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© Pilot Publishing Company Ltd. 2005 Chapter 12 International Finance I --- Exchange Rate
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Chapter 12 International Finance I --- Exchange Rate

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Chapter 12 International Finance I --- Exchange Rate. Contents:. Definitions Relation between domestic price and foreign price Exchange rate system Changes in the demand for and supply of foreign currency Determinants of the equilibrium exchange rate - PowerPoint PPT Presentation
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Page 1: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Chapter 12International Finance I ---

Exchange Rate

Page 2: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Contents:

• Definitions• Relation between domestic price and foreign

price • Exchange rate system• Changes in the demand for and supply of foreign c

urrency• Determinants of the equilibrium exchange rate• Automatic adjustment for BOP deficits under

different exchange rate systems

Page 3: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Contents:

• Government policies on eliminating BOP deficit under a fixed exchange rate system

• Comparison between flexible and fixed exchange rate systems

Page 4: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Definitions

Page 5: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Definitions

Foreign exchange (fe) refers to foreign currency or claims on foreign currency such as cheques drawn in the currency

Page 6: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate or exchange value of a foreign currency (e) is the price of the currency (in terms of another currency). Without specification of the currency, it is the amount of domestic currency required to exchange for a unit of foreign currency. Note: When e , exchange value of foreign currency rises while that of domestic currency drops.

Effective exchange rate index is the price index of exchange rates of the domestic currency. Note: When the index , the exchange value of the domestic currency rises.

Page 7: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Relation between Domestic Price and Foreign Price

Page 8: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Relation between domestic price and foreign price

Domestic price of a good is its price in domestic currency (Pd). Foreign price of a good is its price in foreign currency (Pf).

Pd = e Pf or Pf = Pd /e

Page 9: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

The slopes of the demand curve for and the supply curve of foreign currency

The demand curve for foreign currency is downward sloping.

Imports: When e rises,

)( fd PeP )( fd PeP QmQm )( fmd PQQ )( fmd PQQ

Page 10: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

The slope of the supply curve (S) of foreign currency depends on the price elasticity of foreign demand for the country’s exports (E).

1. If E is elastic S is upward sloping

2. If E is unitarily elastic S is vertical

3. If E is inelastic S is downward sloping

)eP

(P df

)eP

(P df

QxQx )Q(Q fxs P )Q(Q fxs PExports: when e rises

Page 11: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange Rate System

Page 12: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate systems

An economic agent who demands foreign currency on the one hand supplies domestic currency on the other hand and vice versa.

Exchange between currencies

Page 13: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Price of foreign currency in domestic currency (or exchange rate)

Quantity of foreign currency

S

D

Equilibrium exchange rate

Equilibrium exchange rate

Demand for and supply of foreign currency

Page 14: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Price of domestic currency in foreign currency

Quantity of domestic currency

S

D

Equilibrium Equilibrium exchange rateexchange rateEquilibrium Equilibrium exchange rateexchange rate

Demand for and supply of domestic currency

Page 15: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Types of exchange rate systems

Flexible / Floating exchange rate system Demand for & supply of foreign currency

determines the market exchange rate

Fixed exchange rate systemThe monetary authority

fixes the official exchange rate

(at a pre-announced value)

Page 16: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Price of foreign currency in domestic currency (e)

Quantity of foreign currency

SS

DD

Equilibrium exchange rate

e*

Balance of payments under different exchange rate systems

Flexible exchange rate system

As Qd = Qs, the market BOP must always be balanced.

The equilibrium e* will finally be reached at which Qd = Qs

0

Page 17: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Price of foreign currency in domestic currency (or exchange rate )

Quantity of foreign currency

S

D

Equilibrium exchange rate

At e1, excess demand for foreign currency exists (the country suffers BOP deficit)

Fixed exchange rate system

e*

e1

Foreign currency is under-valued

At the pre-announced e, Qd may not equal Qs.

