Principles of Economics - 3e Chapter 29 Exchange Rates and International Capital Flows

Exchange Rates and Int Capital Flows FIGURE Trade Around the World Is a trade between the United States and the European Union good or bad for the economy ?

Credit of US Dollar banknotes by Commons , Public CHAPTER OBJECTIVES In this chapter , you will learn about How the Foreign Exchange Market Works Demand and Supply Shifts in Foreign Exchange Markets Effects of Exchange Rates Exchange Rate Policies Introduction to Exchange Rates and International Capital Flows BRING IT HOME is a Stronger Dollar Good for the Economy ?

From 2002 to 2008 , the dollar lost more than a quarter of its value in foreign currency markets . On January , 2002 , one dollar was worth euros . On April 24 , 2008 it hit its lowest point with a dollar being worth euros . During this period , the trade between the United States and the European Union grew from a yearly total of approximately billion dollars in 2002 to billion dollars in 2008 . Was this a good thing or a bad thing for the economy ?

We live in a global world . consumers buy trillions of dollars worth of imported goods and services each year , not just from the European Union , but from all over the world . businesses sell trillions of dollars worth of exports . citizens , businesses , and governments invest trillions of dollars abroad every year . Foreign investors ,

696 29 Exchange Rates and International Capital Flows businesses , and governments invest trillions of dollars in the United States each year . Indeed , foreigners are a major buyer of federal debt . Many people feel that a weaker dollar is bad for America , that it an indication of a weak economy , but is it ?

This chapter will help answer that question . The world has over 150 different currencies , from the Afghanistan afghani and the Albanian lek all the way through the alphabet to the Zambian and the dollar . For international economic transactions , households or will wish to exchange one currency for another . Perhaps the need for exchanging currencies will come from a German that exports products to Russia , but then wishes to exchange the Russian rubles it has earned for euros , so that the can pay its workers and suppliers in Germany . Perhaps it will be a South African that wishes to purchase a mining operation in , but to make the purchase it must convert South African rand to . Perhaps it will be an American tourist visiting China , who wishes to convert dollars to Chinese yuan to pay the hotel bill . Exchange rates can sometimes change very swiftly . For example , in the United Kingdom the pound was worth about just before the nation voted to leave the European Union ( also known as the vote ) in June 2016 the pound fell to just after the vote and continued falling to reach lows a few months later . For engaged in international buying , selling , lending , and borrowing , these swings in exchange rates can have an enormous effect on . This chapter discusses the international dimension of money , which involves conversions from one currency to another at an exchange rate . An exchange rate is nothing more than a is , the price of one currency in terms of another so we can analyze it with the tools of supply and demand . The module of this chapter begins with an overview of foreign exchange markets their size , their main participants , and the vocabulary for discussing movements of exchange rates . The following module uses demand and supply graphs to analyze some of the main factors that cause shifts in exchange rates . A module then brings the central bank and monetary policy back into the picture . Each country must decide whether to allow the market to determine its exchange rate , or have the central bank intervene . All the choices for exchange rate policy involve distinctive and risks . How the Foreign Exchange Market Works LEARNING OBJECTIVES By the end of this section , you will be able to foreign exchange market Describe different types of investments like foreign direct investments ( portfolio investments , and hedging Explain how appreciating or depreciating currency affects exchange rates Identify who from a stronger currency and from a weaker currency Most countries have different currencies , but not all . Sometimes small economies use an economically larger neighbor currency . For example , Ecuador , El Salvador , and Panama have decided to is , to use the dollar as their currency . Sometimes nations share a common currency . A example of a common currency is the decision by 17 European some very large economies such as France , Germany , and replace their former currencies with the euro at the start of 1999 . With these exceptions , most of the international economy takes place in a situation of multiple national currencies in which both people and need to convert from one currency to another when selling , buying , hiring , borrowing , traveling , or investing across national borders . We call the market in which people or use one currency to purchase another currency the foreign exchange market . You have encountered the basic concept of exchange rates in earlier chapters . In The International and Capital Flows , for example , we discussed how economists use exchange rates to compare statistics from Access for free at

How the Foreign Exchange Market Works 697 countries where they measure in different currencies . These earlier examples , however , took the actual exchange rate as given , as if it were a fact of nature . In reality , the exchange rate is a price of one currency expressed in terms of units of another currency . The key framework for analyzing prices , whether in this course , any other economics course , in public policy , or business examples , is the operation of supply and demand in markets . LINK IT Visit this website for an exchange rate calculator . The Extraordinary Size of the Foreign Exchange Markets Ifyou travel to a foreign country that uses a different currency , you will undoubtedly need to make a trip to a bank or foreign currency to exchange whatever currency you re holding for that country currency . Even though this is a simple transaction , it is part ofa very large market . The quantities traded in foreign exchange markets are breathtaking . A 2019 Bank of International Settlements survey found that trillion per traded on foreign exchange markets , which makes the foreign exchange market the largest market in the world economy . In contrast , 2019 real was trillion . Your transaction is simple enough . Suppose you carry a 100 bill . You bring it into the foreign currency office and look up , and you see a bunch of different numbers on a digital board . For example , if you are traveling to Turkey , whose national currency is the Turkish Lira , one line of the board might read . DOLLARS BUY SELL This means that the office will give you Turkish Lira in exchange for dollar . Ifyou have 100 , the will give you 550 Turkish Lira . If you want to sell Turkish Lira for dollars , the will surely buy them from you , but not at the same exchange rate , since the will make some money on the exchange . So if you bring 550 Turkish Lira and ask for dollars , it will not give you 100 dollars , but instead about 95 . The important point is that this one transaction , when repeated all over the world for all sorts of different transactions , ends up totaling trillion worth of exchanges per day . Table shows the currencies most commonly traded on foreign exchange markets . The dollar dominates the foreign exchange market , being on one side of of all foreign exchange transactions . The dollar is followed by the euro , the British pound , the Australian dollar , and the Japanese yen . Currency Daily Share dollar Euro Japanese yen British pound Australian dollar TABLE Currencies Traded Most on Foreign Exchange Markets as of September , 2019 The Daily Share shows the percentage of transactions where the currency is on one side of the exchange . Source )

698 29 Exchange Rates and International Capital Flows Currency Daily Share Canadian dollar Swiss franc Chinese yuan TABLE Currencies Traded Most on Foreign Exchange Markets as of September , 2019 The Daily Share shows the percentage of transactions where the currency is on one side of the exchange . Source ) and Suppliers of Currency in Foreign Exchange Markets In foreign exchange markets , demand and supply become closely interrelated , because a person or who demands one currency must at the same time supply another vice versa . To get a sense of this , it is useful to consider four groups of people or who participate in the market ( that are involved in international trade of goods and services ( tourists visiting other countries ( international investors buying ownership ( or ) of a foreign ( international investors making investments that do not involve ownership . Let consider these categories in turn . Firms that buy and sell on international markets that their costs for workers , suppliers , and investors are measured in the currency of the nation where their production occurs , but their revenues from sales are measured in the currency of the different nation where their sales happened . Thus , a Chinese exporting abroad will earn some other , will need Chinese yuan to pay the workers , suppliers , and investors who are based in China . In the foreign exchange markets , this will be a supplier of dollars and a demander of Chinese yuan . International tourists will supply their home currency to receive the currency of the country they are visiting . For example , an American tourist who is visiting China will supply dollars into the foreign exchange market and demand Chinese yuan . We often divide investments that cross international boundaries , and require exchanging currency into two categories . Foreign direct investment ( refers to purchasing a ( at least ten percent ) in another country or starting up a new enterprise in a foreign country For example , in 2008 the Belgian beer brewing company bought the for 52 billion . To make this purchase , would have to supply euros ( the currency of Belgium ) to the foreign exchange market and demand dollars . The other kind of international investment , portfolio investment , involves a purely investment that does not entail any management responsibility . An example would be a investor who purchased government bonds , or deposited money in a British bank . To make such investments , the American investor would supply dollars in the foreign exchange market and demand British pounds . Business people often link portfolio investment to expectations about how exchange rates will shift . Look at a investor who is considering purchasing issued bonds . For simplicity , ignore any bond interest payment ( which will be small in the short run anyway ) and focus on exchange rates . Say that a British pound is currently worth in currency . However , the investor believes that in a month , the British Access for free at

