PRINCIPLES OF MACROECONOMICS 2e

for AP Courses

Chapter 15 Exchange Rates and International Capital Flows

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COLLEGE PHYSICS

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Chapter # Chapter Title

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CH.15 OUTLINE

FIGURE 15.1

• Is a trade deficit between the United States and the European Union good or bad for the U.S. economy?

(Credit: modification of work by Milad Mosapoor/Wikimedia Commons)

15.1 How the Foreign Exchange Market

Works

Demanders and Suppliers of Currency in Foreign Exchange Markets

International Financial Investment

A Portfolio Investor Trying to Benefit from Exchange Rate Movements

• Expectations of the future value of a currency can drive demand and supply of that currency in foreign exchange markets.

Participants in the Exchange Rate Market

Strengthening and Weakening Currency

Illustrate: Strengthen or Appreciate vs. Weaken or Depreciate

• Exchange rates can fluctuate substantially, even between bordering countries such as the U.S. and Canada.
• By looking closely at the time values (the years vary slightly on these graphs), we see that the values in part (a) are a mirror image of part (b).
• The depreciation of one currency correlates to the appreciation of the other and vice versa.
• When comparing the exchange rates between two countries, the depreciation (or weakening) of one country (like the U.S. dollar here) indicates the appreciation (or strengthening) of the other currency (like the Canadian dollar).

(Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/EXCAUS)

How Do Exchange Rate Movements

Affect Each Group?

• Exchange rate movements affect exporters, tourists, and international investors in different ways.

15.2 Demand and Supply Shifts in

Foreign Exchange Markets

Example: Demand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate

1. The quantity measured on the horizontal axis is in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos.

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Example: Demand and Supply for the U.S. Dollar and Mexican Peso Exchange Rate, Continued

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1. The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the price of pesos measured in U.S. dollars.
1. In both graphs, the equilibrium exchange rate occurs at point E, at the intersection of the demand curve (D) and the supply curve (S).

Exchange Rate Market for Mexican

Peso Reacts to Expectations about

Future Exchange Rates

• An announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso from investors who wish to benefit from the appreciation (from D₀ to D₁).
• Similarly, it will make investors less likely to supply pesos to the foreign exchange market (from S₀ to S₁).
• Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.

Differences across Countries in

Rates of Return

Exchange Rate Market for U.S. Dollars

Reacts to Higher Interest Rates

• A higher rate of return for U.S. dollars makes holding dollars more attractive.
• Thus, the demand for dollars in the foreign exchange market shifts to the right, from D₀ to D₁, while the supply of dollars shifts to the left, from S₀ to S₁.
• The new equilibrium (E₁) has a stronger exchange rate than the original equilibrium (E₀), but in this example, the equilibrium quantity traded does not change.

Relative Inflation

Exchange Rate Markets React to Higher Inflation

• If a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it.
• Thus, a rise in inflation in the Mexican peso would lead demand to shift from D₀ to D₁, and supply to increase from S₀ to S₁.
• Both movements in demand and supply would cause the currency to depreciate.
• Here, we draw the effect on the quantity traded as a decrease, but in truth it could be an increase or no change, depending on the actual movements of demand and supply.

Purchasing Power Parity

15.3 Macroeconomic Effects of Exchange Rates

Fluctuations in Exchange Rates

Banking and International Borrowing

• The scenario of international borrowing that ends on the left is a success story, but the scenario that ends on the right shows what happens when the exchange rate weakens.

15.4 Exchange Rate Policies

• A nation may adopt one of a variety of exchange rate regimes:
• floating rates in which the foreign exchange market determines the rates;
• pegged rates where governments intervene to manage the exchange rate's value;
• a common currency where the nation adopts another country or group of countries' currency.

Floating Exchange Rates

U.S. Dollar Exchange Rate in

Japanese Yen

• Even seemingly stable exchange rates such as the Japanese Yen to the U.S. Dollar can vary when closely examined over time.
• This figure shows a relatively stable rate between 2011 and 2013.
• In 2013, there was a drastic depreciation of the Yen (relative to the U.S. Dollar) by about 14% and again at the end of the year in 2014 also by about 14%. (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/DEXJPUS)

Using Soft Pegs and Hard Pegs

Pegging an Exchange Rate

1. If an exchange rate is pegged below (30 cents/real) what would otherwise be the equilibrium, then the quantity demanded of the currency will exceed the quantity supplied.
2. If an exchange rate is pegged above (40 cents/real) what would otherwise be the equilibrium, then the quantity supplied of the currency exceeds the quantity demanded.

A Merged Currency

How do Tobin taxes control the flow of capital?

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