Exchange Rates, Capital Flows and the Balance of e Payments ‘A nation is mot in danger of financial disaster merely because tt owes money to itself Andrew Mellon om “2 After reading this chapter, you should be able to: . Define the nominal exchange rate; . Use supply and demand to analyse how the nominal exchange rate is determined in the short run; Distinguish between flexible exchange rates and fixed exchange rates, and discuss the advantages and disadvantages of each system; A. Define the real exchange rate and show it is related to the prices of goods across pairs of countries; . Discuss the strengths and weaknesses of monetary and fiscal policies under fixed and flexible exchange rates. eee ym re w Dealing with exchange rates and different currencies can be confusing, A New York couple approaching retirement decide to buy a dream holiday home in Europe. After extensive research on the internet they whittle the options down to two houses, one in the west of Ireland and one in the Scottish highlands. After visiting both properties they cannot decide which they prefer. ‘It’s easy’ said the wife, ‘let's choose the cheapest.’ Her husband agrees and checks the prices. The Irish property is on offer at 500,000 euros and the Scottish at 450,000 pounds. Finding the comparison difficult the husband says, ‘Which is the cheapest in real money?’ (by which he means the American dollar). ‘I haven't a clue,’ replies the wife, ‘but I have just read that since our trip the dollar has appreciated against the euro and the pound has depreciated against the dollar. What does that mean?’ To which her husband replies, ‘It means we are moving to Florida!’ Regardless of whether they are interested in a foreign property, negotiating a business deal or simply chilling out in another country, dealing with unfamiliar currencies is a problem every international traveller faces. These problems can be further complicated by the fact that exchange rates may change unpredictably. ‘Thus the number of Russian rubles, Japanese yen, Australian dollars or US dollars that one euro can buy may vary over time, sometimes quite a lot ‘The economic consequences of variable exchange rates are much broader than their impact on travel and tourism, For example, the competitiveness of European exports depends in part on the prices of European goods in termsen CChaptera9 Exchange Rates, Capital Flows and the Balance of Payments each other nominal exchange rate the rate, or price, at which two currencies can be traded for of foreign currencies, which in turn depend on the exchange rate between the euro and those currencies. Likewise, the prices Europeans pay for imported goods depend in part on the value of their currency relative to the currencies of the countries that produce those goods. Exchange rates also affect the value of financial investments made across national borders. For countries that are heavily dependent on trade and international capital lows — the majority of the world’s nations and certainly most European coun tries ~ fluctuations in the exchange rate may have a significant economic impact, "This chapter discusses exchange rates and the role they play in open economies. We will start by distinguishing between the nominal exchange rate ~ the rate at which one national currency trades for another ~ and the real exchange rate - the rate at which o-* country's goods trade for another's. We shall show how exchange rates affect the pric of exports and imports, and thus the pattern of trade Next we shall turn to the question of how exchange rates are determined, Exchan: rates may be divided into two broad categories, flexible and fixed. The value of a flext= exchange rate is determined freely in the market for national currencies, known as t {foreign exchange market, Flexible exchange rates vary continually with changes in ¢/ ‘supply of and demand for national currencies. In contrast, the value of a fixed exchany rate is set by the government at a constant level. ‘Although most large industrial countries have a flexible exchange rate, many sme. and developing economies fix their exchange rates, so we shall consider the case of fixe exchange rates as well. We shall explain first how a country’s government (usualy central bank) goes about maintaining a fixed exchange rate at the officially determin level. Though fixing the exchange rate generally reduces day-to-day fluctuations in the value of a nation’s currency, we shall see that, at times, a fixed exchange rate can becom= severely unstable, with potentially serious economic consequences. We shall also s that the choice of exchange rate regime has important implications for the effectiveness of monetary and fiscal policies as a means to close output gaps. EXCHANGE RATES ‘The economic benefits of trade between countries in goods, services and assets ar similar to the benefits of trade within a country. In both cases, trade in goods and servic.» permits greater specialisation and efficiency, whereas trade in assets allows financi:: investors to earn higher returns while providing funds for worthwhile capital projects However, there is a difference between the two cases, which is that trade in goods, services and assets within a country normally involves a single currency - euros, sterling, dollars yen or whatever the country's official form of money happens to be ~ whereas trac: hetween nations usually involves dealing in different currencies. So, for example, Dutch resident wants to purchase an automobile manufactured in South Korea, she (0 more likely, the automobile importe:) must first trade euros for the Korean currenc: called the won. The Korean car manufacturer is then paid in won. Similarly, a Britis pension fund wishing to purchase shares in an American company (a US dollar financis asset) must first trade sterling for dollars and then use the dollars to purchase the shares. ‘The price the Dutch importer or the British pension fund must pay for won or dollars is known as the exchange rate, When discussing exchange rates We must take care t distinguish between the nominal exchange rate and the real exchange rate. NOMINAL EXCHANGE RATES ‘The nominal exchange rate is simply the price of one currency ii terms of another currency, and is normally expressed as the amount of ‘foreign’ currency that can be bought with one unit of the ‘domestic’ currency.Table 29.1 Cotas | United States Idotlar} United Kingdom (pound) "Japan (yen! “Denmark (krone) = | Sweden {kronal | ty) Praia Exchange rates re TANG Nominal Exchange Rates for the Euro, 14 April 2011 Etre cu | (2) 1) roast osm | 0.9025 1.1331 | i988 0 ones 7.4506 | onda ia | onor | | 02529 | | For example, suppose we treat the euro as the domestic currency and sterling as the foreign currency. Then, if €1 can be exchanged for £0.80 the nominal exchange rate between the euro and pound is 0.80 pounds per euro. Alternatively, if we think of ster- ling as the domestic currency we could express the same nominal exchange rate as 1.25 euros per pound (1.25 = 1/0.8). Table 29.1 gives nominal exchange rates between the euro and six other cur -ncies, as published by the ECB on 14 April 2011. Table 29.1 shows that exchange rates can be expressed either as the amount of foreign currency needed to purchase one euro (column (1)) or as the number of euros needed to purchase one uait of the foreign currency (column (2)). These two ways of expressing the exchange rate are equivalent: each is the reciprocal of the other. For example, on 14 April 2011, the exchange rate between the euro and the dollar could have been expressed either as 1.4401 dollars per euro or as 0.6943 euros per dollar, where 0.6943 = 1/1.4401. Nomini ange rates Example 29.1 Based on Table 29.1, find the exchange rate between the British and American currencies. Express the exchange rate in both dollars per pound and pounds per dollar. From Table 29.1, we see that 0.8825 pounds will buy one euro, and that 1.4401 dollars will also buy one euro. Therefore 0.8825 pounds and 1.4401 dollars were equal in value on 14 April 2011. Thatis: £0.8825 = $1.4401 Dividing both sides of this equa- tion by 0.8825 we get £1 = $1.6318 In other words, the British ‘American exchange rate can be expressed as 1.6318 dollars per pound, Alternatively, dividing by 1.4401 gives $1 = £0.6128 ‘That is, one dollar buys 0.6128 pounds. Figure 29.1 shows the nominal exchange rates for the euro against a =~ USD/EURO ter —— GBP/EURO 18 oy ° g 78 Bia é 1 08 : +05 09 vd tte FESH FLESH SHS Figure 29.1. Euro Nominal Exchange Rates US dollars (left axis) and British pounds (right axis] per euro, January 1999 to December 2010.Chapter 29 Exchange Rates, Capital Flows and the Balance of Payments the US dollar and the British pound from the euro’s launch in 1999 to the end of 2010. The exchange rate is measured as the number of dollars or pounds per euro. You can see from Figure 29.1 that the euro’s value fluctuated over these eleven years. Starting from a value of approximately 1.16 dollars per euro in January 1999, the exchange rate fell con- sistently, reaching a low of just over 0.80 dollars per euro in early 2002 and then increased steadily to over 1.50 dollars per euro by mic-2008, Note that with the onset of recession in 2008 the pound depreciated against the euro. (If you are interested in more recent changes, ‘use an online source such as ECB, at www.ecb. nt, or Pacific Exchange Rate Service, at | http://fix.sauder.ube.ca, to check movements in exchange rates.) | ‘An increase in the value of a currency relative to other currencies eee Siaency relive | iS Known as appreciation; a decline in the value of a currency ° | relative to other currencies is called depreciation. As can be seen | | appreciation an inzeae in | | to other currencies from Figure 29.1, the euro clepreciated against the dollar in 1999 and 2001, and appreciated 2002 between 2002 and the start of the recession in 2008, We shall discuss the reasons a currency may appreciate or depreciate later in this chapter. Geprecistion a decrease in the value of a currency relative to other currencies FLEXIBLE VERSUS FIXED EXCHANGE RATES 'As we saw in Figure 29.1, the exchange rate is not constant but varies continually. Indeed, changes in the exchange rates between currencies occur daily, hourly and even ‘minute by minute. Such fluctuations in the value of a currency are normal for countries ‘such as the United Kingdom, the United States and the Eurosystem, ~~ —]_ which have a flexible or floating exchange rate. When exchange | Aeible(Roating) exchange rates are flexible, the value of a currency varies according to the fate an exchange rare whose supply of and demand for the currency in the foreign exchange pee nocoffcally xed but | jyarket = the market on which currencies of various nations are et meee traded for one another. We shall discuss the factors that determine of and demand for the | the supply of and demand for currencies shortly. | Some countries do not allow their currency values to vary with | market conditions but instead maintain a fixed