Exchange Rates

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This is an article from Macroeconomics. To get back to the list of all topics click here.

[1]Exchange rates are known to anyone that has travelled internationally before. They are essentially the amount of one currency needed to buy another currency. In the economy, exchange rates are important as they affect imports and exports (and hence affect output and trade). This article discusses the differences between the nominal and real exchange rates, their advantages and disadvantages, how they are determined and their affect on the economy. Lastly, the article discusses policy related to these exchange rates.

Contents

Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 387-413 (Chapter 14).

Nominal Exchange Rates

[2]Nominal exchange rates are simply the value of one currency against another. For example, how much is one Australian Dollar worth compared to the US Dollar? As of 4pm September 10 2010, one Australian Dollar was worth 0.9170 US Dollars.

[3]In this course, we define the nominal interest rate as e, and we define it as:

e = Foreign Currency/Domestic Currency

Since we are in Australia, we tend to define the domestic currency to be the Australian Dollar. The definition can be stated as the number of units of foreign currency that the domestic currency wil buy. From this, we can conclude that as increase in e, corresponds to an appreciation of the domestic currency, while a decrease in e corresponds to a depreciation of the domestic currency.

Flexible vs. Fixed Exchange Rates

[4]From the above definition it can be seen that currencies can change value. This is only true however for flexible exchange rates, which are typical for countries like Australia. However this isn't always the case: some countries choose to maintain a fixed exchange rate, such as Latvia which has fixed its currency rate to the Euro. For the moment, we will focus only on flexible exchange rates.

Real Exchange Rates

[5]While the nominal exchange rate gives the value of one currency against another, it does not give an indication of the value difference in the goods or services. The real exchange rate gives this indication by the equation:

Real Exchange Rate = Price of domestic good / Price of foreign good, in domestic currency

Notice that the price of domestic good and the price of foreign good are measured in the same currency. The foreign good in terms of domestic currency is given by the price of foreign goods in terms of foreign currency multiplied by the nominal exchange rate. Hence, the equation can be rewritten as:

Real Exchange Rate = P/(Pf/e) = eP/Pf

Where:

P = Price of domestic good (in domestic currency)
e = Nominal interest rate
Pf = Price of foreign good (in foreign currency)

[6]Hence, when the real exchnge rate is high, it means that the price of domestic goods is more expensive relative to foreign goods. This corresponds to a difficulty in exporting, but an increase in importing.

The equation also implies that the real exchange rate follows the nominal exchange rate. That is, an increase in e will increase the real exchange rate.

Determining the Exchange Rate

[7]The question to answer now is what determines the nominal exchange rates. Here we focus on flexible exchange rates but fixed exchange rates will be discussed later.

Purchasing Power Parity

[8]The Purchasing Power Parity (PPP) model is a popular model for understanding nominal interest rate fluctuations. It is based on the assumption of the Law of one price which states that if transport costs are low, then goods should have the same price all around the world. If this was not the case, then it would easy for merchants to buy goods at cheaper locations, transport it and sell the good at an increased price for greater profits. As goods left the cheaper location, prices there would rise (as supply is less) while prices would decrease in the more expensive location (as there is more supply).

PPP can be used to determine the nominal interest rate by comparing how much currency is traded for a good at both locations. If a meal costs AUD$8.50 in Australia and 85TB in Thailand, then we say that:

$8.50 = 85 TB and dividing by 8.5 yields:
$1 = 10 TB

Another useful application of PPP is that if a country is experiencing inflation, then the exchange rate changes.

Shortcomings of PPP

[9]The problem with PPP is its main premise that goods are traded at the same price everywhere. This is not the case since not all goods are traded everywhere, and not all goods are the same. In addition, transport costs are not always low and this makes calculating nominal interest rates with PPP faulty. Hence PPP is only a real indicator in the long run, but it fails in the short run.

Exchange Rates Model: Supply and Demand

Supply and Demand curves for Australian Dollars

[10]To understand the behaviour of exchange rates in the short run, the supply and demand model is utilised. The supply of Australian dollars comes from households and firms, and there are two reasons for this:

Households and firms supply Australian Dollars so they can buy foreign goods
Households and firms supply Australian Dollars so they can buy foreign assets

Since in both cases foreign goods or assets are priced at foreign currencies.

Now if the exchange rate is high, that is, the Australian dollar buys a high amount of foreign currency, then there would be an incentive for households to supply more Australian currency. This is because more foreign currency for less Australian currency means cheaper foreign goods or assets.

