Chapter 22 or 35 International Finance: Pre-Class & In-Class Activities Packet Name/I.D. Number: Section: Date: Part 3. Discussion Questions and Problems 1. Explain the link between the Mexican demand for U.S. goods and the supply of pesos. Next, explain the link between the U.S. demand for Mexican goods and the supply of dollar. 2. The lower the dollar price of a peso, the higher the quantity demanded of pesos, and the lower the quantity supplied of pesos. Do you agree or disagree? Explain. 3. What does it mean to say that the U.S. dollar has depreciated in value in relationship to the Mexican peso? What does it mean to say that the Mexican peso has appreciated in value relative to the U.S. Dollar ? 4. Suppose the United States and Japan have a flexible exchange rate system. Explain whether each of the following events will lead to an appreciation or depreciation in the U.S. dollar and Japanese yen. a. U.S. real interest rates rise above Japanese real interest rates. b. The Japanese inflation rate rises relative to the U.S. inflation rate. c. U.S. income increases with no change in Japanese 5. What are the strong and weak points of the flexible exchange rate system? What are the strong and weak points of the fixed exchange rate system? 6. Explain the details of the purchasing power parity (PPP) theory. 7. Explain how a growing budget deficit can affect the value of a country's currency on the foreign exchange market. 8. What does it mean to say that a currency is overvalued? undervalued? 9. Under a flexible exchange rate system, if the equilibrium exchange rate is 0.10 USD = 1 MXN and the current exchange rate is 0.12 = 1 MXN, will the U.S. dollar appreciate or depreciate? Explain. 10. What is an optimal currency area?8 5/4/2015 2. Country 1 produces good X and country 2 produces good Y. People in both countries Country I's good (good X) will become begin to demand more of good X and less of good Y. Assume there is no labor mobility more expensive for the residents of maen the two countries and that a fle country 2, and they will buy less. exchange rate system exists. What will happen to the unemployment rate in country Country 2's good (good Y) will become 2? Explain your answer. ess expensive for the residents of SELFTEST As the demand for good Y falls, the unemployment SELFTEST rate in country 2 will rise. This increase in the country 1, and they will buy more. As a unemployment rate is likely t is likely to be temporary, though The increased demand for good X (produced by result of the additional purchases of 1) will increase the demand for country 1's currency, leading to an appreciation in country I's good Y, country 2's unemployment rate currency and a depreciation in country 2's currency. will begin to decline. (continued) 3. How important is labor mobility WALL STREET JOURNAL in determining whether or not an area is an optimal currency area? The Wall Street Journal is a is a rich Labor mobility is very important to source of information which provides real determining whether or not an area is an life examples of micro- and macro SELFTEST optimal currency area. If there is little or no abor mobility, an area is not likely to be an economic activities. Check today's issue optimal currency area. If there is labor to see the most current news. mobility, an area is likely to be an optimal http://www.wsj.com currency area. CH 36 . 62 912:054 File Details SP22 ECON-201-1217 Pr... 7 5/4/2015 OPTIMAL CURRENCY AREA MANAGED FLOAT A geographic area in which exchange . A managed flexible exchange rate rates can be fixed or a common system, under which nations now and currency used without sacrificing then intervene to adjust their official domestic economic goals, such as low reserve holdings to moderate major unemployment. swings in exchange rates. Examples include the 50 U.S. states and the European Union THE CURRENT INTERNATIONAL JU THE CURRENT INTERNATIONAL MONETARY SYSTEM I MONETARY SYSTEM II Today's international monetary system is . Proponents of the managed flexible described as a managed flexible exchange rate system, or managed float. exchange rate system believe it offers For the most part, the exchange rate system is several advantages: flexible, although nations do periodically It allows nations to pursue independent intervene in the foreign exchange market to adjust exchange rates. monetary policies. Because it is a managed float system, it is It solves trade problems without trade difficult to tell if nations will emphasize the restrictions. "float" part or the "managed" part in the future. It is flexible and therefore can easily adjust to shocks. THE CURRENT INTERNATIONAL MONETARY SYSTEM III 1. What is an optimal currency area? Opponents of the managed flexible exchange An optimal currency area is a rate system believe it has several geographic area in which exchange disadvantages: rates can be fixed or a common SELFTEST It promotes exchange rate volatility and uncertainty and results in less international currency used without sacrificing any trade than would be the case under fixed domestic economic goals. exchange rates. It promotes inflation. > It corrects trade deficits only a long time after a depreciation in currency; in the interim, it can make things worse. CH 36 . 