How the Foreign Exchange Market Works pound will be worth in currency . Thus , as Figure ( a ) shows , this investor would change for British pounds . In a month , if the pound is worth , then the portfolio investor can trade back to dollars at the new exchange rate , and have nice . A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly . Say that an investor expects that the pound , now worth in US . currency , will decline to . Then , as ( shows , that investor could start off with in British currency ( borrowing the money if necessary ) convert it to in currency , wait a month , and then convert back to approximately in British making a nice . Ofcourse , this kind of investing comes without guarantees , and an investor will suffer losses if the exchange rates do not move as predicted . a ) An international investor who expects that . in the future , a British pound ( will buy in currency instead of its current exchange rate of may hope for the following chain of events to occur Now convert Exchange rate for back pound ( changes to from to earn a profit of . Take in currency convert it to in British currency . An international investor who expects that , in the future . a British pound ( will buy only 40 in currency instead of its current exchange rate of 50 may hope for the following chain of events to occur Now convert the back to approximately Take in British currency Exchange rate for and convert it to pound ( changes in from to currency . earn a profit of . FIGURE A Portfolio Investor Trying to Benefit from Exchange Rate Movements Expectations of a future value can drive its demand and supply in foreign exchange markets . Many portfolio investment decisions are not as simple as betting that the currency value will change in one direction or the other . Instead , they involve trying to protect themselves from movements in exchange rates . Imagine you are running a US . that is exporting to France . You have signed a contract to deliver certain products and will receive million euros a year from now . However , you do not know how much this contract will be worth in US . dollars , because the exchange rate can fluctuate in the next year . Lets say you want to know for sure what the contract will be worth , and not take a risk that the euro will be worth less in dollars than it currently is . You can hedge , which means using a transaction to protect yourself against a risk from one ofyour investments ( in this case , currency risk from the contract ) you can sign a contract and pay a fee that guarantees you a certain exchange rate one year from of what the market exchange rate is at that time . Now , it is possible that the euro will be worth more in dollars a year from now , so your hedging contract will be unnecessary , and you will have paid a fee for nothing . However , if the value of the euro in dollars declines , then you are protected by the hedge . When parties wish to enter contracts like hedging , they normally rely on a institution or brokerage company to handle the hedging . These companies either take a fee or create a spread in the exchange rate in order to earn money through the service they provide . Both foreign direct investment and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency . With portfolio investment , the client purchases less than ten percent of a company . As such , business players often get involved with portfolio investment with a short term focus . With foreign direct investment the investor purchases more than ten percent ofa company and the investor

700 29 Exchange Rates and International Capital Flows typically assumes some managerial responsibility . Thus , foreign direct investment tends to have a more run focus . As a practical matter , an investor can withdraw portfolio investments from a country much more quickly than foreign direct investments . A portfolio investor who wants to buy or sell government bonds can do so with a phone call or a few computer keyboard clicks . However , a that wants to buy or sell a company , such as one that manufactures automobile parts in the United Kingdom , will that planning and carrying out the transaction takes a few weeks , even months . Table summarizes the main categories of currency and suppliers . Demand for the Dollar Comes from Supply of the Dollar Comes from A exporting firm that earned foreign A foreign firm that has sold imported goods in the United States , currency and is trying to pay earned dollars , and is trying to pay expenses incurred in its expenses home country Foreign tourists visiting the United States tourists leaving to visit other countries Foreign investors who wish to make direct investors who want to make foreign direct investments in other investments in the economy countries Foreign investors who wish to make investors who want to make portfolio investments in other portfolio investments in the economy countries TABLE The Demand and Supply in Foreign Exchange Markets Participants in the Exchange Rate Market The foreign exchange market does not involve the ultimate suppliers and of foreign exchange literally seeking each other . If Martina decides to leave her home in Venezuela and take a trip in the United States , she does not need to a citizen who is planning to take a vacation in Venezuela and arrange a currency trade . Instead , the foreign exchange market works through institutions , and it operates on several levels . Most people and who are exchanging a substantial quantity of currency go to a bank , and most banks provide foreign exchange as a service to customers . These banks ( and a few other ) known as dealers , then trade the foreign exchange . This is called the interbank market . In the world economy , roughly are foreign exchange dealers . The economy has less than 100 foreign exchange dealers , but the largest 12 or so dealers carry out more than half the total transactions . The foreign exchange market has no central location , but the major dealers keep a close watch on each other at all times . The foreign exchange market is huge not because of the demands of tourists , or even foreign direct investment , but instead because of portfolio investment and the actions of interlocking foreign exchange dealers . International tourism is a very large industry , involving about trillion per year Global exports are about of global or about 19 trillion per year . Foreign direct investment totaled about 870 billion in the end of 2021 . These quantities are dwarfed , however , by the trillion per in foreign exchange markets . Most transactions in the foreign exchange market are for portfolio movements of capital between because of the large foreign exchange dealers actions as they constantly buy and sell with each other . Strengthening and Weakening Currency When the prices of most goods and services change , the price rises or falls . For exchange rates , the terminology is different . When the exchange rate for a currency rises , so that the currency exchanges for more Access for free at

How the Foreign Exchange Market Works 701 of other currencies , we refer to it as appreciating or When the exchange rate for a currency falls , so that a currency trades for less of other currencies , we refer to it as depreciating or weakening . To illustrate the use of these terms , consider the exchange rate between the dollar and the Canadian dollar since 1980 , in Figure ( a ) The vertical axis in Figure ( a ) shows the price of in currency , measured in terms of Canadian currency . Clearly , exchange rates can move up and down substantially . A US . dollar traded for Canadian in 1980 . The dollar appreciated or strengthened to Canadian in 1986 , or weakened to Canadian in 1991 , and then appreciated or strengthened to Canadian by early in 2002 , fell to roughly Canadian in 2009 , and then had a sharp spike up and decline in 2009 and 2010 . In August 2022 , the dollar stood at Canadian . The units in which we measure exchange rates can be confusing , because we measure the exchange rate of the dollar exchange using a different Canadian dollar . However , exchange rates always measure the price ofone unit of currency by using a different currency . 70 ( 40 , Canadian Dollars per Dollar 120 100 090 , I ( OZ ?

ID ) mi Year , dollar exchange rate dollars ( 0100 . 11 , 5010 , 050 ( 04 ( 83317001 ?

