Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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N. Gregory Mankiw, Principles of Economics, 8th Edition

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Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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All-in-one Platform

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Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

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Chapter 28: International Currency Markets

Figure 28.1: Currencies from around the world. [1]​

“If I go to California, I take my own money and I spend it. But if I go to France, I have to buy Euros before I can spend my money. It makes travel abroad a little more exotic, but I do have to pay a commission and I have to continually translate the cost of goods to dollars in order to understand costs.”

“I once took an extended trip to France where I bought 180 Euros with my $200 and then bought 14,600 rubles with my Euros. Next, I actually got a bargain – over 780 Zloty in Warsaw for 14,600 rubles – and exchanged those for 4,972 Krona as I landed in Prague. Finally, in New York, I traded the Kronas for about $120. I had spent $80 in cash during the trip.”

So how are these values determined?

Table 28.1: Recent Exchange Rates and Their Change over a Five-Year Time Period​​

As we can see, exchange rates can change significantly. Most of these exchange rates are determined in international currency markets; some are also set by governments. Let’s look at the international currency markets first.

28.1 Objectives for Chapter 28

After completing this chapter, you should be able to:

  • Analyze the supply and demand for U.S. dollars or foreign exchange.
  • Discuss the factors that affect exchange rates.
  • Forecast exchange rate changes based on a variety of events.
  • Discuss the tradeoffs between a strong and weak currency.
  • Explain the difference between real and nominal exchange rates.
  • Assess the direction of causality between the value of the dollar and the trade deficit.
  • Discuss the interrelationship between monetary and fiscal policies and exchange rates.
  • Explain the difference between fixed and floating exchange rates.

28.2​ International Market for Currencies

Think of markets for currencies that stretch from international city to international city – at airports where tourists come and go, at waterfronts where ships arrive and depart, or at financial institutions around the world. Currencies can be bought and sold for twenty-four hours a day, as we move around the world from London to New York to Hong Kong to Jakarta to New Delhi and back to London.

28.2.1 Exchange Rates

​An exchange rate is the price of one currency in terms of another. As a matter of convention, foreign exchange market participants most often define exchange rates as the number of units of the other currency it takes to buy a dollar.1 Members of the popular press mean the same thing when they use the term “value of the dollar.” If it takes more of a foreign currency to buy a dollar, the international value of the dollar has increased relative to other currencies. If a dollar can be purchased with less foreign currency, the value of the dollar has decreased relative to other currencies.

Consider a tourist changing money for a trip she is taking to Europe for vacation. Why might this be a good time to travel versus a bad time, in terms of the dollar appreciating or depreciating relative to the euro?

The best places to travel while the dollar is strong:


The value of the dollar is the number of units of foreign currency it takes to buy one dollar. An increase in the value of the dollar is a rise in its price in terms of other currencies. For example, suppose that the Japanese yen price of a dollar increases from ¥100 per dollar (the currency symbol for the Japanese yen is ¥) to ¥110 yen per dollar. This is the same thing as saying the value of the yen falls relative to the dollar.

If the exchange rate is ¥100 yen per U.S. dollar (¥100/$1) then each yen costs one cent ($1/¥100 or $0.01/¥1). If the exchange rate changes to ¥110/$1, then the value of the yen has fallen to $1/¥110, which equals $.009/¥1 or 9/10 of a penny per yen. The point here is that the value of the dollar against the yen is the reciprocal of the value of the yen against the dollar. If one currency appreciates, that means that the other currency depreciates.

Question 28.01

Question 28.01

Think of a supply and demand model to describe a currency market. What would be bought and sold? What would be the price?

Hover here to see the hint for Question 28.01.
Click here to see the answer to Question 28.01.

​Figure 28.2 shows an index number representing a composite of the currencies of our top trading partners per dollar. (The value of the dollar rose in the 1990s; that is, it took more units of other currencies, on average, to buy a U.S. dollar.) The value of the dollar fell quickly in the 2000s to reach a trough in 2009. From 2012 until 2016 it mostly rose. In most of 2017 it was about ten percent below its recent peak in 2016, but by the end of 2018 and beginning of 2019 it is back at its 2016 peak.

ECN28_Figure28.2_updated.jpg
Figure 28.2: Trade Weighted U.S. Dollar Index.

Think of this   as an index of the weighted average foreign currency price of a U.S. dollar.​

Question 28.02

Referring to Figure 28.2, did the U.S. dollar appreciate or depreciate between 2002 and 2007?

​Question 28.03

Question 28.03

Refer to Figure 28.2. From the point of view of U.S. trading partners, have U.S. goods become more expensive or less expensive since 2011?

Hover here to see the hint for Question 28.03.
Click here to see the answer to Question 28.03.

​28.2.2 International Demand for Dollars

The next step in developing our model of currency markets is to think about what constitutes demand for dollars in the international currency market.

Question 28.04

Question 28.04

Why do individuals, businesses, and governments in other countries demand dollars? Is the slope of the demand curve positive or negative? Why?