[11]The demand for Australian Dollars, by contrast, comes from the foreign country. The reasons are the same for the supply side except that it means foreign countries want to buy Australian goods or assets. Hence the demand curve is downward sloping, since if the exchange rate is high, then the foreign country can only buy Australian dollar for a high value of foreign currency, making Australian goods and assets less attractive.

The equilibrium point of the exchange rates is given by the point of intersection between the supply and demand curves, also known as the fundamental value of exchange rate. This point then moves due to shifts in the supply and demand, which gives the reason for how flexible exchange rates are determined and changed.

Shifts in the Supply for Dollars

[12]The supply curve shifts outward (to the right) due to:

  • Increased demand for foreign goods (could be because of better quality or cheaper)
  • Increased Australian GDP which increases consumption, part of which goes to the foreign sector
  • Increase in real interest rates in the foreign market. This means that Australians will expect higher returns on investment in the foreign market and hence supply more Australian Dollars.

Shifts in the Demand for Dollars

[13]Factors that will increase the demand for Australian Dollars (outward shift to the right) include:

  • Increased demand for Australian goods
  • Increased GDP in foreign market
  • Increased interest rates in Australia

Monetary policy and Exchange Rates

[14]Since the supply and demand for Australian dollars is dependant on interest rates, it is simple to see what will happens as the reserve bank carries out its monetary policy. A tightening of monetary policy, involving higher interest rates, increases foreign demand for Australian dollars. In doing so, the demand curve shift to the right. At the same time though, the increase in interest rates means that Australians are less inclined to supply dollars since they can save and earn high interest in their own country. Hence the supply of Australian Dollars decreases, shifting the curve to the left. The final result is a new equilibrium point with higher exchange rates, and hence and appreciation of the Australian dollar.

[15]Other effect of this monetary policy are higher imports and decreased exports. This is due to the higher exchange rate which effectively increases Australians' purchasing power but makes their exports too expensive for other markets. Since both imports and exports are part of the Aggregate Demand, increases in the exchange rate

Fixed Exchange Rates

[16]Fixed exchange rates are those that are set at a value by the government, central bank and/or other agencies. In reality these economies still have an equilibrium exchange rate (or a fundamental exchange rate) but the traded exchange rate may be below or above this point. In such cases, these economies tend to have excess supply or demand for their currency, which is inefficient. To get around this, these economies tend to buy or sell their excess supply or demand (in effect becoming suppliers or demanders).

For example, imagine if the fixed interest rate for a country is 1.2% but the fundamental exchange rate is 1%. Under such circumstances, the economy will have excess supply. To solve this, the government (or central bank) will buy more of their own currency, thereby increasing demand to match the supply.

Governments that hold this policy tend to keep accounts, known as international reserves for the purposes of buying and selling currencies.

Other policies that can be taking are restrictions on international trade in an attempt to affect exports and imports. These measures are usually used last, such as when the fundamental value dips far below the fixed rate.

Speculative Attacks

[17]It is sometimes the case that investors in foreign markets choose to sell all their foreign assets because they speculate that the exchange rate will change. This is known as a speculative shock which has the effect of increasing supply of domestic currency. This in turn tends to actually devalue the currency and hence, ironically, the speculation itself can cause the event to happen.

Monetary Policy and Fixed Exchange Rates

[18]Since stabilising exchange rates for a fixed exchange rate economy involves the central bank to buy currency, it implies that it can be the case that the central bank will run out of money if the fundamental rate dips really low. In such situations, the only other option left for central banks is to use monetary policy to increase interest rates which will then increase demand for domestic currency.

Policy makers have to be cautious when implementing their strategies: an increase in interest rates may balance the exchange rates but it could also mean slowing down the economy and making a recession. In effect, countries that choose a fixed exchange rate give up the ability to use monetary policy effectively.

Discussion

[19]The advantages associated with a flexible exchange rate are:

  • the ability to use monetary policy to manipulate the exchange rate
  • automatic stabilisation of the exchange rate to equilibrium by the market forces

While the advantages associated with a fixed exchange rate is simply that the exchange rate is fixed, hence making trade easier.


References

"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011).

  1. Textbook p. 387
  2. Textbook p.388
  3. Textbook p. 389
  4. Textbook p. 390
  5. Textbook p.391
  6. Textbook p. 392
  7. Textbook p. 393
  8. Textbook p. 394
  9. Textbook p. 396
  10. Textbook p.397
  11. Textbook p. 398
  12. Textbook p. 398
  13. Textbook p. 398
  14. Textbook p. 400
  15. Textbook p. 402
  16. Textbook p.402
  17. Textbook p. 405
  18. Textbook p.408
  19. Textbook p. 411
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