exchange rate. The foreign exchange market the | yalue of a fixed exchange rate is set by official government policy. < ‘A government that establishes a fixed exchange rate typically | various nations are traded for i determines the exchange rate’s value independently, but sometimes | | currency in the foreign | | | one another | t | exchange rates are set according to an agreement among a number i 4 exchange market the foreign exchange mark of governments. Between the end of the Second World War and the early 1970s most of the world’s currencies operated within the Bretton Woods exchange rate system, which required a fixed value against the US dollar. From 1979 to 1999 countries in the European Union attempted to fix the value of their currencies against a composite or ‘basket’ currency known as the European Currency Unit, or ECU. In the next part of the chapter we shall focus on flexible exchange rates, but shall return later to the case of fixed rates, We shall also discuss the costs and benefits of each type of fixed exchange rate an exchange rate whose value is set by official government policy usge vate the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are ‘expressed in terms of a ‘common currency exchange rate. REAL EXCHANGE RATES ‘As explained in Example 29.2, the real exchange rate measures the price of a domestic ‘good or service relative to the price of an equivalent foreign good or service, Example 29.2 The real exchange rate Suppose an Irish-made computer costs €1,500 and an equivalent British-made computer costs £1,000. Which computer is the cheapest?Exchange ates a As the computers are priced in different currencies we cannot make a direct com- parison to decide which is the cheapest, To convert the prices to the same currency we can use the nominal exchange rate, Por example, if Ireland is the domestic country and €1 currently buys £0.8 then the price of the British computer is 1,000/0.8= €1,250 and the real exchange rate is just the price of the Irish computer relative to the price of the British computer when both prices are measured in euros, ‘That is, 1,500/1,200 = 1. indicating that the Irish computer is 20 per cent more expensive. Alternatively, we cout convert the Irish price into sterling and compare it to the British price. At a nominal exchange rate of 0.8 pounds per euro, €1,500 is equivalent to £1,200 (1,500 X 0.8) and the real exchange rate is 1,200/1,000 = 1.20 as before. More generally if we denote the nominal exchange rate as ¢ (pounds per euro), the domestic price level as P (in euros) and the foreign price as P! (in pounds) then, as shown in Example 29.2, the real exchange rate can be expressed as: meer (29.1) The real exchange rate has important implications for a country’s competitiveness. In Example 29.2 the Irish-made computer is 20 per cent dearer than the British computer, putting Irish manufacturers at a competitive disadvantage on export markets. Likewise, the higher the real exchange rate the greater the incentive for Irish firms and households to import computers from the UK. Conversely, if the real exchange rate is ]ow, then the home country will find it easier to export while domestic residents will buy fewer imports, Hence, other things being equal, we would expect net exports to be lower when the real exchange rate is relatively high but to increase as the real exchange rate falls. ‘A decrease in the real exchange rate is known as a real depreciation of the domestic currency. Asa lower real exchange rate makes domestic goods more competitive relative to foreign goods, a real depreciation will, other things being equal, lead to an increase in net exports. Conversely, an increase in the real exchange rate is known as a real appre- ciation of the domestic currency, As a higher real exchange rate makes domestic goods less competitive relative to foreign goods, a real appreciation will, other things being equal, lead to a decline in net exports. In 1999 the average sterling-euro exchange rate was €1 = £0.6587 and in 2007 the | Exercise 2 average rate was €1 = £0.6843, Based on 2005 = 100 the Harmonised Consumer Price Index (HCPI) for the Eurosystem was 87.85 in 1999’ and 104.4 in 2007. The ‘equivalent UK price index rose from 92.3 to 104.7 over the same period, Has the euro experienced a veal depreciation or a real appreciation against sterling over this period? a] ene Eee) ‘ Ehren eer aire Cre et ecu Rc cdg One of the oldest, and simplest, theories of how nominal [ exchange rates are determined is called partatsing power parity, | I or PPP, which can be derived from a market equilibrium | economic concept, called the law of one price, The law of one | Wlatvely small the price of price states that if transportation costs are relatively smal, the | Shinrernationaly tated price of an internationally traded good must be the same in all (|S 4 locations. For example, consider a generic product called a | © ne price if transportation costs arean Chapter29 Exchange Rates, Capital Flows and the Balance of Payments © swiager’. Ignoring transportation costs, the price of a widget ought to be the same in say New York, London and Berlin. Suppose that were not the case - that the price of a widget in New York was only half the price in London, In that case, widget traders would have a strong incentive to buy widge:s in New York and ship them to London, where they could be sold at double the price of purchase. As widgets left New York, reducing the local supply, the ptice would rise, while the increased sup into London would reduce the local price and, according to the Equilibrium Principle, the interns tional market for widgets would return to equilibrium only when unexploited opportunities 0 profit by trade had been eliminated~specifically, only when the prices of widgets in New York at London became equal Let's look ata specific example, Suppose that a widget costs $10 in New York and £6.25 in Londo: If PPP holds for widgets, what is the nominal exchange rate between dollar and the pound? Becau~: the market value of a widget must be the same in both locations, we know that the London pri must equal the New York price, so that £6.25 = $10 or dividing by 6.25 £1 = $1.6. Hence the nomir. exchange rate between the pound and the dollar should be 1.6 dollars per pound or letting ster be the domestic currency and using equation 29.1: = PP = 10/6.25 ‘Note that PPP implies that the price of a widget must be the same when measured in the sam: currency so that the real exchange rate is constant. That is, P/ = eP. One popular application of PPP is the Big Mac Index which has been published by the Econom: magazine since 1986. ‘The Big Mac Index simply compares the prices of a McDonalds Big Mac = different countries and asks if the implied PPP exchange rate differs from the actual exchange ra between the two countries. Table 29.2 gives some of the results from the 2010 Big Mac Indes. Note that the implied PPP nominal exchange rate is the ratio of the local currency price to the doll » price 3.73, or P/IP. ‘The final column of Table 29.2 tells us by how much each custency is undervalued or overvalue against the dollar. For example, the nominal exchange rate needed to make the Canadian doll price équal to the US dollar price is C$1.12 = $1, or 4.17/3.73. However, as the actual exchange rate is C$1.04 = $1 the Canadian dollar is overvalued by 7 per cent. That is, the exchange rate wou have to increase by 7 per cent to equalise the prices. Note that, as we are measuring the exchang~ rate as the number of Canadian dollars per US dollar, an increase implies a fall in the value of the Canadian dollar. Table 29.2 The Big Mac index July 2010 aa OUR eA es Exchangs..| Exchange. od (ie eed ese iy Pate nore eer a 1. Local currency price divided by the actual exchange rate, 2. Local currency price divided by the US price, $3.73,Determination ofthe nominal exchange ate L Exchange rates m The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. More precisely, the nominal exchange rate e for any given country is the number of units of foreign currency that can be bought for one unit of the domestic currency. An appreciation is an increase in the value of a currency relative to other currencies (a rise in 0); a depreciation is a decline in a currency's value (a fall in ¢). ws Anexchange rate can be either flexible meaning that it varies freely according to supply of and demand for the currency in the foreign exchange market ~ ot fixed, meaning that its value is established by official government policy. & The real exchange rateis the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency, A useful formula for the real exchange rate is eP/Pf, where ¢ is the nominal exchange rate, Pis the domestic price level, and Pf is the foreign price level. «An increase in the real exchange rate implies that domestic goods are becoming more expensive relative to foreign goods, which tends to reduce exports and stimulate imports. Conversely, ald a decline in the real exchange rate tends to increase net exports. DETERMINATION OF THE NOMINAL EXCHANGE RATE Countries that have flexible exchange rates, such as the United Kingdom, the United States and those that use the euro as their common currency, see the international values of their currencies change continually. What determines the value of the nominal exchange rate at any point in time? In this section, we shall try to answer this basic economic question. Again, our focus for the moment is on flexible exchange rates, whose values are determined by the foreign exchange market. Later in the chapter, we shall discuss the case of fixed exchange rates. DETERMINATION OF THE EXCHANGE RATE: 4 SUPPLY AND DEMAND ANALYSIS In this section, we shall analyse the behaviour of nominal exchange sates by using a simple demand and supply model. However, in this case the market is the foreign exchange market, which, as we have seen, is a market on which different currencies (euros, dollars, sterling, yen, etc.) are traded for one another and the price is the nominal: exchange rate or the value of one currency in terms of another. To focus our attention on Europe we shall concentrate on the market for euros. For convenience we shall use the terms ‘Eurosystem’ and ‘Europe’ as meaning the same thing, even though many European countries do not use the euro as their currency. This is a simplifying assump- tion that enables us to focus on the fundamentals of the foreign exchange market. As we shall see, euros are demanded in the foreign exchange market by foreigners who seek to purchase European goods and assets, and are supplied by European residents who need foreign currencies to buy foreign goods and assets. The equilibrium exchange rate is the value of the euro that equates the number of euros supplied and demanded in the foreign exchange market. Our aim is to analyse the supply of and demand for euros, and thus the euro exchange rate. The supply of euros ‘Anyone who holds euros ~ from an international bank to a Russian citizen whose euros are buried in the back