Hover here to see the hint for Question 28.04.
Click here to see the answer to Question 28.04.

​French citizens might want dollars in order to buy American wine, or more likely, American movies or American cars. The demand for exports from the U.S. lies behind the international demand for the dollar. But there are other reasons to demand dollars. French businesses might demand dollars to buy American raw materials (which can also be U.S. exports) or to make investments in the U.S., such as building a factory in the U.S. French banks and individuals might also want to buy financial assets. 

At an exchange rate of .8 euros per dollar, a $20,000 U.S. automobile costs 16,000 euros. If the exchange rate or the value of the dollar falls to .6 euros per dollar, the same automobile costs a French citizen 12,000 euros. Given the fall in price to French buyers, the quantity demanded of automobiles will increase, and the quantity demanded of dollars to buy those automobiles will likely increase. Thus, demand for currency is a normal demand; the demand curve for currency is downward sloping. As the value (foreign currency price) of the dollar falls, the quantity demanded increases.

In international currency markets, the demand for U.S. dollars comes from the international demand for U.S. products, capital investments, and financial assets. It takes dollars, not euros or pesos, to buy those products and to make those investments. Toyota, BMW, and Mercedes-Benz (automobile manufactures based in Japan and Germany) used dollars to build new factories in Kentucky, South Carolina, and Alabama. Demand for U.S. dollars also comes from the demand for dollar-denominated financial assets; it takes dollars to buy a share of stock on the New York Stock Exchange or a Treasury bond from the U.S. Treasury. Most banks within the U.S. require dollars to open up a checking or savings account.

Figure 28.3: Demand for Dollars

28.2.3 International Supply of Dollars

The supply curve for currency is more difficult. People and institutions in the U.S. have the dollars. Why would U.S. citizens want to supply dollars to the international market? Think of the above discussion and then explain.

​If U.S. individuals, businesses, and governments want to buy French goods and services, make investments in France, or buy French financial assets, they need euros in order to do so. For a U.S. citizen to get euros, they will have to supply dollars to the international currency market. Thus, the supply of U.S. dollars to the foreign exchange market resembles the demand for U.S. dollars but works in reverse. The greater the U.S. demand for French goods, the greater the U.S. supply of dollars in the currency market. The greater the U.S. demand for French investment and French financial assets, the greater the U.S. supply of dollars will be in that market.

Figure 28.4: Supply of Dollars​

If the international price of the dollar is .8 euros per dollar, we can buy .8 euros worth of goods for one dollar. At .4 euros per dollar, we can only buy one-half of the number of goods for the same dollar. Thus, as the euro price of a dollar falls, the cost of the French goods to a U.S. citizen rises, and the quantity demanded of the French goods will decrease. If the quantity of French goods demanded decreases, the quantity of dollars supplied to the international currency market decreases. Thus, as shown in Figure 28.4, the supply curve is upward-sloping, indicating that more dollars are supplied as the value of the dollar increases.

​28.2.4 Supply and Demand in the Currency Market

The movement to an equilibrium price and an equilibrium quantity in the international currency market is the same process that we encountered in our first discussions of markets. If the price of the dollar is below the equilibrium price Figure 28.5, the quantity demanded will be greater than the quantity supplied. The shortage will result in the bidding up of the price of the dollar. As the price of the dollar increases, the quantity supplied will increase (as we demand more goods, etc.) and the quantity demanded will decrease (as those in other countries will demand fewer U.S. goods, etc.). Foreign goods will be cheaper for us and we will buy more. Our imports will rise. As the price of the dollar increases, our goods will be more expensive for those abroad to buy. Thus, our exports will begin to fall. That process will continue until we reach an equilibrium price: the equilibrium exchange rate.

Figure 28.5: Supply and Demand for Dollars​

28.3 Determinants of Exchange Rates

How Much Food Can You Buy for $5 Around the World?

Why are these quantities of food so different around the world? Part of the answer is due to differences in the costs of producing, but it is also due to differences in exchange rates. Let’s explore.

​The value of currencies changes continuously in countries that have not fixed their exchange rates. We know from our model above that these changes must be due to shifts in demand, supply, or both. Factors that affect exchange rates vary depending on the time period under consideration. In the short run, demand for goods and services as well as financial factors – particularly interest rate changes, investment opportunities and the relative stability of financial markets in the two countries – have the primary influence. In the intermediate run, exchange rates are determined by economic conditions such as the level of income and prices in the two countries. Finally, in the long run, exchange rates are influenced by the concept of purchasing power parity between the two countries.

Table 28.2: Factors Influencing Exchange Rates​​

As demand for U.S. goods and services increases, demand for dollars increases. As a result, the quantity demanded of dollars is higher at each exchange rate. Similarly, as the demand for foreign goods and services increases, the supply of dollars to buy foreign goods and services increases.

