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CHAPTER OUTLINE

20 Part 2Open-Economy

Macroeconomics: The Balance of Payments and

Exchange RatesThe Open Economy with Flexible Exchange Rates

The Market for Foreign ExchangeFactors That Affect Exchange RatesThe Effects of Exchange Rates on the Economy

An Interdependent World Economy

Appendix: World Monetary Systems Since 1900

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When people in countries with different currencies buy from and sell to each other, an exchange of currencies must also take place.

Exchange Rate

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appreciation of a currency The rise in value of one currency relative to another.

depreciation of a currency The fall in value of one currency relative to another

E ↓ Home currency appreciates and foreign currency depreciates.

Similarly,

E ↑ Home currency depreciates and foreign currency appreciates.

Appreciation and Depreciation

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floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand.

Governments, private citizens, banks, and corporations exchange USD for Baht, and Baht for USD every day.

Those who demand/buy USD are holders of Baht seeking to exchange them for USD.

Those who supply/sell USD are holders of USD seeking to exchange them for Baht.

The Open Economy with Flexible/Floating Exchange Rates

The Market for Foreign Exchange

The Supply of and Demand for USD (Home Currency is Baht)

foreign exchange All currencies other than the home currency of a given country.

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1. Firms, households, or governments that import US goods into Thailand or want to buy US-made goods and services (IMPORTS—Buy US goods)

2. Thai citizens traveling to/in US (Buy US scenery)

3. Holders of Baht who want to buy US stocks or bonds (Buy US assets)

4. Thai companies that want to invest in US (Buy US factories)

5. Speculators who anticipate a decline in the value of Baht relative to USD (Buy US currency)

The Demand for USD

Some Buyers and Sellers in International Exchange Markets: US and Thailand

The Supply of USD

1. Firms, households, or governments that export Thai goods into US or want to buy Thailand-made goods and services (EXPORTS—Sell Thai goods to US)

2. US citizens traveling to or in Thailand (Sell Thai scenery to US)

3. Holders of USD who want to buy Thai stocks or bonds (Sell Thai assets to US)

4. US companies that want to invest in Thailand (Sell Thai factories to US)

5. Speculators who anticipate a rise in the value of Baht relative to USD

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FIGURE 20.2 The Demand for USD in the Foreign Exchange Market (Thai Imports)

FIGURE 20.3 The Supply of USD in the Foreign Exchange Market (Thai Exports)

When the price of USD falls, US-made goods and services appear less expensive to Thai buyers. If US prices are constant, Thai buyers will buy more US goods and services and the quantity of USD demanded will rise.

When the price of USD rises, Americans can obtain more Baht for each USD. This means that Thailand-made goods and services appear less expensive to US buyers. Thus, the quantity of USD supplied is likely to rise with the exchange rate.

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When exchange rates are allowed to float, they are determined by the forces of supply and demand.

An excess demand for USD will cause the USD to appreciate against the Baht.

An excess supply of USD will lead to a depreciating USD.

FIGURE 20.4 The Equilibrium Exchange Rate

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Factors That Affect Exchange Rates

The Law of One Price

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A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of relatively high-inflation countries to depreciate.

Factors That Affect Exchange Rates

Purchasing Power Parity

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The higher price level in Thailand makes imports relatively less expensive.

Thai citizens are likely to increase their spending on imports from US, shifting the demand for USD to the right, from D0 to D1.

At the same time, Americans see Thai goods getting more expensive and reduce their demand for exports from Thailand.

The supply of USD shifts to the left, from S0 to S1.

The result is an increase in the price of USD.

The USD appreciates, and the Baht is worth less.

FIGURE 20.5 Exchange Rates Respond to Changes in Relative Prices

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If Thailand’s interest rates rise relative to US interest rates, US citizens holding USD may be attracted into the Thai securities market.

To buy bonds/assets in Thailand, American buyers must exchange USD for Baht.

The supply of USD shifts to the right, from S0 to S1.

However, Thai citizens are less likely to be interested in US securities because interest rates are higher at home.

The demand for USD shifts to the left, from D0 to D1.

The result is a depreciated USD and a stronger Baht.

Relative Interest Rates

FIGURE 20.6 Exchange Rates Respond to Changes in Relative Interest Rates

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Initially, a depreciation of a country’s currency may worsen its balance of trade.

The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports. Baht prices of exports and imports change due to depreciation but both quantity of exports and imports remain unchanged as they take time to adjust.

balance of trade (Thailand) = Baht price of exports × quantity of exports

− Baht price of imports × quantity of imports

Exchange Rates and the Balance of Trade: The J Curve

J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect.

FIGURE 20.7 The Effect of a Depreciation on the Balance of Trade (the J Curve)

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A cheaper Baht is a good thing if the goal of the Central Bank is to stimulate the domestic economy.

Process is described as follows.

Money supply increases Thai interest rate decreases Thai citizens want to buy more assets in foreign countries and foreigners wants to buy less assets in Thailand demand for USD increases and supply of USD decreases exchange rate increases Baht depreciates Exports increase and imports decrease AD shifts to the right.

The depreciation of a country’s currency tends to increase its price level.

Exchange Rates and Prices

Monetary Policy with Flexible Exchange Rates

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appreciation of a currency

balance of payments

balance of trade

balance on capital account

balance on current account

depreciation of a currency

exchange rate

floating, or market-determined, exchange rates

foreign exchange

J-curve effect

law of one price

marginal propensity to import (MPM)

net exports of goods and services (EX − IM)

price feedback effect

purchasing-power-parity theory

trade deficit

trade feedback effect

Planned aggregate expenditure in an open economy:

AE ≡ C + I + G + EX − IM

Open-economy multiplier =

)(1

1

MPMMPC

R E V I E W T E R M S A N D C O N C E P T S