garden ~ is a potential supplier of euros to the foreign exchangeChapter 29 Exchange Rates, Capital Flows and the Balance of Payments market. In practice, however, the principal suppliers of euros to the foreign exchange market are Furopean households and firms. Why would a European household or firm ‘want to supply euros in exchange for foreign currency? There are two major reasons. First, a Buropean household of firm may need foreign currency to purchase foreign goods or services. For example, a Dutch auto- mobile importer may need yen to purchase Japanese cars, or an Italian tourist may need dollars to make purchases in New York. In each case the European household or firm must supply euros to buy the foreign Supply of euros Demand for euros Exchange rate: dollars per euro Quantity of euros traded Figure 29.2. The Supply and Demand for Euros inthe currency. Second, a European household or Dollar-Eure Market firm may need foreign currency to purchase The supply of euros is upward-sloping because an foreign assets. For example, an Irish pension increase in the number of doltars offered for each euro fund may wish to acquire shares issued by makes US goods, services and assets more attractive to American companies. Because American European buyers. Similarly, the demand for euros is assets are normally priced in dollars, the downward-sloping because holders of dollars will be Dee aes eae {ess willing to buy euros the more expensive they are in pension fund will need to trade euros for terms of dollars. The equilibrium rate e*, also called the dollars to acquire these assets. fundamental value of the exchange rate, equates the The supply of euros to the foreign quantities of euros supplied and demanded. exchange market is illustrated in Figure 29.2, ‘We shall focus on the market in which euros are traded for US dollars, but bear in mind that similar markets exist for every other pair of traded currencies. The vertical axis of Figure 29.2 shows the dollar-euro exchange rate as measured by the mumber of dollars that can be purchased with each euro. The horizontal axis shows the number of euros being traded in the market. Note that the supply curve for euros is upward-sloping. In other words, the more dollars each euro can buy, the more euros people are willing to supply to the foreign exchange market. Why? At given prices for American goods, services and assets, the more dollars a euro can buy, the cheaper those goods, services and assets will be in euro terms. For example, if a computer game costs $55 in the United States, and a euro can buy $1.00, the euro price of the computer game will be €55. However, if a euro can buy $1.10, then the euro price of the same computer game will be €50 (or $55/$1.10). Assuming that lower euro prices will induce Buropeans to increase their expenditures on American goods, services and assets, a higher dollar-euro exchange rate will increase the supply of euros to the foreign exchange market, ‘Thus the supply curve for euros is upward-sloping. The demand for euros In the dollar-euro foreign exchange market, demanders of euros are those who wish to acquire euros in exchange for dollars. Most demanders of eurosin the dollar-euro market are American households and firms, although anyone who happens to hold dollars is free to trade them for euros, Why demand euros? The reasons for acquiring euros are analogous to those for acquiring dollars. First, households and firms that hold dollars will demand euros so that they can purchase European goods and services. For example, an American importer who wants to purchase French wine needs euros to pay the French exporter, and an American student studying in a European university must pay tuition fees in euros. The importer or the student can acquire the necessary euros only by offering dollars in exchange. Second, households and firms demand euros in order to purchase European assets. The purchase of a French factory by an American company, and the acquisition of German bonds by an American bank are two examples,‘The demand for curos is represented by the downward-sloping curve in Figure 29.2. ‘The curve slopes downwards because the more dollars an American citizen must pay to acquire a euro, the less attractive Buropean goods, services and assets will be. Hence the demand for euros will be low when enros are expensive in terms of dollars and high when euros are cheap in terms of dollars The equilibrium value of the euro As mentioned earlier, the Eurosystem maintains a flexible, or floating, exchange rate, which means that the value of the dollar-curo exchange rate is determined by the forces of supply and demand in the foreign exchange market. In ~~~ Figure 29.2 the ‘equilibrium value of the euro is e*, the dollar-euro fundamental value of the exchange rate at which the quantity of euros supplied equals | exchange tate (or equilibrium the quantity of euros demanded. The equilibrium value of the exchange rate) the exchange exchange rate is also called the fundamental value of the exchange rate, In general, the equilibrium value of the euro is not constant of the currency foreign exchange market. Changes in the supply of euros Recall that people supply euros to the dollar-euro foreign exchange market in order to purchase American goods, services and assets, Factors that affect the desire of European households and firms to acquire American goods, services and assets will therefore affect the supply of euros to the foreign exchange market. Some factors that will increase the supply of euros, shifting the supply curve for euros to the tight, include the following: = Anincreased preference for American goods. For example, suppose that Californian wine becomes more popular in Europe, To acquire the dollars needed to buy more Californian wine, European wine importers will increase their supply of euros to the foreign exchange market. ® An increase in European real GDP. An increase in European real GDP will raise the incomes of Europeans, allowing them to consume more goods and services (cecall the consumption function, introduced in Chapter 22). Some part of this increase in consumption will take the form of goods imported from the United States. To buy more American goods, Europeans will supply more euros to acquire the necessary dollars. ® An increase in the interest rate on American assets. Recall that European households and firms acquire dollars in order to purchase American assets as well as goods and services, Other factors, such as risk, held constant, the higher the interest rate paid by American assets, the more American assets Europeans will choose to hold. To purchase additional American assets, Buropean households and firms will supply more euros to the foreign exchange market, Conversely, reduced demand for American goods, a lower European GDP or a lower interest rate on American assets will reduce the number of dollars Europeans need, in turn reducing their supply of euros to the foreign exchange market and shifting the supply curve for euros to the left. Of course, any shift in the supply curve for euros will affect the equilibrium exchange rate, as Bxample 29.3 shows Computer games, the euro and the dollar Suppose American firms come to dominate the computer game market, with games that are more exciting and realistic than those produced in Europe. All else being equal, how will this change affect the relative value of the euro and the dollar? rate that equates the quantities but changes with shifts in the supply of and demand foreuros in the _ | ae supplied and Example 29.3Chapter 29 Exchange Rates, Capital Plows and the Balance of Payments Increased quality of American products increases the supply fof euros as Europeans buy them Supply Supply’ Exchange rate: dollars per euro Quantity of euros traded Figure 29.9 An Increase in the Supply of Euros Lowers the Value of the Euro To buy more American computer games Europeans must supply more euros to the forsign exchange market to acquire the dollars they need to buy the games. The supply curve for euros shifts from S to S’, lowering the ‘equilibrium value of the eure from e* to e* Exercise 29.2 Example 29.4 ‘The increased quality of American com puter games will increase the demand for the games in Europe, To acquire the dollars necessary to buy more American computer games, Furopean importers will supply more curos to the foreign exchange market. As igure 29.3 shows, the increased supply of curos shifts the supply curve to the right and reduces the equilibrium value of the euro: in other words, the euro will depreciate against the dollar. At the same time, the value of the dollar will appreciate against the euro: @ given number of dollars will buy more euros than it did before. Changes euros ‘The factors that can cause a change in the demand for euros in the foreign exchange market, and thus a shift of the euro demand curve, are analogous to the factors that affect the supply of euros. Factors that will increase the demand for euros include the following: An increased preference for European goods. For example, airlines in the United States might find that planes built by the French company Airbus are superior to others such as the US-built Boeing, and decide to expand the number of Airbus planes in their fleets. To buy the European planes, US airlines would demand more euros on : the foreign exchange market. = An increase in real GDP abroad, which implies higher incomes abroad, and thus more demand for imports from Europe. 