Graphing Question 28.01

Graphing Question 28.02

28.3.1 Financial Conditions (Short Run)

​ Current or Projected Change in Domestic or Foreign Interest Rates

Forces changing supply and demand for a currency work at different speeds, but all are likely working at any one time. Changes in interest rates in the U.S. relative to Thailand, for example, will change the demand for (and supply of) dollars very quickly. If interest rates increase here, Thai businesses will want to use their baht to buy dollars in order to earn the new higher U.S. interest rate, causing the international price of the dollar to rise (and the value of the Thai baht to fall relative to the dollar). You should be able to work out the effects on supply.

​Fed's Kaplan sees three more interest rate hikes 'likely' [1]

​“My base case for 2019 is to gradually and patiently raise the  federal funds rate into a range of 2.5 to 2.75 percent or, more likely,  into a range of 2.75 to 3 percent,” Kaplan said in an essay outlining  policy views.  

The  Fed last month raised its target range for short-term interest rates to  2 pct to 2.25 percent, a move Kaplan said he supported. Three more rate  hikes would lift rates to 2.75 percent to 3 percent; any higher would  move monetary policy from a “neutral” stance to a “restrictive” one, he  said, slowing economic growth, pushing up on unemployment, and pushing  down on inflation.                                

An Saphir -Reuters, October 24, 2018

Question 28.05

Question 28.05

Interest rates increase in the U.S. Think of institutions buying bonds or opening bank accounts in other countries. What is the effect of the increased interest rates in the U.S. on the supply and demand for U.S. currency? What is the effect on the exchange rate?

Hover here to see the hint for Question 28.05.
​Click here to see the answer to Question 28.05.

FOREX-Dollar falls, euro lifted as Fed turns cautious

​"The dollar weakened on Thursday after the Federal Reserve pledged to  be patient with further interest rate hikes, a move that lifted the euro  and the Australian dollar. 

The Fed left interest rates unchanged  on Wednesday, as expected, but discarded its promises of “further  gradual increases” in interest rates. 

The dollar fell to a  three-week low against other major currencies and U.S. Treasury yields  dropped after the Fed changed its tone. "

                       -​Tom Finn for Reuters, January 31, 2019

Question 28.06

Question 28.06

Describe the effect of expectations that the U.S. will hold or lower interest rates on the supply and demand for dollars.

Hover here to see the hint for Question 28.06.
Click here to see the answer to Question 28.06.​

Question 28.07

Question 28.07

Describe the effect of the U.S. Federal Reserve raising interest rates on the supply and demand for dollars.

Hover here to see the hint for Question 28.07.
Click here to see the answer to Question 28.07.

28.3.2​ Economic Conditions (Intermediate Run)

Changes in income and relative price levels are always affecting exchange rates through changes in the demand for exports and imports. But these economic forces take longer to have an effect than the financial flows around the world.

A. Changes in Incomes

Growth in income in the home country (e.g., the U.S.) enables it to supply more dollars to buy foreign goods. The net effect is the supply of dollars will increase causing the dollar to decline in value. Similarly, if income in the foreign country increases, consumers in that country may use some of their income to buy U.S. goods and services, causing the international demand for the dollar to increase. Thus, the value of the dollar will rise.

​B. Changes in Relative Prices

As prices of goods in the U.S. increase relative to prices in another country (e.g., Canada), dollar-denominated goods become more expensive, causing the demand for dollars to decrease. Therefore, the value of the dollar will decline. In contrast, if the price of goods in Canada increases relative to U.S. prices, the demand for dollar-denominated goods will increase causing the value of the dollar to increase as well.​

Question 28.08

Question 28.08

What is likely to happen to the value of the dollar if Thai income rises? Think about the Thai demand for imports. Separately, what happens when prices in the U.S. rise faster than the Thai prices? That is, the U.S. is experiencing higher inflation.

Hover here to see the hint for Question 28.08.
Click here to see the answer to Question 28.08.

28.3.3 Purchasing Power Parity (Long Run)

​Over longer periods of time, exchange rates will approach a level that provides “purchasing power parity,” meaning that prices around the world will tend to be equal – so that the purchasing powers of currencies are equal or “on a par” with one another. Exchange rates will adjust so that goods that can be traded will eventually cost the same all over the world. Differences in prices will eventually be only due to transportation costs. Purchasing power parity has often been described as the “law of one price.” We would only expect this to hold for tradable goods. It would not work for haircuts, car repairs, or even Big Macs.

The reasoning is that if the cost of the product is different in two countries, then there would be an arbitrage opportunity whereby someone could buy the product in one country and sell it in another country for a profit. As entrepreneurs encounter this profit opportunity, more will engage in buying and selling the product. As they do so, the opportunity eventually disappears. Prices rise where they were lower as the buyers buy, and prices fall where they were higher as the buyers sell.

Let’s illustrate the logic behind purchasing power parity with an example. Suppose that an automobile made and sold in the U.S. is also made and sold in Japan. Suppose the Japanese automobile costs ¥2,200,000 ((¥ = yen), the U.S. automobile costs $20,000, and the current exchange rate is ¥100 yen per dollar. Does purchasing power parity hold in this case? To check, let’s see what the automobile from Japan would cost in U.S. dollars. In U.S. dollars, the price of the car purchased in Japan is higher. Assuming shipping costs aren’t too high, it would make sense for someone in Japan to buy U.S. cars for $20,000 and ship them to Japan where they could be sold at a profit for the equivalent of $22,000. As a result, prices of these U.S.  cars would be likely to increase in the U.S. and prices of similar cars in Japan to decline.