A COO Year dollar exchange rate dollars FIGURE Strengthen . Weaken or Depreciate Exchange rates tend to fluctuate substantially , even between bordering companies such as the United States and Canada . By looking closely at the time values ( the years vary slightly on these graphs ) it is clear that the values in part ( a ) are a mirror image of part ( which demonstrates that the depreciation of one currency correlates to the appreciation of the other and vice versa . This means that when comparing the exchange rates between two countries ( in this case , the United States and Canada ) the depreciation ( or weakening ) of one country ( the dollar for this example ) indicates the appreciation ( or

702 29 Exchange Rates and International Capital Flows strengthening ) of the other currency ( which in this example is the Canadian dollar ) Source Federal Reserve Economic Data ( FRED ) In looking at the exchange rate between two currencies , the appreciation or strengthening of one currency must mean the depreciation or weakening of the other . Figure ( shows the exchange rate for the Canadian dollar , measured in terms of US . dollars . The exchange rate of the US . dollar measured in Canadian dollars , in Figure ( a ) is a perfect mirror image with the Canadian dollar exchange rate measured in dollars , in Figure ( A fall in the Canada . ratio means a rise in the ratio , and vice versa . Click to View content ( books pages Canadian Dollars per Dollar . With the price of a typical good or service , it is clear that higher prices sellers and hurt buyers , while lower prices buyers and hurt sellers . In the case of exchange rates , where the buyers and sellers are not always intuitively obvious , it is useful to trace how a stronger or weaker currency will affect different market participants . Consider , for example , the impact of a stronger US . dollar on six different groups of economic actors , as Figure 294 shows ( US . exporters selling abroad ( foreign exporters ( that is , selling imports in the US . economy ) tourists abroad ( foreign tourists visiting the United States ( investors ( either foreign direct investment or portfolio investment ) considering opportunities in other countries ( and foreign investors considering opportunities in the US . economy . A Stronger Dollar Dollar A US . exporting firm firm exporting to the United States A tourist abroad A foreign tourist in the United States A US . investor abroad investor in the United States FIGURE How Do Exchange Rate Movements Affect Each Group ?

Exchange rate movements affect exporters , tourists , and international investors in different ways . For a selling abroad , a stronger dollar is a curse . A strong dollar means that foreign currencies are correspondingly weak . When this exporting earns foreign currencies through its export sales , and then converts them back to dollars to pay workers , suppliers , and investors , the stronger dollar means that the foreign currency buys fewer US . dollars than if the currency had not strengthened , and that the ( as measured in dollars ) fall . As a result , the may choose to reduce its exports , or it may raise its selling price , which will also tend to reduce its exports . In this way , a stronger currency reduces a exports . Conversely , for a foreign selling in the US . economy , a stronger dollar is a blessing . Each dollar earned through export sales , when traded back into the exporting home currency , will now buy more home currency than expected before the dollar had strengthened . As a result , the stronger dollar means that the Access for free at

How the Foreign Exchange Market Works 703 importing will earn higher than expected . The will seek to expand its sales in the US . economy , or it may reduce prices , which will also lead to expanded sales . In this way , a stronger dollar means that consumers will purchase more from foreign producers , expanding the country level of imports . For a tourist abroad , who is exchanging dollars for foreign currency as necessary , a stronger US . dollar is a . The tourist receives more foreign currency for each dollar , and consequently the cost of the trip in dollars is lower . When a country currency is strong , it is a good time for citizens of that country to tour abroad . Imagine a tourist who has saved up for a trip to South Africa . In February 2018 , bought South African rand , so the tourist had rand to spend . By 2018 , bought rand , which for the tourist translates to rand . For foreign visitors to the United States , the opposite pattern holds true . A relatively stronger dollar means that their own currencies are relatively weaker , so that as they shift from their own currency to US . dollars , they have fewer dollars than previously . When a currency is strong , it is not an especially good time for foreign tourists to visit . A stronger dollar injures the prospects ofa investor who has already invested money in another country . A investor abroad must convert US . dollars to a foreign currency , invest in a foreign country , and then later convert that foreign currency back to US . dollars . If in the meantime the US . dollar becomes stronger and the foreign currency becomes weaker , then when the investor converts back to US . dollars , the rate of return on that investment will be less than originally expected at the time it was made . However , a stronger dollar boosts the returns ofa foreign investor putting money into a investment . That foreign investor converts from the home currency to dollars and seeks a investment , while later planning to switch back to the home currency . If , in the meantime , the dollar grows stronger , then when the time comes to convert from US . dollars back to the foreign currency , the investor will receive more foreign currency than expected at the time the original investment was made . The preceding paragraphs all focus on the case where the dollar becomes stronger . The column in Figure illustrates the corresponding happy or unhappy economic reactions . The following Work It Out feature centers the analysis on the opposite a weaker dollar . Effects of a Weaker Dollar Let work through the effects of a weaker dollar on a exporter , a foreign exporter into the United States , a tourist going abroad , a foreign tourist coming to the United States , a investor abroad , and a foreign investor in the United States . Step . Note that the demand for exports is a function of the price of those exports , which depends on the dollar price of those goods and the exchange rate of the dollar in terms of foreign currency . For example , a Ford pickup truck costs in the United States . When it is sold in the United Kingdom , the price is per British pound , or . The dollar affects the price foreigners face who may purchase exports . Step . Consider that , if the dollar weakens , the pound rises in value . If the pound rises to per pound , then the price of a Ford pickup is now . A weaker dollar means the foreign currency buys more dollars , which means that exports appear less expensive . Step . Summarize that a weaker dollar leads to an increase in exports . For a foreign exporter , the outcome is just the opposite . Step . Suppose a brewery in England is interested in selling its Bass Ale to a grocery store in the United States . If the price of a six pack of Bass Ale is and the exchange rate is per British pound , the price for the grocery store is per six pack . If the dollar weakens to per pound , the price of Bass Ale is now 12 .

704 29 Exchange Rates and International Capital Flows Step . Summarize that , from the perspective of purchasers , a weaker dollar means that foreign currency is more expensive , which means that foreign goods are more expensive also . This leads to a decrease in imports , which is bad forthe foreign exporter . Step . Consider tourists going abroad . They face the same situation as a are purchasing a foreign trip . A weaker dollar means that their trip will cost more , since a given expenditure of foreign currency ( hotel bill ) will take more dollars . The result is that the tourist may not stay as long abroad , and some may choose not to travel at all . Step . forthe foreign tourist to the United States , a weaker dollar is a boon . It means their currency goes further , so the cost of a trip to the United States will be less . Foreigners may choose to take longer trips to the United States , and more foreign tourists may decide to take trips . Step . Note that a investor abroad faces the same situation as a are purchasing a foreign asset . A investor will see a weaker dollar as an increase in the price of investment , since the same number of dollars will buy less foreign currency and thus less foreign assets . This should decrease the amount of investment abroad . Step . Note also that foreign investors in the Unites States will have the opposite experience . Since foreign currency buys more dollars , they will likely invest in more assets . At this point , you should have a good sense of the major players in the foreign exchange market involved in international trade , tourists , international investors , banks , and foreign exchange dealers . The next module shows how players can use the tools of demand and supply in foreign exchange markets to explain the underlying causes of stronger and weaker currencies ( we address stronger and weaker more in the following Clear It Up feature ) CLEAR IT UP Why is a stronger currency not necessarily better ?

One common misunderstanding about exchange rates is that a stronger or appreciating currency must be better than a weaker or depreciating currency . After all , is it not obvious that strong is better than weak ?