5 An increase in the interest rate on European assets, which would make those assets more attractive to foreign savers. To acquire additional European assets, foreign savers would demand more euros. “The United States goes into a recession, and real GDP falls, All else being equal, how is this economic weakness likely to affect the value of the euro? Monetary policy and the exchange rate Suppose that the European Central Bank decides to increase euro interest rates. How might this decision affect the euro’s equilibrium exchange rate? The effects of this policy change on the value of the euro are shown in Figure 29.4. Before the policy change, the equilibrium value of the exchange rate is e*, at the inter section of supply curve $ and demand curve D. Higher euro interest rates make euro: denominated assets more attractive to foreign financial investors. The increased willingness of foreign investors to buy European assets increases the demand for euros, shifting the demand curve rightwards from D to D’ and the equilibrium point from E to F. As a result of this increase in demand, the equilibrium value of the euro rises from e* to e*". In short, a tightening of monetary policy by the ECB raises the demand for euros, causing the euro to appreciate. By similar logic, an easing of monetary policy, which reduces the real interest rate, would weaken the demand for the euro, causing it to depreciate.Pixed exchange rates Pe Figure 29.4 A Tighter Monetary Poticy Strengthens the Euro Tighter monetary policy in Europe raises euro interest rates, increasing the demand for euro assets by foreign savers. An increased demand for European assets increases the demand for euros. The demand Demand’ curve for euros shifts from D to D’, increasing the equilibrium vatue of the euro from e* to ev. Tighter European monetary policy raises interest rates in Europe so increasing the demand for euros as Americans increase savings in Europe aa ‘Suppose the US Federal Reserve cuts dollar interest rates. What is the likely effect on | Exercise 29 the dollar-euro exchange rate? | Determining the excha Supply and demand analysis is a useful tool for studying the short-run determination of the exchange rate. European households and firms supply euros to the foreign exchange market to acquire foreign currencies, which they need to purchase foreign goods, services and assets. Foreigners demand euros in the foreign exchange market to purchase European goods, services and assets. The equilibrium exchange rate, also called the fundamental value of the exchange rate, ‘equates the quantities of euros supplied and demanded in the foreign exchange market. i An increased preference for foreign goods, an increase in European real GDP or an increase in the interest rate on foreign assets will increase the supply of euros on the foreign exchange market, lowering the value of the euro. An increased preference for European goods by foreigners, an increase in real GDP abroad or an increase in the interest rate on European assets will increase the demand for euros, raising the value of the euro. itor FIXED EXCHANGE RATES So far, we have focused on the case of flexible exchange rates, the relevant case for most large industrial countries such as the United Kingdom, the United States and the Eurosystem. However, the alternative approach, fixing the exchange rate, has been quite important histori- cally, Prior to the introduction of the euro in 1999 most European countries had a strong preference for fixed exchange rates between their currencies. One reason is that exchange rate flexibility and volatility is often seen asa threat to trade between European countries and the continuing process of economic integration. In this section we shall see how our conclusions change when the nominal exchange rate is fixed rather than flexible. HOW TO FIX AN EXCHANGE RATE In contrast to a flexible exchange rate, whose value is determined solely by supply and demand in the foreign exchange market, the value of a fixed exchange rate isChapter 29. Exchange Rates, Capital Flows and the Balance of Payments determined by the government (in practice, usually the finance ministry with the cooperation of the central bank). Today, the value of a fixed exchange rate is usually set in terms of a major currency (for instance, several countries in Central and Eastern Europe (CEE) link their currency to the euro and China pegs its currency to the US dollar), or relative to a ‘basket’ of currencies, typically those of the country’s trading partners. Historically, currency values were often fixed in terms of gold or other precious metals, but in recent years precious metals have rarely if ever been used for that purpose. Once an exchange rate has been fixed, the government usually attempts to keep it unchanged for some time. However, sometimes economic circumstances force the government to change the value of the exchange rate, A reduction in the official value of a currency is called a devaluation; an increase in the official value is called a revaluation. “The devaluation of a fixed exchange rate is analogous to the depreciation of a flexible exchange rate; both involve a reduction in the currency's value. Conversely, a revaluation is analogouss to an appreciation. ‘When the officially fixed value of an exchange rate is greater than its ‘an exchange rate that has an offically fixed value less than fundamental value, the exchange rate is said to be overvalued, The its fundamental value official value of an exchange rate can also be lower than its fundamental value, in which case the exchange rate is said to be undervalued. Example 29.5 An overvalued exchange rate — devaluation a reduction in the official value of a currency (in a fixed exchange rate system) revaluation an increase in the official value of a currency (in a fixed exchange rate system) oveevaluued exchange rate an exchange rate that has an offically fixed value greater than its fundamental value undervalued exchange rate Suppose the Bank of England decides to fix the value of sterling against the euro, Assuming that the official exchange rate is greater than the fundamental rate, explain what actions the Bank must take to main- tain the official exchange rate. Figure 29.5 uses the demand and supply model to illustrate how exchange rates are fixed and the problems associated with maintaining an official exchange rate at a level different from its fundamental value In Figure 29.5 the exchange rate is —~ ‘Quantity of measured as euros per pound. The foreign Excess supply of euros sterting exchange market is in equilibrium at point E peehaeinps | and the equilibrium exchange rate is e*. exchange cate ay Suppose the Bank of England decides to fix the exchange rate at ¢,. As the official value Figure 29.5 An Overvalued Exchi Rate is greater than the fundamental value, the Market equilibrium is at E and the intial value of the currency is overvalued. The problem this fundamental exchange rate is e*. Fixing the exchange creates is that the currency will be over- rate at e, creates an excess supply equal to AB per supplied. At the exchange rate e, demand is period. To maintain the official value, the central bank ‘ > must use its foreign exchange reserves to continuously % Point A and supply at point B, implying purchase A@ of its own currency in each period. excess supply equal to the quantity AB. If the Bank does not interfere, the excess supply will force the exchange rate (price) down and the market will clear at point E. Hence, to keep the PR exaeenererey exchange rate at its official value ¢, the Bank must continuously foreign corrency asels held BY | purchase sterling equal to the quantity AB per period. To purchase a central bank forthe purpose | i+ own currency the Bank must hold foreign curtency assets called of purchasing the domestic currency in the foreign foreign exchange reserves. exchange market For example, the Bank of England may hold euro deposits in German banks or German government debt, which it can sell forFined exchange rates ee euros to buy sterling in the foreign exchange market as needed. Because a country with an overvalued exchange rate must use part of its reserves to support the value of its currency in each period, over time its available reserves will decline. However, as we shall see in the next section, this is not a sustainable strategy for the central bank. SPECULATIVE ATTACKS ‘Attempts to maintain an overvalued exchange rate can be ended quickly and unexpectedly by the onset of a speculative attack ‘A speculative atvack involves massive selling of domestic currency assets by both domestic and foreign financial investors. For example, in a speculative attack on sterling, financial investors would attempt to get rid of any financial assets ~ stocks, bonds and deposits in banks ~ denominated in sterling. A speculative attack is most likely to occur when financial investors fear that an overvalued currency will soon be devalued since, in a devaluation, financial assets denominated in the domestic currency suddenly become worth much less in terms of other currencies. Ironically, speculative attacks, which are usually prompted by fear of devaluation, may turn out to be the cause of devaluation. Thus a speculative attack may actually be a self-fulfilling prophecy. ‘The effects of a speculative attack are shown in Figure 29.6, which continues the story told in Figure 29.5. The supply and demand for sterling are indicated by the curves marked 5 and D, implying a fundamental value of sterling of e* euros per pound. As before, the official value of sterling is ¢, ~ greater than the fundamental value ~ so sterling is overvalued. To maintain the official rate at ¢,, the Bank of England must use its foreign exchange reserves 0 continually buy back sterling, in the amount corresponding to the line seg- ment AB in Figure 29.6. Unfortunately, the Bank of England’s | stock of foreign exchange reserves is finite, As reserves continue to fall financial markets will realise that the Bank cannot continue to buy its own currency indefinitely and will start to anticipate a sterling devaluation, which reduces the excess supply and moves ¢ closer to e*. When this expec- tation takes hold, financial investors will sell sterling in the belief that it can be bought back at a lower price once the devaluation happens. For example, suppose that in Figure 29.6, ¢, = €1.60 and e* = €1.50. Hence, if sterling were to be devalued from its official value of £1 = €1.60 toits fundamental value of £1=€1.50, then a £l million sterling speculative attack a massive selling of domestic currency assets by financial investors Excess supply in normal times Speculative attack Quantity of Excess supply during sterling a speculative attack Figure 29.6 A Speculative Attack Initially, sterling is overvalued at e, euros per pound. To maintain this official exchange rate the Bank of England must buy sterling in the amount AB per period. Fearing devaluation, financial investors launch 8 speculative attack selling investment, worth €1.6 million at the official exchange rate, would suddenly be worth only €1.5 million. To try to avoid these losses, financial investors will sell their sterling-denominated assets and offer the sterling proceeds on the foreign exchange market to sterling-denominated assets, and supply additional sterling to the foreign exchange market. As a result, the supply curve for sterling shifts from S to S’, towering the fundamental value further an¢ farcing the central bank to buy sterling in the ammount AC to maintain the official exchange rate at e, This more rapid loss of reserves may lead the central bank to devalue sterling.rau CChapter29 Exchange Rates, Capital Flows and the Balance of Payments buy assets denominated in other currencies, ‘The resulting flood of sterling into the market will shift the supply cutve of sterling (o the right, from $ to S” in Figure 29.6. Effectively, speculators are being offered a one way bet. If sterling is devalued, they gain by repurchasing sterling assets at the lower exchange rate. If sterling is not devalued, the value of assets in their portfolios will not change. For example, if a speculator sells assets worth £1 million, or €1.60 million, at the official exchange rate they can repwuchase these assets for C150 million if the exchange rate is devalued to £1 = €1.50. ‘Alternatively, if the devaluation does not happen, the value of the speculators’ invest- ment remains constant at €1,60 or £1 million. “This speculative attack creates a serious problem for the British authorities. Prior to the attack, maintaining the