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© Pilot Publishing Company Ltd. 2005
Contents:
• Definitions• Relation between domestic price and foreign
price • Exchange rate system• Changes in the demand for and supply of foreign c
urrency• Determinants of the equilibrium exchange rate• Automatic adjustment for BOP deficits under
different exchange rate systems
© Pilot Publishing Company Ltd. 2005
Contents:
• Government policies on eliminating BOP deficit under a fixed exchange rate system
• Comparison between flexible and fixed exchange rate systems
© Pilot Publishing Company Ltd. 2005
Definitions
Foreign exchange (fe) refers to foreign currency or claims on foreign currency such as cheques drawn in the currency
© Pilot Publishing Company Ltd. 2005
Exchange rate or exchange value of a foreign currency (e) is the price of the currency (in terms of another currency). Without specification of the currency, it is the amount of domestic currency required to exchange for a unit of foreign currency. Note: When e , exchange value of foreign currency rises while that of domestic currency drops.
Effective exchange rate index is the price index of exchange rates of the domestic currency. Note: When the index , the exchange value of the domestic currency rises.
© Pilot Publishing Company Ltd. 2005
Relation between domestic price and foreign price
Domestic price of a good is its price in domestic currency (Pd). Foreign price of a good is its price in foreign currency (Pf).
Pd = e Pf or Pf = Pd /e
© Pilot Publishing Company Ltd. 2005
The slopes of the demand curve for and the supply curve of foreign currency
The demand curve for foreign currency is downward sloping.
Imports: When e rises,
)( fd PeP )( fd PeP QmQm )( fmd PQQ )( fmd PQQ
© Pilot Publishing Company Ltd. 2005
The slope of the supply curve (S) of foreign currency depends on the price elasticity of foreign demand for the country’s exports (E).
1. If E is elastic S is upward sloping
2. If E is unitarily elastic S is vertical
3. If E is inelastic S is downward sloping
)eP
(P df
)eP
(P df
QxQx )Q(Q fxs P )Q(Q fxs PExports: when e rises
© Pilot Publishing Company Ltd. 2005
Exchange rate systems
An economic agent who demands foreign currency on the one hand supplies domestic currency on the other hand and vice versa.
Exchange between currencies
© Pilot Publishing Company Ltd. 2005
Price of foreign currency in domestic currency (or exchange rate)
Quantity of foreign currency
S
D
Equilibrium exchange rate
Equilibrium exchange rate
Demand for and supply of foreign currency
© Pilot Publishing Company Ltd. 2005
Price of domestic currency in foreign currency
Quantity of domestic currency
S
D
Equilibrium Equilibrium exchange rateexchange rateEquilibrium Equilibrium exchange rateexchange rate
Demand for and supply of domestic currency
© Pilot Publishing Company Ltd. 2005
Types of exchange rate systems
Flexible / Floating exchange rate system Demand for & supply of foreign currency
determines the market exchange rate
Fixed exchange rate systemThe monetary authority
fixes the official exchange rate
(at a pre-announced value)
© Pilot Publishing Company Ltd. 2005
Price of foreign currency in domestic currency (e)
Quantity of foreign currency
SS
DD
Equilibrium exchange rate
e*
Balance of payments under different exchange rate systems
Flexible exchange rate system
As Qd = Qs, the market BOP must always be balanced.
The equilibrium e* will finally be reached at which Qd = Qs
0
© Pilot Publishing Company Ltd. 2005
Price of foreign currency in domestic currency (or exchange rate )
Quantity of foreign currency
S
D
Equilibrium exchange rate
At e1, excess demand for foreign currency exists (the country suffers BOP deficit)
Fixed exchange rate system
e*
e1
Foreign currency is under-valued
At the pre-announced e, Qd may not equal Qs.