Question 28.09

Question 28.09

What would happen to the Japanese yen price of a dollar if Japanese entrepreneurs imported U.S. automobiles? What would happen to the price of U.S. automobiles?

Hover here to see the hint for Question 28.09.
Click here to see the answer to Question 28.09.

Graphing Question 28.03

Graphing Question 28.04

Purchasing power and the use of the Big Mac to compare currency values.

Question 28.10

Question 28.10

From the video, one can see that the cost of a Big Mac at McDonald’s restaurants in Indonesia, Finland, and the U.S. is $.74, $3.70, and $2.63 respectively. Explain how these prices support or refute the purchasing power parity theory.

Hover here to see the hint for Question 28.10.
Click here to see the answer to Question 28.10.

28.4 The Trade-offs Between a Strong and Weak Currency

​"Perhaps no other piece of economics jargon has caused as much confusion as the term “strong dollar.” The phrase suggests patriotic strength, of the USA riding roughshod over its economic rivals. In reality, dollar strength just means purchasing power – a stronger dollar lets U.S. residents and businesses buy more things from overseas, while a weaker dollar helps them sell more things to overseas customers. "

                            -Bloomberg, March 17, 2017 [4]

Question 28.11

Question 28.11

Does a strong dollar offer any benefits to the U.S.?

Hover here to see the hint for Question 28.11.
Click here to see the answer to Question 28.11.​

Question 28.12

Question 28.12

What should the U.S. government do in this case?

Hover here to see the hint for Question 28.12.
Click here to see the answer to Question 28.12.

28.5​ Real and Nominal Exchange Rates

​A friend of mine, a French professor who spends most summers in Paris, was excitedly telling me how the euro/dollar exchange rate had gone to 1 euro per dollar from 1.2 euros per dollar. He had concluded that his summer would cost much less. Yet during the same time that the value of the euro fell, prices in France had increased about 20 percent faster than in the U.S. In actuality, then, nothing about the cost of his summer had changed. He could get more euros for each dollar, but the cost of living and increased by the same amount.

This situation exemplifies the fact that real exchange rates are what determine purchasing power, not nominal exchange rates. News articles, currency exchange kiosks, and banks almost always quote nominal exchange rates between two currencies.​

Question 28.13

Question 28.13

Can you explain why there was no change in the real exchange rate in this euro/dollar example?

Hover here to see the hint for Question 28.13.
Click here to see the answer to Question 28.13.

If you are mathematically inclined, consider the following. To calculate the real exchange rate, multiply the nominal exchange rate by the ratio of price indices as shown below.

After the 20 percent increase in prices in Europe and the change in the nominal exchange rate:

In this instance, the real exchange rate has not changed. It is one euro per dollar at the beginning. The nominal exchange rate increased from 100 to 120 at the same time prices abroad increased by 20 percent. The real exchange rate remained at one euro per dollar.

Nominal versus real exchange rate.

28.6 Do Changes in Exchange Rates Cause Changes in the Trade Deficit or Is It the Other Way Around?

Table 28.3: Direction of causality between the value of the dollar and net exports​

An increase in the value of the dollar causes U.S. products to be more expensive for foreigners, while also causing U.S. imports of foreign goods to be cheaper. As a result, net exports (Exports – Imports) fall. However, if net exports fall for other reasons (e.g., a change in preferences), the relationship between the exchange rate and net exports is the opposite. For example, if U.S. tastes for German cars change because BMWs are thought to be more fashionable, our demand for imports will rise, thus lowering net exports. To purchase a greater amount of imports, the supply of dollars to buy foreign goods must rise. As a result, the value of the dollar will fall. So a decrease in net exports will have caused the value of the dollar to fall.

The chain of causality can also be the opposite. For example, if U.S. interest rates are projected to increase relative to European interest rates, financial investors will demand more dollars. The value of the U.S. dollar will rise. As a result of the rise in the value of the dollar, our exports will be more expensive and, therefore, fall. Our imports will be cheaper, causing them to increase. Thus, an increase in the value of the dollar will have caused our net exports to fall.

The direction of causation and the underlying cause behind the change in the value of the dollar becomes crucial to understanding the relationship the value of the dollar and the trade deficit.

Question 28.14

Tastes for imported goods decrease. If nothing else changes, what will happen to the international value of the dollar?

A

It will increase.

B

It will decrease.

C

It will not change.

D

One cannot tell.

Question 28.15

If the international value of the dollar increases, what will happen to the U.S. trade deficit?

A

It will increase.

B

It will decrease.

C

It will not change.

D

One cannot tell.

28.7 Monetary Policy, Fiscal Policy, and Exchange Rates

With exchange rates that are determined in markets and international trade that makes up a significant portion of GDP, the functioning of monetary and fiscal policies become slightly more involved than our analysis up to this point.