value of sterling required the central bank to spend each riod an amount of international reserves corresponding to the line segment AB. Now suddenly the central bank must spend a larger quantity of reserves, equal to the dis- tance AC in Figure 29.6, to maintain the fixed exchange rate. These extra reserves are needed to purchase the sterling being sold by panicky financial investors. In practice, such speculative attacks often force devaluation by reducing the central bank's reserves to the point where further defence of the fixed exchange rate is considered hopeless. Thus, a speculative attack ignited by fears of devaluation may actually end up produc- ing the very devaluation that was feared. EXCHANGE RATE SYSTEMS Historically, relatively small countries have independently fixed the values of their currencies against the currency of a major trading partner. Argentina and Hong Kong have pegged against the US dollar, while CEE transition economies have attempted to maintain stable currency values against the German mark and now the euro. Likewise, between the foundation of the State in 1922 and 1979 the Irish authorities maintained a fixed one-to-one exchange rate between the Irish pound and sterling. In these cases the responsibility for maintaining the fixed exchange rate normally rests with the smaller . country, and the fixed exchange rate policy is rarely the result of 2 cooperative agreement between the two countries concerned. To protect international trade and promote economic integration, countries in Western Europe have also favoured fixed exchange rates between their currencies, However, rather than follow independent exchange rate policies European countries attempted to maintain stable currency values by collectively agreeing to operate a fixed exchange system. The most successfu and long-lived attempt by European countties to achieve stable exchange rates wes known as the European Monetary System (EMS), which lasted from 1979 until the introduction of the euro in 1999. Economic Naturalist 29.2 Witt On 1 January 1999 eleven member states of the Buropean Union, Austria, Belgium, Germany, Ireland, fly, Luxembourg, the Netherlands, Portugal and Spaia gave up currencies and adopted a new common currency called the curo. These countries were subsequently, joined by Greece (2001), Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009) and Estonia (2011) to form the euro arca representing more than 330 million EU citizens. Other countries will join once they satisfy the conditions for adopting the single currency but the United Kingdom ‘continues to ‘opt-out’ and retain its own currency, the pound sterling. Why have seventeen countries decided to use the euro as their currency and why has the United Kingdom stayed out? Political considerations apart, the answer must be that the participating countries consider that the benefits 6 Finland, France, exceed the costs while the reverse is true for non-participations.Exchange rates and stabilisation policy ® ‘phe most important benefits are the elimination of currency tracactions cont ce exchange rate volatility which are believed to be detrimental 7 tokens ee es en pie i eae ining the si srency is the complete sactifice of monetary policy as ssational central hank to the Frankfurt based Buropean Central Hank (ECB) which sets a 1 Tac the entire euro area, the so-call ‘one-size monetary policy’. The key question is does the one < monetary policy ft all participants? ‘Thhe answer is most likely to be yes, if partner pane tend experience recessionary and expansionary gaps at the same time: If, for example, all countries ercing inflationary pressures, then an ECB decision to raise interest rates will be to the bene of all, However, if some economies are in recession while others are expanding, an interest rate orld not suit the former while an interest rate cut would only increase inflationary pressures it * reer If this is the case, then the cost of sacrificing policy independence may be high enoug “ Gutweigh the benefits from the common currency. Put another way, the cost of sacrificing po independence are likely to be lowest when national business cycles are closely synchronised partner countries face similar problems, and require similar policies, at the same time. When * is the case, the benefits may exceed the costs, and countries are said to form an optimum currency ‘area. One reason Why the United Kingdom has retained policy independence is that success: governments have taken the view that the UK business cycle is not sufficiently synchronised with th euro area business cycle to ensure that the costs of joining would be low and that members would guarantee a net benefit: EXCHANGE RATES AND STABILISATION POLICY “The choice between fixed and flexible exchange rates has important implications for stabilisation policy. In this section we shall see that monetary policy is most effective when exchange rates are flexible and least effective when they are fixed. Conversely, we shall see thet fiscal policy is least effective when exchange rates are flexible and most effective when they are fixed, In Chapters 25 and 26 we used the IS-LM model to analyse how fiscal and monetary policies can be used to close output gaps. However, in these chapters we assumed that the economy was ‘closed’, and ignored international rade and capital flows. To incorporate these factors into the model, we will first modify the IS and LM curves to account for exchange rate changes and capital movements and then introduce a new curve called the balance of payments, or BP, curve to control for ‘equilibrium in the foreign sector. THE 1S CURVE IN AN OPEN ECONOMY In Chapter 24 we defined the IS curve as a combinations of interest rate and output combinations at which the market for goods and services is in equilibrium. We also saw that changes in autonomous expenditures such as a change in net exports will cause the IS curve to shift. In this chapter we have introduced the real exchange rate and shown that a fallin the real exchange rate, a real depreciation, will increase net exports. Conversely, a rise in the real exchange rate, a real appreciation, leads to a fall in net exports. Hence, a fall in the real exchange rate leads to higher net exports (an increase in autonomous expenditure) and shifts the IS curve to the right (see Figure 23.2). Likewise, an increase in the real exchange rate leads to lower net exports (a decrease in autonomous expendi- ture) and shifis the 1S curve to the left. Note that we have defined the real exchange rate as eP/P%, where ¢ is the nominal exchange rate and P and P! are the domestic and foreign price levels. To simplify things, we shall assume, for the moment, that prices do not change in the short run and that changes in the nominal exchange rate are reflected by changes in the real exchange rate. Hence, 2 fallin the nominal exchange rate increases,| sz Chapter 29 Exchange Rates, Capital Flows and the Balance of Payments, Example 29.6 net exports and shifts the IS to the right, whereas an increase in the nominal exchange rate shifts the IS curve to the left. THE LM CURVE IN AN OPEN ECONOMY In Chapter 24 we defined the LM curve as combinations of interest rate and output combinations at which the market for money is in equilibrium. We also assumed that the money supply was exogenous and controlled by the central bank via open-market operations. We shall now see that opening the economy to international trade and capital movements has important implications for this assumption. To see why, we will construct simplified balance sheets for the commercial banks and the central bank. To simplify things we make the following assumptions: ® Commercial banks hold two assets ~ loans to the public and government (L) and reserves (RES) ~ and one liability, deposits held by the public (DEP). Commercial banks hold their reserves as deposits with the central bank. ‘The economy’s stock of foreign exchange reserves (FXR) are held by the central bank, ‘The central bank holds two assets: FXR and a portfolio of government bonds (B), ‘The central bank's liabilities are commercial bank reserves, RES, and currency in circulation with the public (CUR). ‘The money supply (MS) is the sum of commercial bank deposit liabilities, DEP, and currency in circulation with the public, CUR. aun # Putting these assumptions together, we can write the commercial and central bank bal- ance sheet identities as: Commercial banks: DEP= + RES Central bank: RES+CUR=B+FXR From the central bank balance sheet RES = B+ FXR « CUR and substituting for reserves in the commercial bank balance sheet gives: DEP=L+B+FXR+CUR ‘As the money supply is defined as MS= DEP + CUR we cari rewrite this expression as: MS=L+B+FXR Hence, the money supply is defined as being equal to the sum of commercial bank loans and the central bank's holding of government bonds plus the stock of foreign exchange reserves. As L (commercial bank lending to the public and government) and B (central bank lending to government) account for total bank lending to the public and government it is sometimes referred to as domestic credit, denoted DCR. Hence the money supply identity can be written as: MS=DCR+ FXR (29.2) Example 29.6 explains these linkages. The money supply in an open economy Suppose a German wine importer signs a contract ro import wine from California at a cost of $1.5 million. If the nominal exchange rate is €1 = $1.50 how does this trans- action affect the Burosystem’s money supply?ee re "To pay for the wine the German importer must purchase 1.5 million dollars from a German or Eurosystem commercial bank. At an exchange rate of €1 = $1.50 the cost will be €1 million. The following sequence explains how this transaction leads to a decline in the Eurosystem’s money supply ® The importer orders $1.5 million from its commercial bank and pays by a €1 million reduction in its bank deposits. The commercial bank purchas equivalent reduction in its reserve asse ¢ the dollars from the central bank and pays by an held at the central bank. ‘These transactions imply that commercial bank deposit liabilities and reserve assets both fall by €1 million while the central bank's stock of foreign exchange reserve assets and its liability to the commercial banks in the form of reserves also fall by €1 million, Note that the balance sheets of the commercial banks and the central bank remain in balance (liabilities = assets). Further, the decline in commercial bank reserves will, by the process described in Chapter 23, lead to a multiple contraction in deposits and bank lending. Hence, we can conclude that, other things being equal, a fall in central bank foreign exchange reserves leads to a decline in the money supply, which shifts the LM curve to the left. Likewise, an increase in the stock of central bank foreign exchange reserves leads to an increase in the money supply, which shifts the LM curve to the right. THE FOREIGN SECTOR ‘The IS-LM model developed in Chapter 24 established equilibrium conditions in two markets of