Do not let the terminology confuse you . When a currency becomes stronger , so that it purchases more of other currencies , it benefits some in the economy and injures others . Stronger currency is not necessarily better , it is just different . Demand and Supply Shifts in Foreign Exchange Markets LEARNING OBJECTIVES By the end of this section , you will be able to Explain supply and demand for exchange rates arbitrage Explain purchasing power parity importance when comparing countries . The foreign exchange market involves firms , households , and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers . Figure ( a ) offers an example for the exchange rate between the dollar and the Mexican peso . The vertical axis shows the exchange rate for dollars , which in this case is measured in pesos . The horizontal axis shows the quantity of dollars traded in the foreign exchange market each day . The demand curve ( for dollars intersects with the supply curve ( of dollars at the equilibrium point ( which is an exchange rate of 10 pesos per dollar and a total volume of billion . Access for free at

Demand and Supply Shifts in Foreign Exchange Markets 705 . 25 in Fe ' 35 a . 50 70 BO 90 Quantity of Dollars Quantity of Pesos Traded Traded lor Pesos ( billions ) for Dollars ( billions ) in ?

i ) FIGURE Demand and Supply for the Dollar and Mexican Peso Exchange Rate ( a ) The quantity measured on the horizontal axis is in dollars , and the exchange rate on the vertical axis is the price of dollars measured in Mexican pesos . The quantity measured on the horizontal axis is in Mexican pesos , while the price on the vertical axis is the price of pesos measured in collars . In both graphs , the equilibrium exchange rate occurs at point , at the intersection of the demand curve ( and the supply curve ( Figure ( presents the same demand and information from the perspective of the Mexican peso . The vertical axis shows the exchange rate for Mexican pesos , which is measured in dollars . The horizontal axis shows the quantity of Mexican pesos traded in tie foreign exchange market . The demand curve ( for Mexican pesos intersects with the supply curve ( Mexican pesos at the equilibrium point ( which is an exchange rate of 10 cents in US . currency for each Mexican peso and a total volume of 85 billion pesos . Note that the two exchange rates are 10 pesos per dollar is the same as 10 cents per peso ( or per peso ) In the actual foreign exchange market , almost all of the trading for Mexican pesos is for US . dollars . What factors would cause the demand or supply to lift , thus leading to a change in the equilibrium exchange rate ?

We discuss the answer to this question in the following section . Expectations about Future Exchange Rates One reason to demand a currency on the foreign market is the belief that the currency value is about to increase . One reason to supply a is , sell it on the foreign exchange the expectation that the currency value is about to decline . For example , imagine that a leading business newspaper , like the the Financial Times , runs an article predicting that the Mexican peso will appreciate in value . Figure illustrates the likely effects of such an article . Demand for the Mexican peso shifts to the right , from Do to , as investors become eager to purchase pesos . Conversely , the supply of pesos shifts to the left , from to , because investors will be less willing to give them up . The result is that the equilibrium exchange rate rises from 10 to 12 and the equilibrium exchange rate rises from 85 billion to 90 billion pesos as the equilibrium moves from to .

706 29 Exchange Rates and International Capital Flows Dollars per Peso I I ' II , I ' Billions of Pesos Traded for . Dollars FIGURE Exchange Rate Market for Mexican Peso Reacts to Expectations about Future Exchange Rates An announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso in the present from investors who wish to from the appreciation . Similarly , it will make investors less likely to supply pesos to the foreign exchange market . Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate . Figure also illustrates some peculiar traits of supply and demand diagrams in the foreign exchange market . In contrast to all the other cases of supply and demand you have considered , in the foreign exchange market , supply and demand typically both move at the same time . Groups in the foreign exchange market like and investors include some who are buyers and some who are sellers . An expectation ofa future shift in the exchange rate affects both buyers and is , it affects both demand and supply for a currency . The shifts in demand and supply curves both cause the exchange rate to shift in the same direction . In this example , they both make the peso exchange rate stronger . However , the shifts in demand and supply work in opposing directions on the quantity traded . In this example , the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall . In this example , the result is a higher quantity . However , in other cases , the result could be that quantity remains unchanged or declines . This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months . When investors expect a country currency to strengthen in the future , they buy the currency and cause it to appreciate immediately . The currency appreciation can lead other investors to believe that future appreciation is thus lead to even further appreciation . Similarly , a fear that a currency quickly leads to an actual weakening of the currency , which often reinforces the belief that the currency will weaken further . Thus , beliefs about the future path of exchange rates can be self reinforcing , at least for a time , and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next . Differences across Countries in Rates of Return The motivation for investment , whether domestic or foreign , is to earn a return . If rates of return in a country look relatively high , then that country will tend to attract funds from abroad . Conversely , if rates of return in a country look relatively low , then funds will tend to to other economies . Changes in the expected rate of return will shift demand and supply for a currency . For example , imagine that interest rates rise in the United States as compared with Mexico . Thus , investments in the United States promise a higher return than previously . As a result , more investors will demand dollars so that they can buy assets and fewer investors will be willing to supply dollars to foreign exchange markets . Demand for the dollar will shift to the right , from Do to , and supply will shift to the left , from to , as Figure shows . The new equilibrium ( will occur at an exchange rate of nine and the same quantity of billion . Thus , a higher interest rate or rate of return relative to other countries leads a nation currency to appreciate or strengthen , and a lower interest rate relative to other countries leads a nation currency to Access for free at

Demand and Supply Shifts in Foreign Exchange Markets 707 depreciate or weaken . Since a nation central bank can use monetary policy to affect its interest rates , a central bank can also cause changes in exchange connection that we will discuss in more detail later in this chapter . I Pesos per Dollar I ?

I ' 65 ' BO 85 95 Billions of Dollars Traded FIGURE Exchange Rate Market for . Dollars Reacts to Higher Interest Rates A higher rate of return for dollars makes holding dollars more attractive . Thus , the demand for dollars in the foreign exchange market shifts to the right , from Do to , while the supply of dollars shifts to the left , from to . The new equilibrium ( has a stronger exchange rate than the original equilibrium ( but in this example , the equilibrium quantity traded does not change . Relative Inflation If a country experiences a relatively high rate compared with other economies , then the buying power of its currency is eroding , which will tend to discourage anyone from wanting to acquire or to hold the currency . Figure shows an example based on an actual episode concerning the Mexican peso . In , Mexico experienced an rate of over 200 . Not surprisingly , as dramatically decreased the peso purchasing power in Mexico . The peso exchange rate value declined as well . Figure shows that the demand for the peso on foreign exchange markets decreased from Do to , while the peso supply increased from to . The equilibrium exchange rate fell from per peso at the original equilibrium ( to per peso at the new equilibrium ( In this example , the quantity of pesos traded on foreign exchange markets remained the same , even as the exchange rate shifted . Exchange Rate of Peso Measured in 10 20 30 40 50 60 70 80 Quantity of Pesos Traded on Foreign Exchange markets FIGURE Exchange Rate Markets React to Higher Inflation If a currency is experiencing relatively high inflation , then its buying power is decreasing and international investors will be less eager to hold it . Thus , a rise in inflation in the Mexican peso would lead demand to shift from Do to , and supply to increase from So to 51 . Both movements

708 29 Exchange Rates and International Capital Flows in demand and supply would cause the currency to depreciate . Here , we draw no effect on the quantity traded , but in truth it could be an increase or a decrease , depending on the actual movements of demand and supply . LINK IT UP Visit this website to learn about the Big Mac index . Purchasing Power Parity Over the long term , exchange rates must bear some relationship to the currency buying power in terms of internationally traded goods . If at a certain exchange rate it was much cheaper to buy internationally traded as oil , steel , computers , and one country than in another country , businesses would start buying in the cheap country , selling in other countries , and pocketing the . For example , if a dollar is worth in Canadian currency , then a car that sells for in the United States should sell for in Canada . If the price of cars in Canada were much lower than , then at least some would convert their dollars to Canadian dollars and buy their cars in Canada . If the price of cars were much higher than in this example , then at least some Canadian buyers would convert their Canadian dollars to dollars and go to the United States to purchase their cars . This is known as arbitrage , the process of buying and selling goods or currencies across international borders at a profit . It may occur slowly , but over time , it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries . We call the exchange rate that the prices of internationally traded goods across countries the purchasing power parity ( exchange rate . A group of economists at the International Comparison Program , run by the World Bank , have calculated the exchange rate for all countries , based on detailed studies of the prices and quantities of internationally tradable goods . The purchasing power parity exchange rate has two functions . First , economists often use exchange rates for international comparison of and other economic statistics . Imagine that you are preparing a table showing the size of in many countries in several recent years , and for ease of comparison , you are converting all the values into dollars . When you insert the Value for Japan , you need to use a exchange rate . However , should you use the market exchange rate or the exchange rate ?