Page 18: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

At e1, Excess demand for foreign currency

Central Bank / Monetary Authority has to

sell foreign currency for domestic currency ( reserve assets & domestic money supply )

Exchange rate maintained at e1

Fixed exchange rate system

Page 19: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Price of domestic currency in foreign currency

Quantity of domestic currency

S

D

Equilibrium exchange rate

Excess supply of domestic currency

Fixed exchange rate system

e*

e1^

Domestic currency is over-valued

An alternative expression

Page 20: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Terms describing changes in exchange rate

Under a flexible exchange rate system, a rise in the price of a foreign currency is described as an appreciation of the foreign currency or a depreciation of the domestic currency (as more units of domestic currency are needed to exchange for a unit of foreign currency).

Under a fixed exchange rate system, a rise in the price of a foreign currency is described as a revaluation of the foreign currency or a devaluation of the domestic currency.

Page 21: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Changes in the Demand for and Supply of Foreign Currency

Page 22: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

S

D’

Exchange rate

Quantity of foreign currency

0D

Demand for foreign currency increases

e’

e

If e is flexible, e rises

If e is fixed, Qd > Qs, i.e., BOP deficit results

Page 23: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

Supply of foreign currency decreases

S’

S

D

e’

e

If e is flexible, e rises

If e is fixed, Qd > Qs, i.e., BOP deficit results

Page 24: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Demand for foreign currency or supply of foreign currency

The equilibrium exchange rate

Conclusion

Flexible e system

Fixed e system

dc depreciates

BOP deficit

Page 25: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

e’

e

D’

D

If e is flexible, e falls

If e is fixed, Qs > Qd, i.e., BOP surplus results

S

Demand for foreign currency decreases

Page 26: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Supply of foreign currency increases

Exchange rate

Quantity of foreign currency

0

S

DD

e’

e

If e is flexible, e falls

If e is fixed, Qs > Qd, i.e., BOP surplus results

S’

Page 27: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Demand for foreign currency or supply of foreign currency

The equilibrium exchange rate

Conclusion

Flexible e system

Fixed e system

dc appreciates

BOP surplus

Page 28: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Determinants of the Equilibrium Exchange Rate

Page 29: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Protectionist measures Spending on imports Spending on imports

Exchange rate

Quantity of foreign currency 00

e’

e

SS

D’

DD

Demand for fc

Demand for fc

Flexible e system: dc appreciates. Fixed e system:

BOP surplus.

Page 30: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

e

S

D

e’

S’

More domestic investment opportunities Outflow of capital

& inflow of capital Outflow of capital & inflow of capital

Demand for fc & supply of fc

Demand for fc & supply of fc

D’

Flexible e system: dc appreciates. Fixed e system:

BOP surplus.

Page 31: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

e

S

D

e’

D’

National income rises

Spending on imports

Spending on imports

National income National income

Demand for fc

Demand for fc

Flexible e system: dc depreciates. Fixed e system:

BOP deficit.

Page 32: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

e

S

D

e’

S’

Interest rate rises Outflow of capital & inflow of capital Outflow of capital & inflow of capital

Demand for fc & supply of fc

Demand for fc & supply of fc

D’

Flexible e system: dc appreciates. Fixed e system:

BOP surplus.

Page 33: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

e

S

D

e’

D’

Money Supply rises

r outflow of capital & inflow of capital

D & S

r outflow of capital & inflow of capital

D & S

Ms LM shifts rightward r & Y

Ms LM shifts rightward r & Y

Y Spending on imports D

Y Spending on imports D

Flexible e system: dc depreciates. Fixed e system:

BOP deficit.

S’

Page 34: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Inflation

Inflation rate of a country that of its trading partner

1. Competitiveness of import-competing products spending on imports1. Competitiveness of import-competing products spending on imports

Demand for fc

Demand for fc

Page 35: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

00

e

S

DD

e’

D’

S’

2. Foreign prices of the country’s exports 2. Foreign prices of the country’s exports

Volume of exports & receipts from exports

Volume of exports & receipts from exports

Supply of fc Supply of fc

If foreign demand for the country’s exports is elastic

If foreign demand for the country’s exports is elastic

Flexible e system: dc depreciates. Fixed e system:

BOP deficit.