sectors ~ the market for goods and services (or the real sector) and the market for money (or the monetary sector). We now wish to incorporate a third sector, the foreign sector, into the model. By the ‘foreign sector’ we mean all transactions that involve the sale or purchase of the domestic currency for another currency. We will classify these trans- actions into two types — net exports, denoted NX, and net capital -—————_________ fiows, denoted KF. As in other chapters net exports are defined as. | capital ows purchases of { the export of goods and services minus imports of goods and ser- | domestic assets by foreigners | vices. Exports are purchases of domestic goods by foreigners, while | less purchases of foreign assets | imports are purchases of foreign goods and services by domestic | by domestic residents residents, Hence, on the foreign exchange market exports generate ‘a demand for the domestic currency while imports generate a supply of the domestic currency. Net capital flows, denoted KF, are defined as purchases of domestic assets by foreign households, firms and institutions minus the purchase of foreign assets by domestic households, firms and institutions. For example, if an American financial institution purchases a euro-denominated German bond, it must purchase (demand) euros on the foreign exchange market. Conversely, if a German financial institution purchases a dollar denominated bond it must sell (supply) euros on the foreign exchange market. Net exports and net capital flows lead to changes in the economy's stock of foreign exchange reserves, FAR. For example, if net exports are positive, the demand for the domestic currency will exceed supply (or the supply of the foreign currency will exceed demand) and FXR will be increasing. Likewise, if net capital flows are negative, the sup- ply of the domestic currency on the foreign exchange market will exceed demand (or the demand of the foreign currency will exceed supply) and FXR will be decreasing. Hence, the change in foreign exchange reserves equals the sum of net exports and net capital flows. That is, using the Greek delta A as shorthand for the phrase ‘the change in’: AFXR = NX + KF We can think of the change in the stock of foreign exchange reserves as the balance of payments, or the total demand for the currency on the foreign exchange market minusba | CChapter29 Exchange Rates, Capital Flows and the Balance of Payments —— of fon a net increase in 8 county's ign exchange reserves the total supply. If the stock of foreign exchange reserves is falling, balance-of-payments deficit a | the country is experiencing a balance-of-payments deficit. Con- net decline ina country’sstock | versely, if the stock of foreign exchange reserves is increasing, the of foreign exchange reserves country is experiencing a halance-of-payments surplus, balance-of payments surplas tock | of foreign exchange reserves is constant. ‘That | Hence the foreign sector willbe in equilibrium when the stock i | oe NK+KF=0 (29.3) THE BP CURVE ‘The IS curve plots combinations of income and the rate of interest at which the market for goods and services (or the real sector) is in equilibrium. Likewise, the LM curve plots combinations of income and the rate of interest, at which the market for money (or the monetary sector) is in equilibrium. We can now introduce a third relationship between income and the rate of interest, called the ‘BP curve’. The BP curve plots com binations of income and the rate of interest at which the balance of payments (or the foreign sector) is in equilibrium. To derive the BP curve we first consider the deter- minants of net exports and net capital flows. Net exports are the difference between the value of goods and services exported by a country and the value of goods and services imported by the country. Hence net exports will depend on the following factors: % Domestic income (Y) The higher domestic income, the greater consumption and imports. Hence, we would expect net exports to fall (imports increase) as domestic income rises. Conversely, we would expect net exports to rise (imports fall) as domestic income falls. Foreign income (¥!) As the domestic country’s exports are the foreign country’simports, we would expect net exports to increase (exports increase) as foreign income rises. Conversely, we would expect net exports to fall exports fail) as foreign income falls. B The real exchange rate (eP/P‘) A fall in the real exchange rate (a real depreciation) leads to an increase in net exports. Conversely, a rise the real exchange rate (a real appreciation) leads to a fall in net exports. Net capital flows represent the difference between purchases of domestic assets by for- eigners and purchases of foreign assets by domestic residents. Hence, net capital flows will depend on the following factors: % The domestic rate of interest (i) The higher the domestic rate of interest, the greater the demand for domestic currency assets and the lower the domestic rate of inter- est, the lower the demand for domestic assets. Hence, we would expect net capital flows (inflows minus outflows) to increase as the domestic rate of interest rises. The foreign rate of interest (#) The higher the foreign rate of interest, the greater the demand for foreign currency assets and the lower [xP curve plow combinations of the foreign rate of interest, the lower the demand for foreign incom and he rateof niet assets. Hence, we would expect net capital flows (inflows minus at which the balance of outflows) to fall as the foreign rate of interest increases. aymeni a se cossam | The BP curve plots combinations of income and the rate of eoumion ie Sei ee interest at which the balance of payments (or the foreign sector) is restrictions on the free , | equilibrium. Of capital and investors treat “fo simplify matters, we will assume that international financial fesets denominuted indifferent | markets are characterised by perfect capital mobility, which Currencies as perfect ubsciures | means that there are no restrictions on the free movement of financial capital between currencies and that investors treat assetsdenominated in different currencies as per- fect substitutes. The absence of restrictions on capital movements means that billions of euros, pounds or dollars can be bought or sold on the world’s foreign exchange markets in afew minutes, normally by computer without any physical transaction actually taking place, and the assumption that different assets are perfect substituces means that investors are concerned with rates of interest only when deciding which currencies to buy or sell For example, if the domestic interest rate were to fall below the foreign interest rate, we would expect to see large-scale selling of domestic asses matched by large-scale purchases of foreign assets, which will force an increase in the domestic interest rate and/ orafallinthe foreign interest rate, Alternatively, if the domestic interest rate were to rise above the foreign interest rate we would cng ecw paty If S and LM intersect above the 8P curve there is a balance of payments surplus Surplus (SI us Is 11S and LM intersect below the BP curve | é i ~~ un Deficit (0) there is a balance of payments deficit Output ¥ Figure 29.7. The BP Curve ‘Assuming perfect capital mobility the BP curve is horizontal with i=. Points above the BP curve are positions of batance-of-payments surplus, and points below the BP curve are positions of balance-of- payments deficit. expect to observe the reverse, with large capital inflows to the domestic currency, which will force a fall in the domestic interest rate and/or a rise in the foreign interest rate Hence, in equilibrium the g between the domestic and foreign interest rate will be closed and i will equal ¢, as illustrated by the horizontal BP curve in Figure 29.7. ‘What happens if the economy is not on the BP curve? For example, suppose the IS and LM curves intersect at an interest rate-output combination that is above or below the BP curve. If this is the case, the two domestic markets (goods and money) will be in equilibrium but the balance of payments will not be in equilibrium. Remember that for any given level of income the BP curve gives the rate of interest necessary for balance of payments equilibrium. Hence, if the IS and LM curves intersect at a point above the BP curve, such as Sin Figure 29.7, the rate of interest will be greater than the for- eign rate of interest and, as net capital flows increase with the rate of interest, the balance of payments will be in surplus. Conversely, if the IS and J.M curves inter- sect at a point below the BP curve, such as Din Figure 29.7, the rate of interest will be lower than the foreign rate of interest and the balance of payments will be in deficit We will see shortly that the way in which the economy adjusts to surpluses and defi- cits depends on whether the exchange rate is fixed or flexible, and is crucial for the effectiveness of fiscal and monetary poli cies in an open economy, EQUILIBRIUM IN THE IS-LM- BP MODEL Overall equilibrium in the IS-LM-BP model is illustrated by Figure 29.8. At point € there is equilibrium in the goods market (ISI, money market ILM) and external sector (BP) Interest rate i y Output Y L_ Figure 29.8 Equilibrium in the |S-LM-BP Model. The intersection of the IS, LM and BP curves at point Edefines the [i, Y) combination that gives simultaneous equilibrium in the market for goods and services (Y= PAE), the money market (M° = Mi] and in the external sector (AFXR = 0).6b Chapter 29 Exchange Rates, Capital Flows and the Balance of Payments, Example 29.7 Equilibrium is at point F, where all three curves intersect. Hence, the interest rate— output combination at point E gives equilibrium in the market for goods and services (Y= PAE), the money market (MD = MS) and the foreign sector (AFXR = 0). We will now ise this mode! to analyse fiscal and monctary policy in the open economy. FISCAL POLICY IN THE OPEN ECONOMY Figure 29.9 illustrates how fiscal policy works in the open economy. ‘The nominal exchange rate is assumed to be flexible in panel (a) and fixed in panel (b). In both panels of Figure 29.9, initial equilibrium is at the point £ with output equal to ¥ and the domestic interest rate equal to the foreign interest rate. Full employment or potential ourput is Y* and the economy is experiencing a recessionary gap. Fiscal policy Can fiscal policy be used to close the recessionary gap in Figure 29.9? Flexible exchange rate, panel (a): a fiscal expansion such as an increase in government purchases or a cut in net taxes shifis the IS curve to the right, to IS’. In the short run, the economy moves along the LM curve to a point such as A. As A is above the BP curve the balance of payments will be in overall surplus and, as a surplus implies an excess demand for the domestic currency, it will force an increase in the nominal exchange rate that, at given prices, leads to an increase in the real exchange rate (eP/P/) and, as the real exchange rate appreciates, net exports