812:057 File Details SP22 ECON-201-1217 Pr... 6 5/4/2015 Specifically, a currency is overvalued if 1 unit 2. How does an overvalued dollar of it fetches more of another currency than it affect U.S. exports and imports? would in equilibrium; a currency is An overvalued dollar means some other currency, undervalued if 1 unit of it fetches less of say the Japanese yen, is undervalued. An overvalued another currency than it would in equilibrium. dollar makes U.S. goods more expensive for the In equilibrium, 1 = peso would fetch $0.10, and Japanese; so they buy fewer U.S. goods, thus reducing U.S. exports. On the other hand, an undervalued yen SELFTEST at the current exchange rate it fetches 0.12 SELFTEST makes Japanese goods cheaper for Americans; so dollars; so the peso is overvalued. In they buy more Japanese goods, and the U.S. imports equilibrium, $1 would fetch 10 pesos, and at more. Thus, an overvalued dollar reduces U.S. exports the current exchange rate, it fetches only 8.33 and raises U.S. imports. pesos; so the dollar is undervalued. 1. 3. In each case, identify whether the U.S. 4. Under a fixed exchange dollar is overvalued or undervalued. a. The fixed exchange rate is $2 = $1 and rate system, why might the the equilibrium exchange rate is $3 = 21. United States want to devalue b. The fixed exchange rate is $1.25 = ( 1 its currency? and the equilibrium exchange rate is $1.10 = 61 c. The fixed exchange rate is $1 = 10 SELFTEST SELFTEST pesos and the equilibrium exchange rate The devaluation of a country's is $1 = 14 pesos. currency makes it cheaper for a. Dollar is overvalued. foreigners to buy the country's b. Dollar is undervalued products. c. Dollar is undervalued. CASE FOR FIXED EXCHANGE RATES CASE FOR FLEXIBLE EXCHANGE RATES A major advantage of fixed exchange It is better for a nation to adopt policies rates is certainty with regard to the to meet domestic economic goals than value of their nation's currency. to sacrifice domestic economic goals to With flexible exchange rates, maintain an exchange rate. individuals are less likely to engage in There is too great a chance that the international trade because of the fixed exchange rate will diverge greatly added risk of not knowing from one day from the equilibrium exchange rate, to the next how many dollars, euros, or creating persistent balance of trade yen they will have to trade for other problems. currencies. This leads deficit nations to impose trade restrictions (tariffs and quotas) that hinder international trade. CH 35 . 42 712:054 File Details SP22 ECON-201-1217 Pr... 5 5/4/2015 FIXED EXCHANGE RATES AND AN PERSISTENT DEFICIT OR SURPLUS OVERVALUED DOLLAR Initially, the demand . If a persistent deficit or surplus in a for and supply of pesos nation's combined current and capital are represented by D, and S,, respectively. account exists at a fixed exchange rate, The equilibrium the nation has a few options to deal exchange rate is 0.10 with the problem: USD 1 MXN, which also happens to be the > devalue or revalue its currency, official (fixed) exchange > enact protectionist trade policies (in the rate. case of a deficit), quotas and/or tariffs > change its monetary policy. 01 36 . 31 CH 36 - 32 OPTIONS UNDER A FIXED RATE SYSTEM: OPTIONS UNDER A FIXED RATE SYSTEM: DEVALUATION AND REVALUATION CHANGES IN MONETARY POLICY Devaluation - A government act that Enact a tight monetary policy to retard inflation and drive up interest rates (at least in the short run). changes the exchange rate by lowering The tight monetary policy will reduce a country's rate of the official price of a currency inflation and thereby lower their prices relative to . Revaluation - A government act that prices in other nations. This will make their goods relatively cheaper than they changes the exchange rate by raising were before (assuming other nations didn't also enact a the official price of a currency. tight monetary policy) and promote their exports and discourage foreign imports. It will also generate a flow of investment funds into the country in search of higher real interest rates. CH4 36 - 34 THE GOLD STANDARD 1. Under a fixed exchange rate system, if one currency is overvalued, then another currency must be A gold standard automatically fixes exchange rates. undervalued. Explain why this is true. To have an international gold standard, nations must The terms overvalued and undervalued refer to the do the following: define their currencies in terms of gold; equilibrium exchange rate: the exchange rate at which stand ready and willing to convert gold into paper the quantity demanded and quantity supplied of a SELFTEST money and paper money into gold at a specified rate; currency are the same