28.7.1 Monetary Policy

In an inflationary period, the Fed may respond with a restrictive monetary policy, causing higher interest rates. The intention is to slow the growth in spending and thereby reduce the growth in prices.

​The increase in interest rates also has an effect on the international demand for the dollar. The resulting increased demand for the dollar will cause the value of the dollar to increase. That, in turn, will cause net exports to fall – a further decrease in spending. Thus, the change in exchange rates reinforces the effects of monetary policy. Monetary policy works through its effects on net exports in addition to investment and consumption. Stimulative monetary policy is made stronger in a similar manner.

28.7.2 Fiscal Policy

Suppose that the government in an economy increases spending or lowers taxes in an attempt to stimulate spending in the economy. As a result of the stimulative fiscal policy, the economy starts to grow.

Our model, however, is further complicated by incorporating exchange rates. The government has to increase borrowing to pay for the fiscal expansion, and as the economy grows, interest rates begin to rise. As interest rates rise relative to those of other trading partners, the international demand for dollars rises. Foreign individuals and businesses seek to purchase dollars to invest in U.S. assets that are now paying a higher rate of return.

​The increased international demand for the dollar causes the value of the dollar to increase. As a result, exports become more expensive and begin to decline. U.S. imports also begin to increase, because they are less costly with the higher value of the dollar.

​Increased imports and falling exports reduce GDP growth, thus mitigating some of the effects of stimulative fiscal policy. The more sensitive the international demand for financial assets is to interest rate changes, the weaker fiscal policy becomes.

​Question 28.16

Question 28.16

Overall trade (as measured by both exports and imports) has grown significantly from 1960 to now. Exports were about 5 percent and imports were 4.5 percent of GDP in 1960. In 2016, exports were 12 percent and imports were 15 percent of GDP. What has likely happened to the effectiveness of fiscal and monetary policy as a result? Why?

​Hover here to see the hint for Question 28.16.
Click here to see the answer to Question 28.16.

​Monetary policy is made stronger by basically the same relationships. Consider a stimulative monetary policy. The expansion in growth of the money supply lowers interest rates. In the U.S., lower interest rates eventually cause a lower value of the dollar, greater exports and fewer imports, and a multiplied, positive effect on total spending. In this case, though, the monetary policy is designed to cause an increased growth in total spending. It is reinforced by the international effects. The larger international trade is as a portion of GDP, the greater that reinforcement will be.

These two examples use restrictive fiscal and expansionary monetary policies. The results of the analyses are the same with expansionary fiscal and restrictive monetary policies.

28.7.3 The Twin Deficits

Table 28.4: The Twin Deficits: How an increasing federal deficit may impact the trade deficit.​

In Chapter 26 we discussed the relationship between federal government deficits and investment. We also looked at a table and implied that there might be a relationship between government deficits and trade deficits. Indeed there can be a relationship, the result of which is sometimes described as the twin deficits.

Rising federal deficits increase the demand for money. Interest rates begin to rise. As interest rates rise, the international demand for the dollar begins to increase. As the demand for the dollar rises, the value of the dollar increases. A higher value of the dollar means that U.S. exports are more expensive and U.S. imports less expensive. Therefore, our net exports fall (exports down; imports up). As a result, a trade deficit will worsen. The twin deficit theory, however, assumes that private saving does not expand enough or that private investment does not fall enough to accommodate the increase in government borrowing. During the 1980s, there did appear to be a fairly strong, direct relationship between the government and trade deficits. However, this relationship appeared to break down in the 1990s and 2000s as other changes counteracted the effects of the increasing federal deficits.​

28.7.4 Exchange Rates and the Current Account Balance

In the last chapter, we talked about the current account deficit having to be balanced by a financial account surplus. Understanding changes in exchange rates gives us a better idea of the process that actually causes that to happen.

We said that in essence, the financial account balance was an accounting of where the excess dollars went in the case of a U.S. trade deficit. But what really makes all of these decisions, (e.g., decisions about investment and holding of dollars and financial assets) just equal to the difference between exports and imports? Those decisions are made by millions of individuals, but they are different individuals from the ones making decisions about imports and exports.

The mechanism is the exchange rate. Suppose we are in equilibrium in the international currency market. An increase in the world’s perception of the U.S. as a good, safe place to invest causes the demand for U.S. financial assets to increase. If this results in an increase in financial flows to the U.S., the financial account surplus increases. That can’t be the end of the story because the financial account surplus is no longer equal to the current account deficit. Our basic understanding of the equality of the financial account surplus and the current account deficit is violated.

To see how the exchange rate is involved in this sequence of events, note that international investors will need to obtain U.S. dollars to invest in the U.S. At the old exchange rate, there is a shortage of dollars on the international currency market. The value of the dollar begins to increase, and as it does, exports will fall and imports will rise. The U.S. dollar appreciates, causing the current account deficit to grow until it is just equal to the financial account surplus. Therefore, the exchange rate will adjust to keep trade and financial flows in balance.