Market exchange rates bounce around . In 2014 , the exchange rate was 105 , but in late 2015 the dollar exchange rate versus the yen was 121 . For simplicity , say that Japan was trillion in both 2014 and 2015 . If you use the market exchange rates , then Japan will be trillion in 2014 ( that is , trillion ( and trillion in 2015 ( that is , trillion ( The misleading appearance of a changing Japanese economy occurs only because we used the market exchange rate , which often has rises and falls . However , exchange rates stay fairly constant and change only modestly , if at all , from year to year . The second function is that exchanges rates will often get closer to it as time passes . It is true that in the short and medium run , as exchange rates adjust to relative rates , rates of return , and to expectations about how interest rates and will shift , the exchange rates will often move away from the exchange rate for a time . However , knowing the will allow you to track and predict exchange rate relationships . Effects of Exchange Rates LEARNING OBJECTIVES By the end of this section you will be able to Explain how exchange rate shifting aggregate demand and supply Explain how shifting exchange rates also can loans and banks Access for free at

Effects of Exchange Rates 709 A central bank will be concerned about the exchange rate for multiple reasons ( Movements in the exchange rate will affect the quantity of aggregate demand in an economy ( frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation banking may contribute to an unsustainable balance of trade and large of international capital , which can set up the economy for a deep recession if international investors decide to move their money to another country . Let discuss these scenarios in turn . Exchange Rates , Aggregate Demand , and Aggregate Supply Foreign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency . As a result , movements in exchange rates can have a powerful effect on incentives to export and import , and thus on aggregate demand in the economy as a whole . For example , in 1999 , when the euro first became a currency , its value measured in currency was euro , which dropped to a low of about in 2000 . By the end of 2013 , the euro had risen ( and the dollar had correspondingly weakened ) to . However , by the beginning of 2021 , the exchange rate was down to . Consider the situation ofa French that each year incurs million in costs , and sells its products in the United States for 10 million . At a time in 1999 , when this converted 10 million back to euros at the exchange rate of ( that is , 10 million ) it received million , and suffered a loss . In 2013 , when this same converted 10 million back to euros at the exchange rate of ( that is , 10 million ) it received approximately million and an even larger loss . In the beginning of 2021 , with the exchange rate back at the would suffer a loss once again . This example shows how a stronger euro discourages exports by the French , because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country . From the point of view of the economy , the example also shows how a weaker dollar encourages exports . Since an increase in exports results in more dollars into the economy , and an increase in imports means more dollars are out , it is easy to conclude that exports are good for the economy and imports are bad , but this overlooks the role of exchange rates . If an American consumer buys a Japanese car for instead of an American car for , it may be tempting to argue that the American economy has lost out . However , the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories . Whoever buys those dollars will have to use them to purchase American goods and services , so the money comes right back into the American economy . At the same time , the consumer saves money by buying a less expensive import , and can use the extra money for other purposes . Fluctuations in Exchange Rates Exchange rates can a great deal in the short run . As yet one more example , the Indian rupee moved from 39 in February 2008 to 51 in March 2009 , a decline of more than in the value of the rupee on foreign exchange markets . Figure earlier showed that even two economically developed neighboring economies like the United States and Canada can see movements in exchange rates over a few years . For that depend on export sales , or that rely on imported inputs to production , or even purely domestic that compete with tied into international in many countries adds up to half or more of a nation movements in exchange rates can lead to dramatic changes in and losses . A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate , where can focus on productivity and innovation , not on reacting to exchange rate . One of the most economically destructive effects of exchange rate can happen through the banking system . Financial institutions measure most international loans are measured in a few large currencies , like dollars , European euros , and Japanese yen . In countries that do not use these currencies , banks often borrow funds in the currencies of other countries , like dollars , but then lend in their own

710 29 Exchange Rates and International Capital Flows domestic currency . The chain of events in Figure 299 shows how this pattern of international borrowing can work . A bank in Thailand borrows one million in US . dollars . Then the bank converts the dollars to its domestic the case of Thailand , the currency is the a rate . The bank then lends the baht to a in Thailand . The business repays the loan in baht , and the bank converts it back to US . dollars to pay off its original US . dollar loan . Bank borrows million in dollars and agree to pay interest . Bank converts to Thai baht at an exchange rate , making 40 million baht . Bank lends 40 million baht at interest . After one year , loan IS repaid with interest , so bank receives 42 million baht Bank converts baht back to dollars at Bank converts baht back to dollars , but exchange rate , making now the exchange rate is 50 , million . so the bank has only . Bank repays million , plus Bank repays million , plus interest , which is million . interest . which is million . Bank has over to cover expenses and . Bank faces a loss of . FIGURE International Borrowing The scenario of international borrowing that ends on the left is a success story , but the scenario that ends on the right shows what happens when the exchange rate weakens . This process of borrowing in a foreign currency and lending in a domestic currency can , as long as the exchange rate does not shift . In the scenario outlined , if the dollar strengthens and the baht weakens , a problem arises . The chain of events in Figure illustrates what happens when the baht unexpectedly weakens from 40 to 50 . The Thai still repays the loan in full to the bank . However , because of the shift in the exchange rate , the bank can not repay its loan in dollars . Of course , if the exchange rate had changed in the other direction , making the Thai currency stronger , the bank could have realized an unexpectedly large . In , countries across eastern Asia , like Thailand , Korea , Malaysia , and Indonesia , experienced a sharp depreciation of their currencies , in some cases 50 or more . These countries had been experiencing substantial of foreign investment capital , with bank lending increasing by 20 to 30 per year through the . When their exchange rates , the banking systems in these countries were bankrupt . Argentina experienced a similar chain of events in 2002 . When the Argentine peso , Access for free at

Exchange Rate Policies 711 Argentina banks found themselves unable to pay back what they had borrowed in dollars . Banks play a vital role in any economy in facilitating transactions and in making loans to and consumers . When most of a country largest banks become bankrupt simultaneously , a sharp decline in aggregate demand and a deep recession results . Since the main responsibilities of a central bank are to control the money supply and to ensure that the banking system is stable , a central bank must be concerned about whether large and unexpected exchange rate depreciation will drive most of the country existing banks into bankruptcy . For more on this concern , return to the chapter on The International Trade and Capital Flows . Summing Up Public Policy and Exchange Rates Every nation would prefer a stable exchange rate to facilitate international trade and reduce the degree of risk and uncertainty in the economy . However , a nation may sometimes want a weaker exchange rate to stimulate aggregate demand and reduce a recession , or a stronger exchange rate to . The country must also be concerned that rapid movements from a weak to a strong exchange rate may hurt its export industries , while rapid movements from a strong to a weak exchange rate can hurt its banking sector . In short , every choice of an exchange it should be stronger or weaker , or or potential . Exchange Rate Policies LEARNING OBJECTIVES By the end of this section , you will be able to Differentiate among a exchange rate , a soft peg , a hard peg , and a merged currency Identify the that come with a exchange rate , a soft peg , a hard peg , and a merged currency Exchange rate policies come in a range of different forms listed in Figure 2910 let the foreign exchange market determine the exchange rate let the market set the value of the exchange rate most of the time , but have the central bank sometimes intervene to prevent fluctuations that seem too large have the central bank guarantee a exchange rate or share a currency with other countries . Let discuss each type of exchange rate policy and its . Floating Soft exchange Hard exchange Merging exchange rates rate pegs rate pegs currencies Completely The market usually Central bank The currency determined determines the intervenes in is made identical by market exchange rate but market to keep to currency of forces central bank currency fixed another nation sometimes at a certain level intervenes FIGURE A Spectrum of Exchange Rate Policies A nation may adopt one of a variety of exchange rate regimes , from floating rates in which the foreign exchange market determines the rates to pegged rates where governments intervene to manage the exchange rate value , to a common currency where the nation adopts another country or group of countries currency . Floating Exchange Rates We refer to a policy which allows the foreign exchange market to set exchange rates as a exchange rate . The US . dollar is a exchange rate , as are the currencies of about 40 of the countries in the world economy . The major concern with this policy is that exchange rates can move a great deal in a short time . Consider the US . exchange rate expressed in terms of another fairly stable currency , the Japanese yen , as Figure 2911 shows . On January , 2002 , the exchange rate was 133 . On January , 2005 , it was 103 . On June , 2007 , it was 122 , on January , 2012 , it was 77 yen per dollar , and on March , 2015 , it was 120 yen per dollar . Since 2015 , it has dropped again by the end of December 2020 , the exchange