© Pilot Publishing Company Ltd. 2005
At e1, Excess demand for foreign currency
Central Bank / Monetary Authority has to
sell foreign currency for domestic currency ( reserve assets & domestic money supply )
Exchange rate maintained at e1
Fixed exchange rate system
© Pilot Publishing Company Ltd. 2005
Price of domestic currency in foreign currency
Quantity of domestic currency
S
D
Equilibrium exchange rate
Excess supply of domestic currency
Fixed exchange rate system
e*
e1^
Domestic currency is over-valued
An alternative expression
© Pilot Publishing Company Ltd. 2005
Terms describing changes in exchange rate
Under a flexible exchange rate system, a rise in the price of a foreign currency is described as an appreciation of the foreign currency or a depreciation of the domestic currency (as more units of domestic currency are needed to exchange for a unit of foreign currency).
Under a fixed exchange rate system, a rise in the price of a foreign currency is described as a revaluation of the foreign currency or a devaluation of the domestic currency.
© Pilot Publishing Company Ltd. 2005
S
D’
Exchange rate
Quantity of foreign currency
0D
Demand for foreign currency increases
e’
e
If e is flexible, e rises
If e is fixed, Qd > Qs, i.e., BOP deficit results
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
Supply of foreign currency decreases
S’
S
D
e’
e
If e is flexible, e rises
If e is fixed, Qd > Qs, i.e., BOP deficit results
© Pilot Publishing Company Ltd. 2005
Demand for foreign currency or supply of foreign currency
The equilibrium exchange rate
Conclusion
Flexible e system
Fixed e system
dc depreciates
BOP deficit
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
e’
e
D’
D
If e is flexible, e falls
If e is fixed, Qs > Qd, i.e., BOP surplus results
S
Demand for foreign currency decreases
© Pilot Publishing Company Ltd. 2005
Supply of foreign currency increases
Exchange rate
Quantity of foreign currency
0
S
DD
e’
e
If e is flexible, e falls
If e is fixed, Qs > Qd, i.e., BOP surplus results
S’
© Pilot Publishing Company Ltd. 2005
Demand for foreign currency or supply of foreign currency
The equilibrium exchange rate
Conclusion
Flexible e system
Fixed e system
dc appreciates
BOP surplus
© Pilot Publishing Company Ltd. 2005
Protectionist measures Spending on imports Spending on imports
Exchange rate
Quantity of foreign currency 00
e’
e
SS
D’
DD
Demand for fc
Demand for fc
Flexible e system: dc appreciates. Fixed e system:
BOP surplus.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
e
S
D
e’
S’
More domestic investment opportunities Outflow of capital
& inflow of capital Outflow of capital & inflow of capital
Demand for fc & supply of fc
Demand for fc & supply of fc
D’
Flexible e system: dc appreciates. Fixed e system:
BOP surplus.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
e
S
D
e’
D’
National income rises
Spending on imports
Spending on imports
National income National income
Demand for fc
Demand for fc
Flexible e system: dc depreciates. Fixed e system:
BOP deficit.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
e
S
D
e’
S’
Interest rate rises Outflow of capital & inflow of capital Outflow of capital & inflow of capital
Demand for fc & supply of fc
Demand for fc & supply of fc
D’
Flexible e system: dc appreciates. Fixed e system:
BOP surplus.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
e
S
D
e’
D’
Money Supply rises
r outflow of capital & inflow of capital
D & S
r outflow of capital & inflow of capital
D & S
Ms LM shifts rightward r & Y
Ms LM shifts rightward r & Y
Y Spending on imports D
Y Spending on imports D
Flexible e system: dc depreciates. Fixed e system:
BOP deficit.
S’
© Pilot Publishing Company Ltd. 2005
Inflation
Inflation rate of a country that of its trading partner
1. Competitiveness of import-competing products spending on imports1. Competitiveness of import-competing products spending on imports
Demand for fc
Demand for fc
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
00
e
S
DD
e’
D’
S’
2. Foreign prices of the country’s exports 2. Foreign prices of the country’s exports
Volume of exports & receipts from exports
Volume of exports & receipts from exports
Supply of fc Supply of fc
If foreign demand for the country’s exports is elastic
If foreign demand for the country’s exports is elastic
Flexible e system: dc depreciates. Fixed e system:
BOP deficit.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
e
S
D
e’
S’
Outflow of capital & inflow of capital Outflow of capital & inflow of capital
Demand for fc & supply of fc
Demand for fc & supply of fc
D’
Flexible e system: dc appreciates. Fixed e system:
BOP surplus.
