is downward sloping. Using the EURO to explain why:
· Demand: A lower price for the EURO – ceteris paribus – would enable foreign citizens to buy more EURO zone goods, and foreigners would thus demand more EUROs. A lower price of the EURO is thus correlated with an increase in the quantity demanded for EUROs.
· Supply: The supply curve for the EURO is upward sloping since a higher price for it means EURO zone citizens can exchange their EUROs for more foreign goods. As EURO zone citizens trade in their EUROs for other currencies, the quantity supplied of the EURO increases and we get positive correlation between the price of the EURO and quantity supplied of the EURO.
Figure 67.2 The exchange rates for the EURO and the US dollar (USD)
Diagram I in figure 67.2 above shows how an initial equilibrium in the exchange rate for the EURO is set at USD1.31. This gives an exchange rate for the US dollar of €0.76, shown in diagram II. Say that there is increased American demand for European goods or an increase in American tourists to Europe:
· EURO: the demand for EUROs will increase from D0 to D1 in diagram I, and the exchange rate for EUROs appreciates from USD1.31 to USD1.35.
· USD: As more US dollars would flow into foreign exchange offices to buy the EURO, the supply of US dollars would increase. This is shown in diagram II, where the supply of US dollars increases from S0 to S1, and the exchange rate for the US dollar depreciates from €0.76 to €0.74. The new exchange rate for the USD is naturally the inverse of the price of the EURO (1 / 1.35).
1. The exchange rate for the US dollar is 7.8 Swedish Crowns (SEK). What is the exchange rate for the SEK? NOTE: changed the price of the USD.
2. What will happen to the exchange rate for the Japanese Yen if more tourists visit Japan?
3. What will be the effect on the Japanese exchange rate if Japanese imports rise?
4. Farawayistan places a large quantity of embassy personnel in Nearistan. These personnel buy lots of goods and services from Nearistani firms. Explain what will happen on the foreign exchange markets in terms of Faraway dollars and Neari pounds.
· Determinants of a floating exchange rate
o Trade flows – demand for goods and services (refer to figure 67.4)
When American exports increase, there will be an increased demand for the dollar as importers in other countries will need more dollars to buy the American goods. The same goes for services and tourism; more banking services and tourism demanded by trade partners mean greater demand for the US dollar.
o ∆D↑ for US exports → ∆↑demand for USD → appreciation of the USD
o ∆↑US imports → ∆↑supply of USD → depreciation of the USD
o Relative inflation (refer to figure 67.3)
· Increase in relative inflation:
o ∆↑ relative inflation in US à ∆¯ demand for US exports & ∆↑ US demand for imports → ∆¯ demand for US dollar & ∆↑ supply of US dollar → USD depreciates
· Decrease in relative inflation:
o ∆↓ relative inflation in US à ∆↑ demand for US exports & ∆↓ US demand for imports → ∆↑ demand for US dollar & ∆↓ supply of US dollar → USD appreciates.
o FDI and portfolio investment (refer to figure 67.3)
One of the main reasons for the phenomenal appreciation of the US dollar during the 1990s was that it was so attractive for foreign firms to invest in the US. Strong growth, high profits and a dynamic and innovative environment attracted billions of investment Yen/EUROs/British pounds. In order to build a plant in the US or buy American shares, one must first buy US dollars; demand for dollars increases and the dollar will appreciate.
· Posit then that one or more of the following happens: profits in US companies rise; US corporate taxes are lowered; US productivity increases; or legislation is limiting foreign ownership in the US is scrapped.
o ∆↑inflows of investment to US ∆↑demand for USD → US dollar appreciates
· Conversely, when American firms set up factories abroad and US investors increase their holdings of European/Japanese bills, bonds and shares, Americans will have to buy other currencies in order to make these exchanges.
o ∆↑US investment abroad → ∆↑supply of USD → US dollar depreciates
o Domestic growth (refer to figure 67.3)
Change in national income: As has been pointed out, when incomes rise there is an increase in spending in households. Some of this spending will of course be on imports.
o ∆↑Y in the US → ∆↑ imports in the US → ∆↑S of USD → US dollar depreciates
o Growth in trade partners’ economies (refer to figure 67.3)
An increase in national income in Mexico, one of America’s main trading partners, will naturally mean increased exports for the US and an increase in demand for US dollars.
o ∆↑Y in Mexico → ∆↑ demand for US exports → ∆↑D for USD → US dollar appreciates
o Speculation (refer to figure 67.3)
· Speculative belief that the US dollar will depreciate → US dollar is sold by speculators→ ∆↑ supply of the US dollar → the USD depreciates
· Speculative belief that the US dollar will appreciate → US dollar is bought by speculators → ∆↑ demand for the US dollar è the USD appreciates
o Other determinants (refer to figure 67.3)
As mentioned in Chapter 57, one main determinant of a floating exchange rate is the level of government deficits and debt an economy has.