in the foreign exchange market. and Let's suppose the equilibrium exchange rate is 0.10 link their money supplies to their holdings of gold. USD = 1 MXN. This is the same as saying that 10 pesos = The change in the money supply that the gold $1. If the exchange rate is fixed at 0.12 USD = 1 MXN standard sometimes requires has prompted some economists to voice the same argument against the (which is the same as 8.33 pesos $1), the peso is gold standard that is often heard against the fixed overvalued and the dollar is undervalued. exchange rate system: It subjects domestic monetary (continued) policy to international instead of domestic considerations CH1 36 - 35 CH 36 - 36 612:057 File Details SP22 ECON-201-1217 Pr... 4 5/4/2015 3. Suppose the U.S. economy grows 4. What does the purchasing power while the Swiss economy does not. How parity theory say? Give an example to will this affect the exchange rate illustrate your answer. between the dollar and the Swiss franc? The purchasing power parity (PPP) theory states that Why? the exchange rate between any two currencies will Ceteris paribus, the dollar will depreciate relative to adjust to reflect changes in the relative price levels of the two countries. SELFTEST the franc. As incomes for Americans rise, the demand SELFTEST for Swiss goods rises. This increases the demand for For example, suppose the U.S. price level rises 5 francs and the supply of dollars on the foreign percent and Mexico's price level remains constant. exchange market. In turn, this leads to a depreciated According to the PPP theory, the U.S. dollar will dollar and an appreciated franc. depreciate 5 percent relative to the Mexican peso. FIXED EXCHANGE RATE SYSTEM OVERVALUATION AND UNDERVALUATION . The system where a nation's currency . A currency is overvalued if its price in is set at a fixed rate relative to all other terms of other currencies is above the currencies, and central banks intervene equilibrium price. in the foreign exchange market to . A currency is undervalued if its price in maintain the fixed rate terms of other currencies is below the equilibrium price. A FIXED EXCHANGE RATE SYSTEM I A FIXED EXCHANGE RATE SYSTEM II The exhibit shows two cases: In a fixed exchange rate a indurioted and a > If the exchange rate is fixed at morphing of peoot official price 1, the peso is system, the exchange overvalued, the dollar is rate is fixed-and it may undervalued, and a surplus of pesos not be fixed at the 10 12 equilibrium exchange > If the exchange rate is fixed at 0.06 X exists. Pricing Price ? rate. official price 2, the peso i undervalued, the dollar is , and a shortage of pesos At the exchange rate, exists. CH 36 . 20 CH 36 - 30 512:057 File Details SP22 ECON-201-1217 Pr... 5/4/2015 INFLATION, EXCHANGE RATES, AND INFLATION, EXCHANGE RATES, AND PURCHASING POWER PARITY (PPP) I PURCHASING POWER PARITY (PPP) II >If the price level in the United States increases by 10 percent while the price level in Mexico remains > PPP theory predicts that the constant, then the U.S. demand for dollar will depreciate in the Mexican goods (and therefore foreign exchange market until pesos) will increase and the supply the original price (in pesos) of of pesos will decrease. > As a result, the exchange rate will American goods to Mexican change; the dollar price of pesos customers is restored. will rise. The dollar depreciates, and > In this example, this requires the peso appreciates. the dollar to depreciate 10 percent. CH4 36 . 20 CHANGES IN REAL INTEREST RATES CHANGES IN REAL INTEREST RATES . The flow of financial capital depends on Financial capital also moves between countries. different countries' real interest rates- >The flow of financial capital depends on interest rates adjusted for inflation. different countries' real interest rates- interest rates adjusted for inflation. If a country's real interest rate increases when compared with real interest rates in other countries, financial capital will flow into that country. The currency of the receiving country will appreciate while the currency of the sending country will depreciate 1. In the foreign exchange market, 2. What could cause the U.S. dollar how is the demand for dollars linked to appreciate against the Mexican to the supply of pesos? peso on the foreign exchange As the demand for dollars increases, the supply of pesos increases. For example, suppose someone in market? Mexico wants to buy something produced in the United The dollar is said to have appreciated States. The American wants to be paid in dollars, but against the peso) when it takes more pesos SELFTEST SELFTEST the Mexican doesn't have any dollars; she has pesos So she has to buy dollars with pesos; in other words, she to buy a dollar and fewer dollars to buy a has to supply pesos to buy dollars. Thus, as she peso. For this to occur, either the demand for demands more dollars, she will necessarily have to dollars must increase (i.e., the supply of pesos supply more pesos. increases) or the supply of dollars must decrease (i.e., the demand for pesos decreases). CH 34 . 