Speculation upon the value of a currencyA bullish speculation upon the domestic currency
© Pilot Publishing Company Ltd. 2005
Automatic Adjustment for BOP Deficits under Different Exchange Rate Systems
© Pilot Publishing Company Ltd. 2005
Automatic adjustment for BOP deficits under different exchange rate systems
Under a flexible e system
BOP Deficit excess D for fc e
)( fd PeP )( fd PeP QmQmImports:
Exports:
)( fmd PQQ )( fmd PQQ
)eP
(P df
)eP
(P df
QxQx
)Q(Q fxs P )Q(Q fxs P
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
e’
e
S
D
Depreciation can improve the BOP deficit
Excess Demand
If foreign demand for the country’s exports is elastic
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 00
e’
e
S
DExcess Demand
Depreciation can improve the BOP deficit
If the demand for exports is unitarily elastic
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
e’
e
DS
If the demand for exports is inelastic and the M-L condition holds
Depreciation can improve the BOP deficit
Excess Demand
© Pilot Publishing Company Ltd. 2005
Marshall-Lerner condition (M-L condition):
The sum of the price elasticities of foreign demand for the country’s exports and the country’s demand for foreign imports is greater than one.
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
e
D S
Excess Demand
Depreciation cannot improve the BOP deficit and e rises persistently
If the demand for export is inelastic but the M-L condition does not hold
© Pilot Publishing Company Ltd. 2005
Under a fixed exchange rate system
r
Y00
IS
LM’
LM
YYY’
r’
r
Facing a BOP deficit
Central bank sells foreign currency for domestic currency
Central bank sells foreign currency for domestic currency
Ms Y & r
Ms Y & r
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 00
Fixed e
S’
D’
D
S
Y spending on imports D
Y spending on imports D
The process continues until deficit 0
r outflow of capital & inflow of capital
D & S
r outflow of capital & inflow of capital
D & S
© Pilot Publishing Company Ltd. 2005
Government Policies on Eliminating BOP Deficit under a Fixed Exchange Rate System
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency
0
Fixed e
D’D
SS
Protectionist policySpending on imports Spending on imports
Demand for fc
Demand for fc
External deficit
© Pilot Publishing Company Ltd. 2005
Quantity of foreign currency
00
Exchange rate S
DDD’
Fixed e
S’
An increase in interest rate Outflow of capital & inflow of capital Outflow of capital & inflow of capital
Demand for fc & supply of fc
Demand for fc & supply of fc
External deficit
© Pilot Publishing Company Ltd. 2005
Contractionary policy -- Prices are rigid
Quantity of foreign currency
00
Exchange rate
DD
SS
D’
Fixed e
Y spending on imports
Y spending on imports
Demand for fc
Demand for fc
External deficit
© Pilot Publishing Company Ltd. 2005
Exchange rate
Quantity of foreign currency 0
Original fixed e
D
S
Devaluation
New fixed e
The Marshall-Lerner condition is required.
© Pilot Publishing Company Ltd. 2005
Advantages of flexible e system (or disadvantages of fixed e system)
Allocate resources efficiently
No BOP problem
No need to hold a large amount of reserve assets
Government policies are free to achieve domestic objectives
Insulated from imported inflation
© Pilot Publishing Company Ltd. 2005
Disadvantages of flexible e system (or advantages of fixed e system)
Bring uncertainty to businessmen
Arouse speculation
Enhance domestic inflation
© Pilot Publishing Company Ltd. 2005
Correcting Misconceptions:
1. There is no BOP problem because the payments must always be balanced.
2. Some economic transactions are favourable to an economy but some are not.
3. The gain from trade is determined by the balance of payments.
4. The supply curve of foreign currency must be upward sloping.