Another theory dealing with the long run determinants of exchange rates is the theory of purchasing power parity (PPP). PPP exists when an identical basket of goods costs the same in two countries at a given exchange rate; at an exchange rate of USD1 = €0.75 a bundle of goods costing USD100 in the US would cost €75 in the EU since there would be perfect parity between the purchasing power of a US dollar and that of a EURO. Assuming perfect flows of goods, money and information between trading nations, domestic consumers will detect price differentials and act upon them.
Say the bundle costs €70in EMU countries at an initial exchange rate of USD1 = $0.75. Americans would get €75 and buy more goods from “Euroland” which would drive up demand for the EURO whilst simultaneously increasing the supply of the USD. Ultimately the EURO would appreciate (and the USD depreciate) and the price differentials would be eradicated, resulting in an exchange rate where the bundle of goods is the same price in the US as it is in “Euroland”.[1] The theory of purchasing power parity thus predicts that exchange rates will ultimately even-out to reflect changes in inflation in trading countries. In other words, in the long run PPP will ultimately be restored via the exchange rate.
However…. while there is some evidence that exchange rates in the long run show some adjustment to purchasing power, there are far too many exceptions abounding to be able to draw general conclusions. The limitations set by the assumptions of the theory would appear to be quite strong.
· Many goods are like ill-mannered infants and saké (Japanese rice wine); they simply don’t travel well – e.g. services such as restaurant meals and cinema tickets are not exportable and many goods will have high transport costs and also meet high trade barriers.
· Goods are not homogenous and thus price differences will exist which show consumer preferences.
· In addition, expenditure taxes can vary considerably between countries and international firms will indulge in price discrimination whenever possible.
Point in fact, a survey of the most integrated single market in the world, the European Union, showed that prices of cinema tickets varied by 170% between lowest and highest prices in the EU.[2] Another example is Switzerland, which is surrounded by 5 countries (including Liechtenstein) and has relatively open borders towards its EU neighbours – yet it is one of the notoriously most expensive countries in the world, where a basket of goods costs an average 40% than the OECD average. These are but a few examples of how purchasing power parity theory comes up a bit short in predicting that exchange rates will adjust and eventually even-out prices.
1. European tastes switch in favour of East Asian culture and goods. What would happen on the foreign exchange market for the EURO?
2. Say that Britain grants ‘tax holidays’ for foreign firms. How would this affect the exchange rate for the British pound?
3. Korea manages to keep its inflation rate lower than that of its trading partners. How might this affect the Korean Won?
4. The European Central Bank (ECB) considers the exchange rate for the EURO to be too low. What actions can be taken?
5. Here’s a tricky one: Using a S/D diagram for the Swiss Franc, show how the repatriation of profits to Switzerland by Swiss firms in Germany would affect the value of the Swiss Franc.
· Effects of the exchange rate on macro goals
This is economics so the odds are fair that any two variables will show causal flows in both directions. This is indeed the case where currency depreciation/appreciation will affect domestic growth, inflation, unemployment and the balance of payments.
o Domestic AD and GDP
Depreciation of the USD →
§ ∆↓ relative P of exports in the US → ∆↑ US export revenue → ∆↑AD
§ ∆↑ relative P of imports in the US → ∆↓ US import expenditure → ∆↑AD
o Inflation
Appreciation of the USD →
§ → ∆↓ relative P imports in the US → ∆↑ US imports → ∆↓AD → ∆↓ inflation rate
§ US firms import a major portion of factors → ∆↓P imported factors → ∆↑AS → ∆↓ inflation rate
§ It is also likely that the increased competition with foreign suppliers will force US firms to become more price competitive and this too will have a dampening effect on US inflation.
o Unemployment
o Depreciation of the USD → ∆↑ exports in the US → ∆↑AD → ∆↓ unemployment
o Appreciation of the USD and thus ∆↓ exports → ∆↓AD in the US → ∆↑ unemployment
o Balance of payments
We will deal with the balance of payments in some depth in Chapters 70 to 73 so for the time being we shall limit the iteration to two brief examples of how a change in the exchange rate can have an impact on net exports in current account.
§ Current account
o Depreciation of the USD →
§ → ∆↓ (relative) P of US exports→ ∆↑ US export revenue → improvement of current account balance
§ ∆↑ (relative) P of imports in the US → ∆↓ US import expenditure → improvement of current account balance
o Appreciation of the USD →
§ → ∆↑ (relative) P of US exports → ∆↓ US export revenue → worsening of current account balance
§ → ∆↓ (relative) P of US imports → ∆↑ US import expenditure → worsening of current account
o Government debt
We not directly one of the main macro objectives, it is clearly desirable for countries to ultimately balance the budget. A government which has taken foreign loans will have to service this debt (i.e. pay interest and repay the principle loan) in the foreign currency of the creditor nation. A depreciation of the Home currency means an increased debt burden in terms of the foreign debt element of overall government debt.
[1] In this case the €70 bundle must equal the USD100 bundle in price at the new exchange rate. This implies a PPP exchange rate of USD1 = €0.70 which consequently means that the EURO has appreciated from 1.33 to 1.43 dollars per EURO.
[2]The flaw of one price, The Economist, Oct 16th 2003