24 412:057 File Details SP22 ECON-201-1217 Pr... 2 5/4/2015 A FLEXIBLE EXCHANGE RATE SYSTEM II CHANGES IN THE EQUILIBRIUM EXCHANGE RATE Appreciation - An increase in the value At 0.08 USD 1 MXN, there is a of one currency relative to other shortage of pesos, placing currencies. upward pressure on the Depreciation - A decrease in the value exchange rate. At the equilibrium exchange of one currency relative to other rate, 0.10 USD 1 MXN, the currencies. quantity demanded of pesos equals the quantity supplied of pesos. CH 36 . 1 FACTORS THAT AFFECT THE A DIFFERENCE IN INCOME GROWTH EQUILIBRIUM EXCHANGE RATES RATES I A difference in income growth rates . An increase in a nation's income will Differences in relative inflation rates usually cause the nation's residents to Changes in real interest rates buy more of both domestic and foreign goods. The increased demand for imports will result in an increased demand for foreign currency. CH1 36 - 16 A DIFFERENCE IN INCOME GROWTH PURCHASING POWER PARITY RATES II (PPP) THEORY . PPP theory states that exchange rates > If U.S. residents experience a growth in income but Mexican between any two currencies will adjust residents do not, U.S. demand for to reflect changes in the relative price Mexican goods will increase, and with it, the demand for pesos. levels of the two countries. >As a result, the exchange rate will change; the dollar price of pesos X will rise. The dollar depreciates, the peso appreciates. DI 36 . 17 CH 35 . 18 312:047 File Details SP22 ECON-201-1217 Pr... 1 5/4/2015 DEMAND FOR GOODS AND THE FOREIGN EXCHANGE MARKET AND SUPPLY OF CURRENCIES EXCHANGE RATE . The exchange rate is determined in the foreign exchange market and is the Demand for price of one currency in terms of U.S. demand for Mexican pesos Supply of U.S. another currency. Mexican goods (in order to buy dollars (to get hose Mexican goods exican pesos) lexican demand Demand for U.S. supply of Mexican fortutorial on for U.S. goods dollars (in order to pesos (to get those U.S. dollars) markets click the buy those U.S. goods Euro. CH35 * 7 (dollar price er peso) (peso price per dollar TRANSLATING U.S. DEMAND FOR PESOS supply of potos INTO U.S. SUPPLY OF DOLLARS AND demand for dollars. MEXICAN DEMAND FOR DOLLARS INTO 0.10 - - MEXICAN SUPPLY OF PESOS other. The US demand for pesos supply of dollars Duso Quantity of Pesos Quantity of Dollars Market for Pesos Market for Dollars The demand for pesos in (a) is linked to the supply of dollars in (b): When Americans demand pesos, they supply dollars. The supply of pesos in (a) is linked to the demand for dollars in (b): When Mexicans demand dollars, Dollar price per peso T Americans buy fewer pesos. they supply pesos . Dollar price per peso Americans buy more pesos. In (a), the exchange rate is 0.10 USD 1 MXN, which is equal to 10 MXN 1 USD in (b). Exchange rates are reciprocals of each other. FLEXIBLE EXCHANGE RATE SYSTEM A FLEXIBLE EXCHANGE RATE SYSTEM I . The system whereby exchange rates are > The demand curve for pesos is determined by the forces of supply and downward-sloping. The higher the dollar price for demand for a currency pesos, the fewer pesos will be demanded; the lower the dollar price for pesos, the more pesos will be demanded. At 0.12 USD 1 MXN, there is a surplus of pesos, placing downward pressure on the exchange rate. 30 100 CH1 36 . 11 CH 36 . 12 212:04 4 File Details SP22 ECON-201-1217 Pr... 5/4/2015 CHAPTER 35 Balance of Payments The Foreign Exchange Market International Flexible Exchange Rates Finance Fixed Exchange Rates ECONOMICS INTHISLECTURE The Current International Monetary System FOREIGN EXCHANGE MARKET KEY TERMS FOREIGN EXCHANGE MARKET . Trade Balance is the value of a country's . The market in which currencies of exports minus the value of its imports, different countries are exchanged. sometimes referred to as net exports "In a universe with a single currency, there would be no foreign exchange . Trade Surplus is the condition that exists market, no foreign exchange rates, no foreign exchange. when the value of a country's exports is But in our world of mainly national currencies, the foreign exchange greater than the value of its imports market plays the indispensable role of providing the essential eficit is the co machinery for making payments across borders, transferring funds and purchasing power from one currency to another, and determining that the value of a country's imports is greater singularly important price, the exchange rate." than the value of its exports All About.The Foreign Exchange Market in the United States - Federal Reserve Bank of NY CH38 + 3 FOREIGN EXCHANGE MARKET EXCHANGE RATE . The market in which currencies of . The Price of one currency in terms of different countries are exchanged. another currency. FEDERAL RESERVE BANK of NEW YORK To learn more about the foreign exchange market click the logo above