712 29 Exchange Rates and International Capital Flows rate stood at 103 yen per dollar . As investor sentiment swings back and forth , driving exchange rates up and down , exporters , importers , and banks involved in international lending are all affected . At worst , large movements in exchange rates can drive companies into bankruptcy or trigger a nationwide banking collapse . However , even in the moderate case of the exchange rate , these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account . Especially in smaller countries where international trade is a relatively large share of , exchange rate movements can rattle their economies . li , lU iii Japanese Yen per Dollar A ! Year FIGURE Dollar Exchange Rate in Japanese Yen Even seemingly stable exchange rates such as the Japanese Yen to the Dollar can vary when closely examined over time . This shows a relatively stable rate between 2011 and 2013 . In 2013 , there was a drastic depreciation of the Yen ( relative to the Dollar ) by about 14 and again at the end of the year in 2014 also by about 14 . Since then , between 2016 and 2020 there was an appreciation of about 13 from 118 yen per dollar to 103 yen per dollar . Source Federal Reserve Economic Data ( FRED ) However , movements of exchange rates have advantages , too . After all , prices of goods and services rise and fall throughout a market economy , as demand and supply shift . If an economy experiences strong or of international capital , or has relatively high , or if it experiences strong productivity growth so that purchasing power changes relative to other economies , then it makes economic sense for the exchange rate to shift as well . Floating exchange rate advocates often argue that if government policies were more predictable and stable , then rates and interest rates would be more predictable and stable . Exchange rates would bounce around less , too . The economist Milton ( for example , wrote a defense of exchange rates in 1962 in his book Capitalism and Freedom Being in favor of exchange rates does not mean being in favor of unstable exchange rates . When we support a free price system for goods and services at home , this does not imply that we favor a system in which prices fluctuate wildly up and down . What we want is a system in which prices are free to but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges . This is equally true in a system of exchange rates . The ultimate objective is a world in which exchange rates , while free to vary , are , in fact , highly stable because basic economic policies and conditions are stable . Advocates of exchange rates admit that , yes , exchange rates may sometimes . They point out , however , that ifa central bank focuses on preventing either high or deep recession , with low and reasonably steady interest rates , then exchange rates will have less reason to vary . Access for free at

Exchange Rate Policies Using Soft Pegs and Hard Pegs When a government intervenes in the foreign exchange market so that the currency exchange rate is different from what the market would have produced , it establishes a peg for its currency . A soft peg is the name for an exchange rate policy where the government usually allows the market to set exchange rate , but in some cases , especially if the exchange rate seems to be moving rapidly in one direction , the central bank will intervene in the market . With a hard peg exchange rate policy , the central bank sets a and unchanging value for the exchange rate . A central bank can implement soft peg and hard peg policies . Suppose the market exchange rate for the Brazilian currency , the real , would be 35 with a daily quantity of 15 billion real traded in the market , as the equilibrium in Figure 2912 ( a ) and Figure 2912 ( show . However , Brazil government decides that the exchange rate should be 30 , as Figure ( a ) shows . Perhaps Brazil sets this lower exchange rate to its export industries . Perhaps it is an attempt to stimulate aggregate demand by stimulating exports . Perhaps believes that the current market exchange rate is higher than the purchasing power parity value of the real , so it is minimizing in the real by keeping it at this lower rate . Perhaps the government set the target exchange rate sometime in the past , and it is now maintaining it for the sake of stability . Whatever the reason , if Brazil central bank wishes to keep the exchange rate below the market level , it must face the rea ity that at this weaker exchange rate of 30 , the quantity demanded of its currency at 17 billion reals is greater than the quantity supplied of 13 billion reals in the foreign exchange market . 20 20 11 13 15 17 11 1314151617 Os Billions of Reals Traded for Dollars ( Pegging an exchange rate above equilibrium Billions of Reals Traded for Dollars ( a ) Pegging an exchange rate below equilibrium FIGURE Pegging an Exchange Rate ( a ) If an exchange rate is pegged below what would otherwise be the equilibrium , then the currency quantity demanded will exceed the quantity supplied . If an exchange rate is pegged above what would otherwise be the equilibrium , then the currency quantity supplied exceeds the quantity demanded . The Brazilian central bank could weaken its exchange rate in two ways . One approach is to use an expansionary monetary policy that leads to lower interest rates . In foreign exchange markets , the lower interest rates will reduce demand and increase supply of the real and lead to depreciation . Central banks do not use this technique often because lowering interest rates to weaken the currency may be in with the country monetary policy goals . Alternatively , Brazil central bank could trade directly in the foreign exchange market . The central bank can expand the money supply by creating reals , use the reals to purchase foreign currencies , and avoid selling any of its own currency . In this way , it can the gap between quantity demanded and quantity supplied of its currency . Figure 2912 ( shows the opposite situation . Here , the Brazilian government desires a stronger exchange rate of 40 than the market rate of 35 . Perhaps Brazil desires the stronger currency to reduce aggregate demand and to , or perhaps Brazil believes that that current market exchange rate is 713

714 29 Exchange Rates and International Capital Flows temporarily lower than the rate . Whatever the reason , at the higher desired exchange rate , the quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals . Brazil central bank can use a monetary policy to raise interest rates , which will increase demand and reduce currency supply on foreign exchange markets , and lead to an appreciation . Alternatively , Brazil central bank can trade directly in the foreign exchange market . In this case , with an excess supply of its own currency in foreign exchange markets , the central bank must use reserves of foreign currency , like dollars , to demand its own currency and thus cause an appreciation of its exchange rate . Both a soft peg and a hard peg policy require that the central bank intervene in the foreign exchange market . However , a hard peg policy attempts to preserve a exchange rate at all times . A soft peg policy typically allows the exchange rate to move up and down by relatively small amounts in the short run of several months or a year , and to move by larger amounts over time , but seeks to avoid extreme . of Soft Pegs and Hard Pegs When a country decides to alter the market exchange rate , it faces a number of . If it uses monetary policy to alter the exchange rate , it then can not at the same time use monetary policy to address issues of or recession . Ifit uses direct purchases and sales of foreign currencies in exchange rates , then it must face the issue of how it will handle its reserves of foreign currency . Finally , a pegged exchange rate can even create additional movements of the exchange rate . For example , even the possibility of government intervention in exchange rate markets will lead to rumors about whether and when the government will intervene , and dealers in the foreign exchange market will react to those rumors . Let consider these issues in turn . One concern with pegged exchange rate policies is that they imply a country monetary policy is no longer focused on controlling or shortening , but now must also take the exchange rate into account . For example , when a country pegs its exchange rate , it will sometimes face economic situations where it would like to have an expansionary monetary policy to it can not do so because that policy would depreciate its exchange rate and break its hard peg . With a soft peg exchange rate policy , the central bank can sometimes ignore the exchange rate and focus on domestic or in other cases the central bank may ignore or recession and instead focus on its soft peg exchange rate . With a hard peg policy , domestic monetary policy is effectively no longer determined by domestic or unemployment , but only by what monetary policy is needed to keep the exchange rate at the hard peg . Another issue arises when a central bank intervenes directly in the exchange rate market . Ifa central bank ends up in a situation where it is perpetually creating and selling its own currency on foreign exchange markets , it will be buying the currency of other countries , like dollars or euros , to hold as reserves . Holding large reserves of other currencies has an opportunity cost , and central banks will not wish to boost such reserves without limit . In addition , a central bank that causes a large increase in the supply of money is also risking an surge in aggregate demand . Conversely , when a central bank wishes to buy its own currency , it can do so by using its reserves of international currency like the dollar or the euro . However , if the central bank runs out of such reserves , it can no longer use this method to strengthen its currency . Thus , buying foreign currencies in exchange rate markets can be expensive and , while selling foreign currencies can work only until a central bank runs out of reserves . Yet another issue is that when a government pegs its exchange rate , it may unintentionally create another reason for additional . With a soft peg policy , foreign exchange dealers and international investors react to every rumor about how or when the central bank is likely to intervene to the exchange rate , and as they react to rumors the exchange rate will shift up and down . Thus , even though the goal of a soft peg policy is to reduce of the exchange rate , the existence of the anticipated in the foreign exchange sometimes increase as international investors Access for free at