Figure 28.6: Equilibrium in the market for foreign exchange.​

28.8 Fixed and Floating Exchange Rates

Some countries, such as China, have fixed their exchange rates or let the exchange rates vary only within small ranges. The U.S. did so also until 1971. Such systems, which encompassed much of the world prior to 1971, mean that the international currency markets did not set exchange rates.

To fix a currency, the country pegs or ties its currency to another currency or a bundle of currencies. To do so, it buys or sells its own currency to maintain the specified value. It is said to have appreciated when the value rises. When a government lowers a fixed exchange rate, it is described as having devalued its currency. If a government increases the value of its fixed exchange rate, it is said to have revalued its currency.

Holding down a rising value of a currency is somewhat easier than preventing a fall in the value of a currency. To prevent an increase, the government only has to supply its own currency on the international currency market. That is relatively easy to do because it is in control of how much money it creates. (There may be inflationary consequences of supplying too much money.)

To prevent a decrease in the value of its currency is more of a challenge. A country does that by buying its own currency with other countries’ currencies that it has accumulated from past current account surpluses. But there is a limit to how much currency of other countries it has and therefore how much of its own currency it can purchase. This is what ultimately defeats a country in its efforts to maintain a fixed value to its currency.

The advantage of fixed exchange rates is that businesses can better forecast the costs and prices they will receive for exports. Costs of doing business are reduced, as businesses do not have to protect themselves from losses for changing exchange rates. However, to maintain fixed exchange rates, governments have to supply other currencies if there is a surplus of the domestic currency in the market and supply their own currencies if there is a shortage.

Recall the explanation of how currency values change to bring the financial and current accounts into balance. With fixed exchange rates, there is not a mechanism to balance the accounts. If there were a shortage of currency on the international market, the government would have to supply the currency on the international market and buy foreign currencies with their own currency if it is to prevent the value of the currency from rising. The shift in demand in Figure 28.7 would be met by an increase in the supply of currency brought about by the government.

Figure 28.7: An increase in demand would result in appreciation. How might the monetary authority prevent the currency from appreciating?​

You should be able to work through the process of how a government will have to respond if it tries to maintain a fixed exchange rate with downward pressure on the value of its currency. When will the government not be able to hold the fixed exchange rate?

Some time ago, a financial crisis ensued in the Philippines, Indonesia, Malaysia, Hong Kong, and Thailand, causing individuals, businesses, and governments to want to move money from those countries to safe havens like the U.S. At the time, the value of the Thai baht and other currencies were fixed to the value of the dollar.​

Question 28.17

Question 28.17

If the Thai baht had been floating, what would have happened to its value during the Asian financial crisis? Use our supply and demand for currency model to explain. What would the Thai government have to do to maintain a fixed exchange rate? What may have caused it to ultimately fail to maintain a fixed exchange rate?

Hover here to see the hint for Question 28.17.
Click here to see the answer to Question 28.17.​

Graphing Question 28.05

28.9 Summary

  • Exchange rates of almost all major currencies are determined in international markets for currencies. 
  • The international demand for the U.S. dollar is the international demand for goods and services produced in the U.S. and for real and financial assets in the U.S. 
  • The international supply of the U.S. dollar is the U.S. demand for goods and services produced in the rest of the world and for real and financial assets outside of the borders of the U.S.
  • Supply and demand working in a currency market determine an equilibrium price level that becomes the exchange rate between two currencies; for example, the number of U.S. dollars it takes to purchase a Canadian dollar, a Mexican peso, and a European euro.
  • In the short run, demand for goods and services and financial conditions, primarily changes in interest rates and investment opportunities between the two countries, determine exchange rates.
  • In the intermediate to long runs, relative inflation rates and purchasing power parity (meaning goods should cost approximately the same across all countries) influence exchange rates.
  • A “strong” and a “weak” dollar both have costs and benefits. 
  • The absolute values of the current and financial account balances will be equal in an economy with flexible exchange rates.
  • It is the change in the value of a currency which in turn changes the balance on the current account that makes the two balances equal.
  • Changes in factors that influence demand and supply in the financial account will ultimately have effects on the exchange rates and thus on the current account balance.
  • The phrase “twin deficits” is often used to describe the federal budget deficit and the international trade deficit. 
  • A fixed exchange rate system is maintained by some countries to eliminate dramatic fluctuations in the value of their currencies. 
  • Monetary policy is made stronger through international trade and financial flows by causing net exports to change in a reinforcing manner. Fiscal policy is made weaker, as changes in net exports counter the intended effects of the fiscal policy.

28.10 Key Concepts

​Exchange rates
Nominal versus real exchange rate
Factors affecting the exchange rate
Real appreciation and real depreciation
The value of the dollar
Purchasing power parity
The twin deficits
Effectiveness of monetary and fiscal policy
Fixed exchange rates

​Glossary

Exchange rates: The price of one currency in terms of another.

Fixed exchange rates: Exchange rates that are set at a given level and government policy is aimed at maintaining that fixed level.