will decline. Other things being equal, the fall in net exports reduces planned aggregate expenditure at each level of income and shifts the IS curve back to the left, re-establishing the initial equilibrium at point &. Hence, fiscal policy is ineffective when the exchange rate is flexible. Fixed exchange rate, panel (b): as in the case of a flexible exchange rate a fiscal expansion shifts the IS curve to the right, to IS’, and in the short run, the economy moves along the LM curve to a point such as A, which, as we have seen, corresponds to a balance-of payments surplus and an excess demand for the domestic currency. A fixed exchange rate means that the central bank will satisfy any excess demand for the domes- tic currency. That is, the central bank will sell the domestic currency in exchange for foreign currency at the official exchange rate. As a result, the stock of foreign exchange reserves (FXR) will increase and, using Equation (29.2), the money supply will increase, : 3 z : i i 5 i 2 2 la] Flexible e (bl Fixede Figure 29.9 Fiscal Policy A fiscal expansion leads to an increase in short-run equilibrium output, under a fixed exchange rate, panel (b), but is ineffective when the exchange rate is flexible, panel (al,Exchange rates and stabilisation policy shifting the LM curve downward, to LM’, and establishing a new equilibrium at point E’ with Y= Y*, Hence, fiscal policy is effective when the exchange rate is fixed. ‘The difference between the two cases is the manner in which external disequilib- rium impacts on the two domestic sectors, ‘The fiscal expansion leads to a balance of payments surplus and an excess demand for the domestic currency. If the exchange rate is flexible, this excess demand leads to an appreciation of the domestic currency and a fall in net exports, which reduces planned aggregate expenditure and offsets the impact of the fiscal expansion, However, i€ the exchange rate is fixed, the central bank will satisfy the excess demand by selling the domestic currency at a fixed price, which, as we have scen, results in an increase in the stock of foreign exchange reserves and hence the money supply (the LM curve shifts to the right), which reinforces the fiscal expansion. MONETARY POLICY IN THE OPEN ECONOMY Figure 29.10 illustrates how monetary policy works in the open economy. Asin Figure 29.9, the nominal exchange rate is assumed to be flexible in panel (a) and fixed in panel (b). In both panels of Figure 29.10, initial equilibrium is at point E with output equal to Y and the domestic interest rate equal to the foreign interest rate. Full employment or potential output is Y* and the economy is experiencing a recessionary gap. Monetary policy Can monetary policy be used to close the recessionary gap in Figure 29.10? Flexible exchange rate, panel (a): an increase in the money supply will shift the LM downward, to LM’. In the short run, the economy moves along the IS curve to a point such as A. As Ais below the BP curve, the balance of payments will be in overall deficit and as a deficit implies an excess supply of the domestic currency it will force a fall in the nominal exchange rate, which at given prices leads to a lower real exchange rate (eP/P4) and, as the real exchange rate depreciates, net exports will increase. Other things being equal, the rise in net exports increases planned aggregate expenditure at each level of income and shifts the IS curve to the right, to IS’, establishing a new equilibrium at point £’ with Y= Y*. Hence monetary policy is effective when the exchange rate is flexible. Interest rate / Interest rate / Output Y {al Flexible (bl Fixed e Figure 29.10 Monetary Poticy ‘A monetary expansion leads to an increase in short-run equilibrium output, under a flexible exchange rate, panel (al, but is ineffective when the exchange rate is fixed, panel (bl. Example 29.8eu Chapter 29. Exchange Rates, Capital Flows and the Balance of Payments Fixed exchange rate, panel (b): as in the case of a flexible exchange rate, a monetary expansion shifts the LM curve down, to LM’. In the short run, the economy moves along the IS curve to a point such as A, which, as we have seen, corresponds to a bal- ance-of payments deficit and an exces exchange tate is fixed the central bank will the domestic currency. That is, the central bank will sell foreign exchange for the domestic currency at the official exchange rate. Ava result, the stock of foreign exchange reserves (/-XR) will fall and, using Equation (29.2), the money supply will also fall, shift- ing the LM curve back up, re-establishing the initial equilibrium at point &. Hence, monetary policy is ineffective when the exchange rate is fixed As in the case of fiscal policy the difference between the two cases is the manner in which external disequilibrium impacts on the two domestic sectors. A monecary expansion leads to a balance-of payments deficit and an excess supply of the domestic currency. If the exchange rate is flexible, this excess supply leads to a depreciation of the domestic currency and a rise in net exports, which increases planned aggregate expenditure (IS shifts to the right) and reinforces the impact of the monetary expansion However, if the exchange rate is fixed, the central bank will stop the excess supply from reducing the exchange rate by buying the domestic currency at a fixed price, which, as we have seen, results in a fall in the stock of foreign exchange reserves, leading to a contraction in the domestic money supply. supply for the domestic currency. When the isfy any take up of any excess supply of MONETARY POLICY AND THE NOMINAL EXCHANGE RATE In Example 29.8 we saw that monetary policy is most effective when the exchange rate is flexible and ineffective when the exchange rate is fixed. We can state this result in a different way; monetary policy can be used to stabilise the economy or it can be used to fix the exchange rate but it cannot be used for both. This can be illustrated by the case of : the United Kingdom, which, to date, has retained its own currency and opted fora flexible exchange rate against other currencies such as the euro and the dollar. Because it operates under a flexible exchange rate, the Bank of England can use active monetary policy to stabilise the economy, For example, if a recessionary gap opens, the Bank can stimulate aggregate demand by increasing the money supply, which reduces interest rates. Conversely, if an expansionary gap opens, the Bank can react by reducing the money supply and increasing interest rates. Now suppose the UK changes policy and decides to fix the value of sterling against the euro. If a recessionary gap opens, any move by the Bank of England to reduce interest rates by increasing the money supply would lead to capital outflows and, as the stock of foreign exchange reserves falls, the money supply would decline as shown in panel (b) of Figure 29.10. Conversely, if an expansionary gap opens and the Bank of England reduces the money supply to increase interest rates, the resulting capital inflows will increase the stock of foreign exchange reserves, reversing the fallin the money supply (Equation 29.3). Hence, with a fixed exchange rate, the central bank must set interest rates, and hence the money supply, ata level consistent with maintaining the fixed exchange rate. Given this constraint, maintaining a fixed exchange rate predetermines domestic monetary policy and it cannot be used to stabilise the economy ‘The conclusion that, in a world of capital mobility, a country must choose between fixed and flexible exchange rates is sometimes called the ‘impossible trinity’, which means that a country can choose only two of the following three types of policy: free capital mobility, an independent monetary policy, which requires a flexible exchange rate, and a fixed exchange rate, which requires a sacrifice of monetary policy indepen- dence. Given capital mobility, the impossible trinity means that a country must choose to use monetary policy to either stabilise the economy or fix the exchange rate, Economic Naturalist 29.3 gives a famous example of the impossible trinity in action.a eine eee WNgomaNC CIA aionctary system (UMS) commenced operation in carly 1979, the United Kingdom was the only member state t0 opt out of the central component known as the Exchange Rate Mechanism (BRM), which was a system designed to limit fluctuations between participating currencies. However, in October 1990 the British Prime Minister Margaret Thatcher gave in to pres- sare from her more pro-Guropean cabinet colleagues and agreed that sterling should participate in the ERM. Sterling entered the ERM at a central rate of 2.95DM per pound sterling (which was prob- ably overvalued) and was permitted a fluctuation range of +6 per cent, However, less than two years Tater, on Wednesday, 16 September 1992, a series of massive speculative attacks forced sterling and the Italian lira not just to be devalued but to leave the ERM completely. What caused the 1992 ERM. crisis and prompted such speculation against these currencies? Somewhat ironically, the background to the crisis lay in the United States, which had started to experience a severe recession in the late 1980s. The recession spread to several European countries and especially the United Kingdom, where unemployment increased from 7.3 per cent to over 10 per cent between 1989 and 1992. The Federal Reserve (Fed) reacted to the US recession by aggressively cutting interest rates, which resulted in a decline in the three-month money market rate from 8.4 per cent in 1989 to 3.5 per cent in 1991. However, because the British authorities had sacrificed policy independence by joining the ERM they were unable to respond to recession in a similar manner. ‘This situation was further complicated by German reunification, which dramatically increased govern- ment spending and created an inflationary surge in the German economy. To moderate the rise in inflation, Germany's central bank, the Bundesbank, followed an opposite path to the Fed and sharply increased short-term interest rates. As the other EMS currencies were linked to the DM via the ERM, this rise in interest rates spread across the system. The widening differential between European and American interest rates increased the attractiveness of European assets, leading to a higher demand for European currencies and a steady appreciation against the dollar. As the United States accounted for approximately 12 per cent of UK exports, this loss of competitiveness against the dollar was a further blow to the British economy. By mid-1992, the United Kingdom could be described as a country facing recession and rising unemployment combined with high interest rates and an overvalued currency. Germany, on the other hand, was experiencing an expansionary gap and rising inflation. Maintaining high interest rates and 2 strong currency may have been the appropriate policy for Germany but not for the United Kingdom, which required lower interest rates and a more competitive exchange