Exchange Rate Policies 715 try to anticipate how and when the central bank will act . The following Clear It Up feature discusses the effects of international capital that across national boundaries as either portfolio investment or direct investment . CLEAR IT UP How do taxes control the flow of capital ?

Some countries like Chile and Malaysia have sought to reduce movements in exchange rates by limiting international capital and . The government can enact this policy either through targeted taxes or by regulations . Taxes on international capital flows are sometimes known as taxes , named after James , the 1981 Nobel laureate in economics who proposed such a tax in a 1972 lecture . For example , a government might tax all foreign exchange transactions , or attempt to tax portfolio investment while exempting foreign direct investment . Countries can also use regulation to forbid certain kinds of foreign investment in the first place or to make it difficult for international financial investors to withdraw their funds from a country . The goal of such policies is to reduce international capital flows , especially portfolio flows , in the hope that doing so will reduce the chance of large movements in exchange rates that can bring disaster . However , proposals to limit international financial flows have severe practical difficulties . National governments impose taxes , not international ones . If one government imposes a tax on exchange rate transactions carried out within its territory , a firm based someplace like the Grand Caymans , an island nation in the Caribbean known for allowing some wheeling and dealing might easily operate the exchange rate market . In an interconnected global economy , if goods and services are allowed to flow across national borders , then payments need to flow across borders , too . It is very fact close to a nation to allow only the flows of payments that relate to goods and services , while clamping down or taxing other flows of financial capital . If a nation participates in international trade , it must also participate in international capital movements . Finally , countries all over the world , especially countries , are crying out for foreign investment to help develop their economies . Policies that discourage international investment may prevent some possible harm , but they rule out potentially substantial economic as well . A hard peg exchange rate policy will not allow fluctuations in the exchange rate . If the government announces a hard peg and then later changes its the government becomes unwilling to keep interest rates high or to hold high levels of foreign exchange the result of abandoning a hard peg could be a dramatic shift in the exchange rate . In the , about of the countries in the world used a soft peg approach and about one quarter used a hard peg approach . The general trend in the was to shift away from a soft peg approach in favor of either rates or a hard peg . The concern is that a successful soft peg policy may , for a time , lead to very little variation in exchange rates , so that and banks in the economy begin to act as ifa hard peg exists . When the exchange rate does move , the effects are especially painful because and banks have not planned and hedged against a possible change . Thus , the argument went , it is better either to be clear that the exchange rate is always , or that it is , but choosing an soft peg option may end up being worst of all . A Merged Currency A approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency . A merged currency approach eliminates foreign exchange risk altogether . Just as no one worries about exchange rate movements when buying and selling between New York and California , Europeans know that the value of the euro will be the same in Germany and France and other

716 29 Exchange Rates and International Capital Flows European nations that have adopted the euro . a merged currency also poses problems . Like a hard peg , a merged currency means that a nation has given up altogether on domestic monetary policy , and instead has put its interest rate policies in other hands . When Ecuador uses the US . dollar as its currency , it has no voice in whether the Federal Reserve raises or owers interest rates . The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations . However , from the standpoint of , say , Portugal , there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a central bank would have made . The lines between these four different exchange rate policies can blend into each other . For example , a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will ook a great deal like a exchange rate . Conversely , a soft peg policy in which the government intervenes often to keep the exchange rate near a level will look a lot like a hard peg . A decision to merge currencies with another country is , in effect , a decision to have a permanently exchange rate with those countries , which is like a very hard exchange rate peg . Table summarizes the range of exchange rates choices , with their advantages and disadvantages . Floating Situation Exchange Soft Peg Hard Peg Rates Currency Oft , er , Maybe less in the short None , unless a Large fluctuations In considerable , run , but still large change In the None exchange rates ?

In the short . changes overtime rate erm Can not happen I Large fluctuations in Can often un al peg Can not Can often happen changes , In which exchange rates ?

happen case substantial volatility can occur None Some power , although , exchange . nation conflicts may arise Very little central Power of central bank to conduct rates make does not between exchange rate bank must keep monetary policy ?

monetary , have its policy and exchange rate fixed . own policy stronger currency Costs of fore 30 not need Hold moderate reserves No need hold that rise and fall over Hold large reserves to hold reserves ?

reserves time reserves Risk of ending up with an Ma end overtime exchange rate that causes a large Adjusts over the medium , either far above or Can not trade imbalance and very high Ad often term , If not the short below the market adust or of term I I eve capital ?

TABLE of Exchange Rate Policies Access for free at Exchange Rate Policies 717 Global would be easier if the whole world had one currency and one central bank . The exchange rates between different currencies complicate the picture . If markets solely set exchange rates , they substantially as portfolio investors try to anticipate tomorrow news . If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs , it gives up at least some of the power to use monetary policy to focus on domestic and , and it risks causing even greater in foreign exchange markets . There is no consensus among economists about which exchange rate policies are best , soft peg , hard peg , or merged currencies . The choice depends both on how well a nation central bank can implement a exchange rate policy and on how well a nation and banks can adapt to different exchange rate policies . A national economy that does a fairly good job at achieving the four main economic goals of growth , low , low unemployment , and a sustainable balance of trade will probably dojust most of the time with any exchange rate policy . Conversely , no exchange rate policy is likely to save an economy that consistently fails at achieving these goals . Alternatively , a merged currency applied across wide geographic and cultural areas carries with it its own set of problems , such as the ability for countries to conduct their own independent monetary policies . BRING IT HOME IS a Stronger Dollar Good for the Economy ?

The foreign exchange value of the dollar is a price and whether a higher price is good or bad depends on where you are standing sellers from higher prices and buyers are harmed . A stronger dollar is good for imports ( and people working for importers ) and investment abroad . It is also good for tourists going to other countries , since their dollar goes further . However , a stronger dollar is bad for exports ( and people working in export industries ) it is bad for foreign investment in the United States ( leading , for example , to higher interest rates ) and it is bad for foreign tourists ( as well as hotels , restaurants , and others in the tourist industry ) In short , whether the dollar is good or bad is a more complex question than you may have thought . The economic answer is it depends .