Flexible exchange rates: Exchange rates that are determined in international currency markets.

International demand for the dollar: The international demand for U.S. goods and services, for U.S. investments, and for U.S. financial assets.

International supply of the dollar: The U.S. demand for imports into the U.S., U.S. demand for international financial assets, and U.S. demand for international investment.

Purchasing power parity: An explanation of currency markets that says in the long run exchange rates will change to reflect differences in domestic prices. As a result, prices of goods around the world will be the same when measured in a single currency.

Trade-weighted value of the dollar: An index of currencies of the major trading partners of the U.S. is used to determine what is happening to exchange rates. If the number of units of currencies it takes to buy a dollar on average is increasing, the trade-weighted value of the dollar is increasing.

Twin deficits: Refers to the connection between changes in the level of the federal budget deficit and the level of the trade deficit.

Value of the dollar: The number of units of another country’s currency it takes to buy one dollar on the international currency market.


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Answer Keys:

Answer to Question 28.01

If you said that it is a currency that is bought and sold and that the price would be the number of units of another currency it takes to buy this currency, you are right. One such market might be the market for U.S. dollars. The price would be the number of yen per dollar, the number of euros per dollar, or the number of pesos per dollar. That price is called the exchange rate and can be stated in two ways – the number of yen per dollar or the number of dollars per yen. As the value of the dollar rises, the value of the yen falls. Refer to Table 28.1 at the opening of the chapter and see if you can explain why the “recent high” for the yen was 86 when the current exchange rate is 122.

Remember that the exchange rate for yen is the dollar price of yen. To find the price of yen measured in dollars, divide $1 by the number of yen it takes to buy a dollar. That is the inverse of what we normally think of as the dollar exchange rate. The recent high for the yen was $1 / 86 yen = 1.12 cents per yen. At the current exchange rate, yen are cheaper – only .81 cents per yen). $1 / 122 yen = .81 cents per yen.

Click here to return to Question 28.01​.






Answer to Question 28.03

More expensive. Assuming U.S. prices haven’t changed much, it now takes more foreign currency to buy a U.S. dollar than it did in 2011 so it takes more foreign currency to buy U.S. goods than it did before.

Click here to return to Question 28.03​.






Answer to Question 28.04

​Individuals, businesses or governments demand dollars to buy American made goods in order to purchase American financial assets (e.g., bonds). They may also demand dollars to speculate in the currency markets or to make investments in the U.S. The demand for dollars slopes downward because a larger quantity of dollars is demanded as the price of dollars in terms of the amount of foreign currency needed to buy dollars decreases.

Click here to return to Question 28.04​.






Answer to Question 28.05

Increased American interest rates mean that U.S. financial assets pay a higher rate of return. Foreign demand for dollars will increase as foreigners try to earn those higher returns by opening U.S. bank accounts and buying bonds. At the same time, the higher interest rates make dollars more attractive to American citizens as well, and foreign currencies less attractive. The international supply of dollars falls. Exchange rates rise, and the quantity bought and sold may rise or fall depending on the magnitudes of the supply and demand curve shifts and the shapes of those curves.

Click here to return to Question 28.05​.






Answer to Question 28.06

If the Federal Reserve holds or lowers interest rates, then U.S. bank accounts and financial assets are less attractive to investors. Thus, European or Japanese investors will supply fewer dollars to the international currency market. At the same time, European or Japanese accounts and financial assets are more attractive to U.S. investors. The international demand for the dollar decreases, while the supply of dollars to buy foreign currency rises. The international value of the dollar therefore declines.

Click here to return to Question 28.06.






Answer to Question 28.07

If the U.S. Federal Reserve raises interest rates, then U.S. accounts and financial assets are more attractive to investors. Thus, foreigners will demand more dollars in the international currency market. At the same time, foreign accounts will be less attractive to U.S. investors. The international supply of the dollar decreases. The international value of the dollar, therefore, rises for both reasons.

Click here to return to Question 28.07​.






Answer to Question 28.08

If Thai income increases, Thai consumption will rise. If consumers in Thailand use some of their income to buy U.S. goods, Thai imports of U.S. goods will rise. The international demand for the dollar increases. The value of the dollar will rise.

Similarly, if prices in Thailand increase by less than U.S. prices, demand for U.S. goods will decrease, and the international demand for the dollar will decrease. A decrease in the value of the dollar results.

Click here to return to Question 28.08.






Answer to Question 28.09

Japanese entrepreneurs would need to obtain U.S. dollars to buy U.S. cars. This would increase the demand for U.S. dollars. As a result, the U.S. dollar would strengthen making the U.S. car more expensive and causing the yen to dollar exchange rate to increase, until purchasing power parity holds.

Click here to return to Question 28.09​.






Answer to Question 28.10

If Big Macs cost only $.74 in Indonesia, theoretically arbitrageurs can buy Big Macs in Indonesia and ship them to Finland. The gain could be $3.70 - $ .74 = $1.96, surely more than enough to pay transportation costs.

