© pilot publishing company ltd. 2005 chapter 12 international finance i --- exchange rate

© Pilot Publishing Company Ltd. 2005

Chapter 12International 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 c

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

different exchange rate systems


Contents:

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

• Comparison between flexible and fixed exchange rate systems


Definitions


Definitions

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


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.


Relation between Domestic Price and Foreign Price


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


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


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


Exchange Rate System


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


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

Quantity of foreign currency

S

D

Equilibrium exchange rate


Demand for and supply of foreign currency


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


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)


Price of foreign currency in domestic currency (e)


SS

DD


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


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


S

D


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.


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



Price of domestic currency in foreign currency

Quantity of domestic currency

S

D


Excess supply of domestic currency


e*

e1^

Domestic currency is over-valued

An alternative expression


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.


Changes in the Demand for and Supply of Foreign Currency


S

D’

Exchange rate


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


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


Demand for foreign currency or supply of foreign currency

The equilibrium exchange rate

Conclusion

Flexible e system

Fixed e system

dc depreciates

BOP deficit


Exchange rate


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


Supply of foreign currency increases

Exchange rate


0

S

DD

e’

e

If e is flexible, e falls

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

S’


Demand for foreign currency or supply of foreign currency

The equilibrium exchange rate

Conclusion

Flexible e system

Fixed e system

dc appreciates

BOP surplus


Determinants of the Equilibrium Exchange Rate


Protectionist measures Spending on imports Spending on imports

Exchange rate


e’

e

SS

D’

DD

Demand for fc

Demand for fc

Flexible e system: dc appreciates. Fixed e system:

BOP surplus.


Exchange rate


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


D’


BOP surplus.


Exchange rate


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.


Exchange rate


0

e

S

D

e’

S’

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



D’


BOP surplus.


Exchange rate


0

e

S

D

e’

D’

Money Supply rises

r outflow of capital & inflow of capital

D & S


D & S

Ms LM shifts rightward r & Y

Ms LM shifts rightward r & Y

Y Spending on imports D

Y Spending on imports D


BOP deficit.

S’


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


Exchange rate


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



BOP deficit.


Exchange rate


0

e

S

D

e’

S’

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



D’


BOP surplus.

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


Automatic Adjustment for BOP Deficits under Different Exchange Rate Systems


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


Exchange rate


e’

e

S

D

Depreciation can improve the BOP deficit

Excess Demand



Exchange rate


e’

e

S

DExcess Demand


If the demand for exports is unitarily elastic


Exchange rate


e’

e

DS

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


Excess Demand


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.


Exchange rate


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


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


Exchange rate


Fixed e

S’

D’

D

S

Y spending on imports D

Y spending on imports D

The process continues until deficit 0


D & S


D & S


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


Exchange rate


0

Fixed e

D’D

SS

Protectionist policySpending on imports Spending on imports

Demand for fc

Demand for fc

External deficit



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



External deficit


Contractionary policy -- Prices are rigid


00

Exchange rate

DD

SS

D’

Fixed e

Y spending on imports

Y spending on imports

Demand for fc

Demand for fc

External deficit


Exchange rate


Original fixed e

D

S

Devaluation

New fixed e

The Marshall-Lerner condition is required.


Comparison between Flexible and Fixed

Exchange Rate Systems


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


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

Bring uncertainty to businessmen

Arouse speculation

Enhance domestic inflation


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.


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:

© pilot publishing company ltd. 2005 chapter 12 international finance i --- exchange rate

Documents

currency exchange rate

foreign currency e

tosell foreign currency

unit of foreign currency

official exchange rate

exchange rate contents

domestic currency drops

foreign price relation