rate However, so long as the United Kingdom maintained its currency link with Germany it could not deviate fer ftom German monetary policy. Britain was now caught on the horns of the impossibility trinity. Given capital mobility, it had to choose between maintaining a fixed exchange rate and using monetary policy to stabilise the domestic economy. As the recession deepened, financial markets became convinced that the British authorities would opt for the latter and launched a massive specu: lative attack against sterling. At first the Bank of England attempted to defend the exchange rate by buying sterling in the foreign exchange market and, on Wednesday 16 September, increased its key lending rate, called the base interest rate, from 10 to 12 per cent, and threatened a further 3 per cent increase as an incentive for speculators to stop selling sterling, The markets were not convinced and continued to sell large amounts of the British currency in anticipation of devaluation. With reserves falling rapidly, the United Kingdom had little choice but to abandon its fixed exchange rate policy and, at 7 pm that evening, the government announced that Britain would leave the ERM and float against the other European currencies. The announced increases in interest rates were reversed and, by the end of 1992, sterling had depreciated by 16 per cent against the dollar and by 11 per cent against the DM. ‘Having driven sterling out of the ERM, the speculators turned their attention to other European economies such as Belgiuim, France, Italy and Spain, which, like the United Kingdom, were experi- encing low growth and required lower interest and more competitive exchange rates. The Italian @ When the EuropesChapter 29. Exchange Rates, Capital Flows and the Balance of Payments © tica was also forced out of the BRM and the Spanish peseta was devalued twice. Speculative attacks continued throughout the first half of 1993 and, in August, the narrow +2.25 PRM fluctuation band was abandoned and replaced with a much wider E15 per cent band, Given this wide range of per- mitted fluctuation, the ERM was now a closer approximation to a flexible exchange-rate system than toa fixed exchange-rate system, "The attempt to circumvent the impossible trinity by defending the exchange rate is estimated to have cost the Bank of England £4 billion in reserves, One of the most prominent speculators, George Soros, is thought to have earned up to £0.5 billion from the crisis and became known as ‘the man who broke the Bank of England’, Wednesday, 16 September 1992 is sometimes referred to as ‘Black Wednesday’. However, for the remaining years of the decade and into the new century the UK economy generally outperformed those of countries such as France and Germany, leading propo- nents of flexible exchange rates to call that day ‘Golden Wednesday’, @e¢@e SUMMARY & The nominal exchange rate between two currencies is the rate at which the currencies can be traded for each other. A rise in the value of a currency relative to other cur- rencies is called an appreciation; a decline in the value of a currency is called a depreciation. & Exchange rates can be flexible or fixed: The value of a flexible exchange rate is deter- mined by the supply and demand for the currency in the foreign exchange market, the market on which currencies of various nations are traded for one another. The gov- ernment sets the value of a fixed exchange rate. ® The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. An increase in the real exchange rate implies that domestic goods and services are becoming more expensive relative to foreign goods and ser- vices, which tends to reduce exports and increase imports. Conversely, a decline in the real exchange rate tends to increase net exports. ® Supply and demand analysis is a useful tool for studying the determination of exchange rates in the short run. The equilibrium exchange rate, also called the fim- damental value of the exchange rate, equates the quantities of the currency supplied and demanded in the foreign exchange market. A currency is supplied by domestic residents who wish to acquire foreign currencies to purchase foreign goods, services and assets. An increased preference for foreign goods, an increase in the domestic GDP, or an increase in the real interest rate on foreign assets will all increase the supply of a currency on the foreign exchange market and thus lower its value. ‘A currency is demanded by foreigners who wish to purchase domestic goods, services and assets, An increased preference for domestic goods by foreigners, an increase in real GDP abroad, or an increase in the domestic real interest rate will all increase the demand for the currency on the foreign exchange market, and thus increase its value. i The value of a fixed exchange rate is officially established by the government. A fixed exchange rate whose official value exceeds its fundamental value in the foreign exchange market is said to be overvalued, An exchange rate whose official value is below its fundamental value is undervalued. A reduction in the official value of a fixed exchange rate is called a devaluation; an increase in its official value is called a revaluation, For an overvalued exchange rate, the quantity of the currency supplied at the official exchange rate exceeds the quantity demanded. ‘To maintain the official rate, the country’s central bank must use its international reserves (foreign currency assets)to purchase the excess supply of its currency in the foreign exchange market. Because a country's international reserves are limited, it cannot maintain an over. valued exchange rate indefinitely. Morcover, if financial investors fear an impending Yevaluation of the exchange rate, they may launch a specilative attack, selling their domestic currency assets and supplying large quantities of the currency to the foreign exchange market. Recause speculative attacks cause a country’s central bank to spend its international reserves even more quickly, they often force a devaluation The choice of exchange rate regime has important implications for stabilisation policies, Monetary policy is most effective when the exchange rate is flexible re Teast effective when the exchange rate is fixed. Conversely fiscal policy is least effective when the exchange rate is flexible and most effective when the exchange rate is fixed, The impossible trinity’ teaches us thatin a world characterised by free capital mobility countries must choose between domestic stabilisation and fixed exchange rates. If they opt for the latter they cannot use macroeconomic policies to stabilise their domestic economies. REVIEW QUESTIONS $9006© Japanese yen trade at 110 yen per dollar and Mexican pesos trade at 10 pesos per dollar, What is the nominal exchange rate between the yen and the peso? Express it in two ways. 2. Define the nominal exchange rate and the real exchange rate. How are the two con- cepts related? Which type of exchange rate most directly affects a country’s ability to export its goods and services? 3. Why do German households and firms supply euros to the foreign exchange market? Why do Americans demand euros in the foreign exchange market? Define an overvalued exchange rate. Discuss four. ways in which government policy makers can respond to an overvaluation, Whatare the drawbacks of each approach? 5. Usea supply and demand diagram to illustrate the effects of a speculative attack on an overvalued exchange rate. Why do speculative attacks often result in a devaluation? 6, Suppose that Poland decides to fix the value of the zloty against the euro, What are the implications for monetary and fiscal policies as means of stabilising the domes- tic economy? 7. The UK has decided to opt out of the euro and follow a Hlexible exchange rate policy. What does this decision imply for the effectiveness of monetary and fiscal policies? PROBLEMS 96000066 1. Using the data in ‘Table 29.1, find the nominal exchange rate between the yen and connect aloty. Express it in two ways. 2. How do your answers to Problem 1 change if the yen appreciates by 10 per cent against the euro while the value of the zloty against the euro remains unchanged? 3. A British-made automobile is priced at £20,000. A comparable US-1nade car costs $26,000. One pound trades for $1.50 in the foreign exchange market. Find the real exchange rate for automobiles from the perspective of the United States and from the petspective of Great Britain. Which country’s cars are more competitively priced?au Chapter29 Bxchange Rates, Capital lows and the Balance of Payments 4, Between last year and this year, the CPI in Blueland rose from 100 to 110, and the CPlin Redland rose from 100 to 105. Bluek nd's currency unit, the blue, was worth €1 last year and is worth 90 cents this year. Redland’s currency unit, the red, was worth $0 euro cents last year and is worth 45 cents this year. Find the percentage change from last year to this year in Blueland!'s nominal exchange rate with Redlaed and in Blucland’s real exchange rate with Redland, (Treat Blueland as the home country.) 5. Gold costs £250 per ounce in London and €312,5 in Rotterdam. Crude oil trades for £90 per barrel in London. According to PPP theory how much should a barrel of crude oil cost in Rotterdam? 6. The demand for and supply of Polish zlotys in the foreign exchange market are Demand = 30,000 — 8,000€ ‘Supply = 25,000 + 12,000€ where the nominal exchange rate e is expressed as euros per zloty. a, What is the fundamental value of the zloty? b. The zloty is fixed at 0.30 curos. Is the zloty overvalued, undervalued, or neither? c. Find the balance-of payments deficit or surplus in both zlotys and euros. 7. The annual demand for and supply of zlotys in the foreign exchange market is as given in Problem 6. The zloty is fixed at 0.30 euros per zloty. The country's inter- national reserves are €600. Foreign financial investors hold chequing accounts in the country in the amount of 5,000 zlotys. Using demand and supply diagrams to illustrate the following: a. Foreign financial investors come to expect a possible devaluation of the zloty to 0.25 euros. - b. In response to their concern about devaluation to 0.25 euros per zloty, foreign financial investors withdraw all Funds from their chequing accounts and attempt to convert those zlotys into euros. 8. Using demand and supply diagrams explain how each of the following might affect the value of the euro, : a. Shares in European companies are perceived as having become much riskier financial investments. ‘ b. American households decide to purchase less French, Spanish and [talian wine, and more Australian, Chilean and South African Wine ‘The ECB decided to increase its main refinancing interest rate while the Bank of England leaves its bank rate unchanged. 9. Using the IS-LM-BP model illustrate how (a) ntonetary policy and (6) fiscal policy can be used to close an expansionary gap under a fixed exchange rate, 10. Repeat Problem 9 but this time assume that the exchange rate is flexible ©