Page 36: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

e

S

D

e’

S’

Outflow of capital & inflow of capital Outflow of capital & inflow of capital

Demand for fc & supply of fc

Demand for fc & supply of fc

D’

Flexible e system: dc appreciates. Fixed e system:

BOP surplus.

Speculation upon the value of a currencyA bullish speculation upon the domestic currency

Page 37: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Automatic Adjustment for BOP Deficits under Different Exchange Rate Systems

Page 38: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Automatic adjustment for BOP deficits under different exchange rate systems

Under a flexible e system

BOP Deficit excess D for fc e

)( fd PeP )( fd PeP QmQmImports:

Exports:

)( fmd PQQ )( fmd PQQ

)eP

(P df

)eP

(P df

QxQx

)Q(Q fxs P )Q(Q fxs P

Page 39: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

e’

e

S

D

Depreciation can improve the BOP deficit

Excess Demand

If foreign demand for the country’s exports is elastic

Page 40: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 00

e’

e

S

DExcess Demand

Depreciation can improve the BOP deficit

If the demand for exports is unitarily elastic

Page 41: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

e’

e

DS

If the demand for exports is inelastic and the M-L condition holds

Depreciation can improve the BOP deficit

Excess Demand

Page 42: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Marshall-Lerner condition (M-L condition):

The sum of the price elasticities of foreign demand for the country’s exports and the country’s demand for foreign imports is greater than one.

Page 43: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

e

D S

Excess Demand

Depreciation cannot improve the BOP deficit and e rises persistently

If the demand for export is inelastic but the M-L condition does not hold

Page 44: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Under a fixed exchange rate system

r

Y00

IS

LM’

LM

YYY’

r’

r

Facing a BOP deficit

Central bank sells foreign currency for domestic currency

Central bank sells foreign currency for domestic currency

Ms Y & r

Ms Y & r

Page 45: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 00

Fixed e

S’

D’

D

S

Y spending on imports D

Y spending on imports D

The process continues until deficit 0

r outflow of capital & inflow of capital

D & S

r outflow of capital & inflow of capital

D & S

Page 46: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Government Policies on Eliminating BOP Deficit under a Fixed Exchange Rate System

Page 47: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency

0

Fixed e

D’D

SS

Protectionist policySpending on imports Spending on imports

Demand for fc

Demand for fc

External deficit

Page 48: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Quantity of foreign currency

00

Exchange rate S

DDD’

Fixed e

S’

An increase in interest rate Outflow of capital & inflow of capital Outflow of capital & inflow of capital

Demand for fc & supply of fc

Demand for fc & supply of fc

External deficit

Page 49: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Contractionary policy -- Prices are rigid

Quantity of foreign currency

00

Exchange rate

DD

SS

D’

Fixed e

Y spending on imports

Y spending on imports

Demand for fc

Demand for fc

External deficit

Page 50: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Exchange rate

Quantity of foreign currency 0

Original fixed e

D

S

Devaluation

New fixed e

The Marshall-Lerner condition is required.

Page 51: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Comparison between Flexible and Fixed

Exchange Rate Systems

Page 52: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Advantages of flexible e system (or disadvantages of fixed e system)

Allocate resources efficiently

No BOP problem

No need to hold a large amount of reserve assets

Government policies are free to achieve domestic objectives

Insulated from imported inflation

Page 53: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Disadvantages of flexible e system (or advantages of fixed e system)

Bring uncertainty to businessmen

Arouse speculation

Enhance domestic inflation

Page 54: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

Correcting Misconceptions:

1. There is no BOP problem because the payments must always be balanced.

2. Some economic transactions are favourable to an economy but some are not.

3. The gain from trade is determined by the balance of payments.

4. The supply curve of foreign currency must be upward sloping.

Page 55: Chapter 12 International Finance I --- Exchange Rate

© Pilot Publishing Company Ltd. 2005

5. Depreciation or devaluation can resolve the problem of payments deficit.

6. Without government intervention, a BOP deficit will persist under a fixed exchange rate system.

Correcting Misconceptions: