the international monetary system: order or disorder? 19

The International Monetary System: Order or Disorder?

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What Are Exchange Rates?

• Exchange rate • Price of a country’s currency in terms of another

country’s currency.

• Appreciate• A unit of a currency buys more units of foreign currency

• Depreciate• A unit of a currency buys fewer units of foreign currency

• Depreciation to one country must be an appreciation to the other.

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What Are Exchange Rates?

• An example:• 1 pound = $1.60 or 62.5 pence = $1• If pound appreciates: 1 pound = $2• Dollar depreciates: $1 = 50 pence

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Table 1 Exchange Rates with the U.S. Dollar

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Devaluation and Revaluation

• Decrease/increase in currency set by governments

• Devaluation• Reduction in the official value of a currency• A unit of a nation’s currency buys fewer units of foreign

currency

• Revaluation• Increase in the official value of a currency• A unit of a nation’s currency buys more units of foreign

currency

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Exchange Rate Determination: Free Market

• Floating exchange rates• Rates determined in free markets by the law of supply and

demand

• Equilibrium exchange rate occurs where the quantity demanded is equal to the quantity supplied

• If the market exchange rate increases in value - appreciation and if decreases in value - depreciation

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Determination of Exchange Rates in a Free Market

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Pric

e of

a E

uro

(in d

olla

rs)

Number of Euros

S

S

D

D

$1.50E

Supply of Euros represents demand for DollarsDemand for Euros represents supply of Dollars.

Exchange Rate Determination

• Demand for a country’s currency• International trade in goods and services• Purchases of physical assets• Trade in financial assets

• Supply of a country’s currency• Arises from its imports of goods and services• Foreign investment by its own citizens

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• What happens to the value of the Euro if• Europeans become concerned about the safety of US

assets• Supply less Euros since demand less dollars• Euro will appreciate

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Figure 2 The Effect of Declining Demand for U.S. Assets on the Exchange Rate

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Pric

e of

a E

uro

(in d

olla

rs)

Number of Euros

S1

S1

D

D

$1.50

E

$1.70

S2

S2

A


• Non clicker-clicker question. What happens to the value of the Euro if• American investors become worried about profit

prospects on German stock market

• A boom in France leads to more French purchases of American goods

• Interest rates on government bonds rise in the United States but are stable in Italy

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• In the short run, major determinants• Interest rates and interest rate differentials

• What happens when yields on American bonds increase relative to British bonds?• US bonds become more attractive to American

and British investors.

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The Effect of a Rise in U.S. Interest Rates

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Pric

e of

a P

ound

(in

dol

lars

)

Number of Pounds

S1

S1

D1

D1

$1.75

E1

$1.50

D2

D2

S2

S2

E2


• In general, • Countries that offer investors higher rates

of return attract more capital• A rise in interest rates is expected to lead

to an appreciation of the currency• A drop in interest rates is expected to lead

to an depreciation of the currency

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• Medium run (it takes time for changes in GDP to occur)• Want to consider affect on exchange rates of

rising or falling incomes

• What happens to the value of the Euro if US economy booms? • American have more income and the demand

for British imports increases.

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The Effect of an Economic Boom Abroad on the Exchange Rate

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Pric

e of

a E

uro

(in d

olla

rs)

Number of Euros

S

S

D1

D1

$1.50

E

$1.60

D2

D2

A

What if Europe is also booming?

The Effect of an Economic Boom Abroad on the Exchange Rate

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Pric

e of

a E

uro

(in d

olla

rs)

Number of Euros

S1

S1

D1

D1

$1.50

E

D2

D2

A

What if Europe is also booming?C

S2


• In general in the medium run• If a country grows faster than the rest of the

world• Imports – grow faster than exports• Demand curve for foreign currency shifts

outward more rapidly than the supply curve• Other things equal, currency depreciates

• But a booming economy attract will attract investors• So currency should appreciate

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• Which effect wins?• Trade in financial assets• Stronger economic performance often leads to

currency appreciation because it improves prospects for investing in the country.

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Exchange Rate DeterminationThe Long-Run: Purchasing-power parity theory of exchange rate determination

• The exchange rate between any two national currencies adjusts to reflect differences in the price levels in the two countries

• The Steel example – American Steel cost $300 per ton and German Steel cost 200 euros per ton. The exchange rate will be $300/200 = $1.50 per euro.

• What happens at $1.60?• What happens at $1.40?

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• Purchasing-power parity theory• Differences in domestic inflation rates are a

major cause of exchange rate movements• If one country has higher inflation than

another, its exchange rate should depreciate• Why?

• Doesn’t always hold in actuality.• This is “all other things constant” analysis.• There more to exchange rate movements that

trade in goods and services – primarily financial transactions.

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Market(floating) Exchange Rate Determination

• Three main points1. Currency appreciation in countries that offer

investors higher rates of return

2. But these countries will also be importing relatively more than other countries, which tends to pull their currencies down

3. Currency values generally will appreciate in countries with lower inflation rates than the rest of the world’s

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Fixed Rates: The Balance of Payments

• Fixed exchange rates• Rates set by government decisions and

maintained by government actions

• Balance of payments deficit• The amount by which the quantity supplied of a

country’s currency (per year) exceeds the quantity demanded

• Arises whenever the exchange rate is pegged at an artificially high level

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A Balance of Payments Deficit

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Pric

e of

a P

eso

(in d

olla

rs)

Billions of Pesos per Year

S

S

D

D

0.50

E

1.00

4 8

BA

Balance ofpayments deficit


• How does the government of Argentina maintain the peso at $1?• Must buy the 4 billion peso surplus• But, they need dollars to do that.

• Lose $4 billion in reserves

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• Balance of payments surplus• The amount by which the quantity

demanded of a country’s currency (per year) exceeds the quantity supplied

• Arises whenever the exchange rate is pegged at an artificially low level

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A Balance of Payments Surplus

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Pric

e of

a Y

uan

(in d

olla

rs)

Billions of Yuan per Year

S

S

D

D

0.16

E

$0.20

600 1,000

BA

Balance ofpayments surplus


• How does the Chinese government maintain the yuan at $0.16?• Must sell the 400 billion yuan surplus• Gain $64 billion in reserves

• What’s the difference between the yuan and peso example• The accumulation of reserves does not force a

central bank to revalue in the way that sufficiently large losses of reserves can force a devaluation.

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• Two main parts to the balance of payments• Current account balance

• International purchases and sales of goods and services• Cross-border interest and dividend payments• Cross-border gifts to and from private individuals and

governments• Approximately = Net exports• U.S. has large current account deficits: IM > X

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• Capital account balance• Purchases and sales of financial assets to and

from citizens and companies of other countries• U.S. has large capital account surplus

• Balance of payment = Current account + Capital account

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• Does the overall balance of payments balance?• Yes, if the exchange rate is floating

• All private transactions must add up to zero• Dollars purchased equals dollars sold

• Not necessarily if the exchange rate is fixed• Government purchases or sales of foreign

currency make up for the deficit or surplus

• STOP HERE!

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the international monetary system: order or disorder? 19

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