​The demand for the Indonesian rupiah would rise, and thus its value would increase until the cost of Big Macs everywhere were equal. (The supply of Finnish markkas would increase, thus bringing down the value of the Finnish markka.) This is the concept of purchasing power parity in action. The Economist must be putting the index together somewhat with tongue-in-cheek manner. Obviously, it would not work with Big Macs, just as it does not with many non-traded goods.

Click here to return to Question 28.10.






Answer to Question 28.11

A strong dollar may mean that confidence in the U.S. economy has increased.  However, it also means that costs of goods produced other places are now lower for U.S. buyers.  And costs of goods and services produced in the U.S. are more expensive for people abroad to buy.

Click here to return to Question 28.11.






Answer to Question 28.12

It is unlikely that the government can do much either way for any significant amount of time. But even if it could, there are real tradeoffs here. A stronger dollar does hurt exports, but it helps importers and consumers. A weaker dollar would help exporters and hurt importers and consumers.

Click here to return to Question 28.12​.






Answer to Question 28.13

To compare real values of currencies in two years, we need to compare not only what has happened to the exchange rates, but what has happened to prices in both countries. If one dollar now buys 20 percent more euros than last year and prices in Europe are 20 percent higher than last year, then one dollar will buy the same amount of goods in Europe as the dollar did last year. The real exchange rate has not changed.

Click here to return to Question 28.13.






Answer to Question 28.16

Fiscal policy will have been made weaker and monetary policy stronger. To understand why, let’s consider a restrictive fiscal policy. Government spending is lowered or taxes are raised. The change in government spending or resulting change in consumption has a multiplied effect on total spending. That reduction in spending reduces the demand for money, which in turn causes lower interest rates. The lower interest rates make financial assets less attractive to international investors abroad; therefore, the international demand for the dollar falls. As it does, the foreign currency/dollar exchange rate falls, and our exports become less expensive and our imports more expensive. The resulting increase in exports and decrease in imports causes a multiplied, positive effect on total spending. The larger exports and imports are as a part of GDP, the greater this increased spending will be. And the less effective the attempts to reduce spending in the economy will be.

Click here to return to Question 28.16.






Answer to Question 28.17

​The supply of the Thai baht would increase as Thai citizens and businesses demand U.S. financial assets. There would be a surplus of Thai baht. The Thai government would buy the surplus to prevent the value of the baht from falling.

Eventually, with continued pressure, the Thai government would run out of other currencies, and the baht would have to fall in value.

Click here to return to Question 28.17​.










Footnote

1​ Not all U.S. dollar foreign exchange rates are priced this way. Exceptions to this rule are the Euro, the British Pound, and the Australian Dollar, all of which are quoted as the U.S. dollar price of the foreign currency.


Image Citations:

[1] Image courtesy of TheDigitalWay in the Public Domain.

Exchange rate
The price of one currency in terms of another.
Value of the dollar
The number of units of another country’s currency it takes to buy one dollar on the international currency market
Consider the axis for the supply and demand of the amount of foreign currency needed to buy a unit of home currency.
What has happened to the amount of foreign currency required to buy U.S. goods on average?
Consider what influences demand for goods and demand for assets (e.g. bonds).
International demand for the dollar
The international demand for U.S. goods and services, for U.S. investments, and for U.S. financial assets.
International supply of the dollar
The U.S. demand for imports into the U.S., U.S. demand for international financial assets, and U.S. demand for international investment.
Funds flow to the currency that pays the higher interest rate. Demand for the currency and supply of the currency to buy the other currency adjust to changes in a country’s interest rate.
If the Federal Reserve holds or lowers interest rates, then U.S. bank accounts and financial assets are less attractive to investors. Thus, European or Japanese investors will supply fewer dollars to the international currency market. At the same time, European or Japanese accounts and financial assets are more attractive to U.S. investors. The international demand for the dollar decreases, while the supply of dollars to buy foreign currency rises. The international value of the dollar therefore declines.
Higher interest rates reduce the returns to the currency.
As income in Thailand increases, Thai demand for foreign goods grows.
Purchasing power parity
The law of one price, meaning that prices around the world will be the same after adjusting for exchange rates.
As imports grow, demand for the currency grows.
Purchasing power parity suggests that goods will cost the same after adjusting for exchange rates.
A currency will strengthen as confidence grows.
With some flexible exchange rate governments do not tend to intervene in the currency markets.
Consider the effects of the changes in the values of the currencies and the changes in the actual domestic prices.
Fiscal policy relies on a change in spending in a country. This change then multiplies throughout the economy. Monetary policy changes the value of interest rates, which impacts the value of the dollar and, therefore, exports and imports.
Twin deficits
Refers to the connection between changes in the level of the federal budget deficit and the level of the trade deficit.
Fixed exchange rates
Exchange rates that are set at a given level and government policy is aimed at maintaining that fixed level.
Consider what happens to demand and supply for Thai Bhat, when investors are fleeing the currency. Also, consider how the Thai central bank defends the currency.