718 29 Key Terms Key Terms appreciating when a currency is worth more in terms of other currencies also called strengthening arbitrage the process of buying a good and selling goods across borders to take advantage of international price differences depreciating when a currency is worth less in terms of other currencies also called weakening a country that is not the United States uses the dollar as its currency exchange rate a country lets the exchange rate market determine its currency value foreign direct investment ( purchasing more than ten percent ofa or starting a new enterprise in another country foreign exchange market the market in which people use one currency to buy another currency hard peg an exchange rate policy in which the central bank sets a and unchanging value for the exchange rate hedge using a transaction as protection against risk international capital of capital across national boundaries either as portfolio investment or direct investment merged currency when a nation chooses to use another nation currency portfolio investment an investment in another country that is purely and does not involve any management responsibility purchasing power parity ( the exchange rate that the prices of internationally traded goods across countries soft peg an exchange rate policy in which the government usually allows the market to set the exchange rate , but in some cases , especially if the exchange rate seems to be moving rapidly in one direction , the central bank will intervene taxes see international capital Key Concepts and Summary How the Foreign Exchange Market Works In the foreign exchange market , people and exchange one currency to purchase another currency . The demand for dollars comes from those US . export seeking to convert their earnings in foreign currency back into US . dollars foreign tourists converting their earnings in a foreign currency back into dollars and foreign investors seeking to make investments in the US . economy . On the supply side of the foreign exchange market for the trading of US . dollars are foreign that have sold imports in the economy and are seeking to convert their earnings back to their home currency tourists abroad and investors seeking to make investments in foreign economies . When currency A can buy more of currency , then currency A has strengthened or appreciated relative to . When currency A can buy less of currency , then currency A has weakened or relative to . If currency A strengthens or appreciates relative to currency , then currency must necessarily weaken or depreciate with regard to currency A . A stronger currency those who are buying with that currency and injures those who are selling . A weaker currency injures those , like importers , who are buying with that currency and those who are selling with it , like exporters . Demand and Shifts in Foreign Exchange Markets In the extreme short run , ranging from a few minutes to a few weeks , speculators who are trying to invest in currencies that will grow stronger , and to sell currencies that will grow weaker exchange rates . Such speculation can create a prophecy , at least for a time , where an expected appreciation leads to a stronger currency and vice versa . In the relatively short run , differences in rates of return exchange rate markets . Countries with relatively high real rates of return ( for example , high interest rates ) will tend to experience stronger currencies as they attract money from abroad , while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies . Access for free at

29 Questions 719 In the medium run of a few months or a few years , rates exchange rate markets . Countries with relatively high will tend to experience less demand for their currency than countries with lower , and thus currency depreciation . Over long periods of many years , exchange rates tend to adjust toward the purchasing power parity ( rate , which is the exchange rate such that the prices of internationally tradable goods in different countries , when converted at the exchange rate to a common currency , are similar in all economies . Effects of Exchange Rates A central bank will be concerned about the exchange rate for several reasons . Exchange rates will affect imports and exports , and thus affect aggregate demand in the economy . Fluctuations in exchange rates may cause for many , but especially banks . The exchange rate may accompany unsustainable of international capital . Exchange Rate Policies In a exchange rate policy , a government determines its country exchange rate in the foreign exchange market . In a soft peg exchange rate policy , the foreign exchange market usually determines a country exchange rate , but the government sometimes intervenes to strengthen or weaken it . In a hard peg exchange rate policy , the government chooses an exchange rate . A central bank can intervene in exchange markets in two ways . It can raise or lower interest rates to make the currency stronger or weaker . It also can directly purchase or sell its currency in foreign exchange markets . All exchange rates policies face . A hard peg exchange rate policy will reduce exchange rate , but means that a country must focus its monetary policy on the exchange rate , not on recession or controlling . When a nation merges its currency with another nation , it gives up on nationally oriented monetary policy altogether . A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene . A exchange rate policy allows monetary policy to focus on and unemployment , and allows the exchange rate to change with and rates of return , but also raises a risk that exchange rates may sometimes make large and abrupt movements . The spectrum of exchange rate policies includes ( a ) a exchange rate , a pegged exchange rate , soft or hard , and ( a merged currency . Monetary policy can focus on a variety of goals ( a ) or unemployment , depending on which is the most dangerous obstacle and ( a rule based policy designed to keep the money supply stable and predictable . Questions . How will a stronger euro affect the following economic agents ?

a . A British exporter to Germany . A Dutch tourist visiting Chile . A Greek bank investing in a Canadian government bond . A French exporter to Germany . Suppose that political unrest in Egypt leads markets to anticipate a depreciation in the Egyptian pound . How will that affect the demand for pounds , supply of pounds , and exchange rate for pounds compared to , say , dollars ?

Suppose US . interest rates decline compared to the rest of the world . What would be the likely impact on the demand for dollars , supply , and exchange rate for dollars compared to , say , euros ?

Suppose Argentina gets under control and the Argentine rate decreases substantially . What would likely happen to the demand for Argentine pesos , the supply of Argentine pesos , and the dollar exchange rate ?

720 29 Review Questions This chapter has explained that one of the most economically destructive effects of exchange rate can happen through the banking system , borrow from abroad to lend domestically . Why is this less likely to be a problem for the banking system ?

A booming economy can attract capital , which promote further growth . However , capital can just as easily out of the country , leading to economic recession . Is a country whose economy is booming because it decided to stimulate consumer spending more or less likely to experience capital than an economy whose boom is caused by economic investment expenditure ?

How would a monetary policy affect the exchange rate , net exports , aggregate demand , and aggregate supply ?

A central bank can allow its currency to fall , but it can not allow its currency to rise . Why not ?

Is a country for which imports and exports comprise a large fraction of the more likely to adopt a exchange rate or a ( hard peg ) exchange rate ?

Review Questions 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . What is the foreign exchange market ?

Describe some buyers and some sellers in the market for dollars . What is the difference between foreign direct investment and portfolio investment ?

What does it mean to hedge a transaction ?

What does it mean to say that a currency appreciates ?

Becomes stronger ?

Becomes weaker ?

Does an expectation ofa stronger exchange rate in the future affect the exchange rate in the present ?

If so , how ?

Does a higher rate of return in a nation economy , all other things being equal , affect the exchange rate of its currency ?

how ?

Does a higher rate in an economy , other things being equal , affect the exchange rate of its currency ?

If so , how ?

What is the purchasing power parity exchange rate ?

What are some of the reasons a central bank is likely to care , at least to some extent , about the exchange rate ?

How can an unexpected fall in exchange rates injure the health of a nation banks ?

What is the difference between a exchange rate , a soft peg , a hard peg , and ?

List some advantages and disadvantages of the different exchange rate policies . Critical Thinking Questions 23 . 24 . 25 . Why would a nation is , adopt another country currency instead of having its own ?

Can you think of any major disadvantages to ?

How would a central bank work in a country that has ?

country currency is expected to appreciate in value , what would you think will be the impact of expected exchange rates on yields ( the interest rate paid on government bonds ) in that country ?

Hint . Think about how expected exchange rate changes and interest rates affect a currency demand and supply . Access for free at 26 . 27 . 28 . 29 . 30 . 31 . 29 Problems 721 Do you think that a country experiencing is more or less likely to have an exchange rate equal to its purchasing power parity value when compared to a country with a low rate ?

Suppose a country has an overall balance of trade so that exports of goods and services equal imports of goods and services . Does that imply that the country has balanced trade with each of its trading partners ?

We learned that changes in exchange rates and the corresponding changes in the balance of trade amplify monetary policy . From the perspective of a nation central bank , is this a good thing or a bad thing ?

If a developing country needs foreign capital , management expertise , and technology , how can it encourage foreign investors while at the same time protect itself against capital and banking system collapse , as happened during the Asian crisis ?

Many developing countries , like Mexico , have moderate to high rates of . At the same time , international trade plays an important role in their economies . What type of exchange rate regime would be best for such a country currency vis a Vis the US . dollar ?

What would make a country decide to change from a common currency , like the euro , back to its own currency ?

Problems 32 . A British pound cost in dollars in 2008 , but in US . dollars in 2017 . Was the pound weaker or stronger against the dollar ?

Did the dollar appreciate or depreciate versus the pound ?