978-0132992282 Chapter 13 Lecture Note Part 1

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a. The exchange rates were fixed because the central banks in those countries offered to

buy or sell the currencies at the fixed exchange rate

1. Trading in currencies occurs around-the-clock, since some market is open in some country

any time of day

2. The spot rate is the rate at which one currency can be traded for another immediately

3. The forward rate is the rate at which one currency can be traded for another at a fixed date

in the future (for example, 30, 90, or 180 days from now)

4. A pattern of rising forward rates suggests that people expect the spot rate to be rising in the

future

1. The real exchange rate tells you how much of a foreign good you can get in exchange for

one unit of a domestic good

2. If the nominal exchange rate is 80 yen per dollar, and it costs 800 yen to buy a hamburger in

Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a

3. The real exchange rate is the price of domestic goods relative to foreign goods, or

e  enomP/PFor (13.1)

4. To simplify matters, we’ll assume that each country produces a unique good

5. In reality, countries produce many goods, so we must use price indexes to get P and PFor

6. If a country’s real exchange rate is rising, its goods are becoming more expensive relative to

the goods of the other country

1. In a flexible-exchange-rate system, when enom falls, the domestic currency has undergone a

nominal depreciation (or it has become weaker); when enom rises, the domestic currency has

2. In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a

strengthening is called a revaluation

3. We also use the terms real appreciation and real depreciation to refer to changes in the real

exchange rate

1. To examine the relationship between the nominal exchange rate and the real exchange rate,

think first about a simple case in which all countries produce the same goods, which are

freely traded

a. If there were no transportation costs, the real exchange rate would have to be e  1, or

else everyone would buy goods where they were cheaper

2. When PPP doesn’t hold, using Eq. (13.1), we can decompose changes in the real exchange

rate into parts

3. This can be rearranged as

enom/enom  e/e  For   (13.3)

4. Thus a nominal appreciation is due to a real appreciation or a lower rate of inflation than

in the foreign country

5. In the special case in which the real exchange rate doesn’t change, so that e/e  0, the

resulting equation in Eq. (13.3) is called relative purchasing power parity, since nominal

6. In touch with data and research: McParity

a. As a test of the PPP hypothesis, the Economist magazine periodically reports on the

prices of Big Mac hamburgers in different countries

b. The prices, when translated into dollar terms using the nominal exchange rate, range

1. The real exchange rate (also called the terms of trade) is important because it represents the

rate at which domestic goods and services can be traded for those produced abroad

2. The real exchange rate also affects a country’s net exports (exports minus imports)

a. Changes in net exports have a direct impact on export and import industries in the country

3. The real exchange rate affects net exports through its effect on the demand for goods

a. A high real exchange rate makes foreign goods cheap relative to domestic goods, so

there’s a high demand for foreign goods (in both countries)

b. With demand for foreign goods high, net exports decline

4. The J curve

a. The effect of a change in the real exchange rate may be weak in the short run and can

even go the “wrong” way

b. Although a rise in the real exchange rate will reduce net exports in the long run, in the

5. The analysis in this chapter assumes a time period long enough that the movements along

the J curve are complete, so that a real depreciation raises net exports and a real appreciation

1. Our theory suggests that the value of the dollar and U.S. net exports should be inversely

2. Looking at data since the early 1970s, when the world switched to floating exchange rates,

confirms the theory, at least in the 1980s (text Figure 13.2)

a. From 1980 to 1985 the dollar appreciated and net exports declined sharply

b. The dollar began depreciating in 1985, but it wasn’t until late 1987 that net exports

began to rise

1997 to 2001

(a) The strong dollar reduced net exports

(b) But a bigger factor was weak growth in foreign economies

(5) From 2002 to 2008, the U.S. real exchange rate declined, though it took until 2006

1. To analyze this, we’ll use supply-and-demand analysis, assuming a fixed price level

2. Holding prices fixed means that changes in the real exchange rate are matched by changes

in the nominal exchange rate

3. The nominal exchange rate is determined in the foreign exchange market by supply and

demand for the currency

4. Demand and supply are plotted against the nominal exchange rate, just like demand and

supply for any good (Figure 13.2; like text Figure 13.3)

Figure 13.2

a. Supplying dollars means offering dollars in exchange for the foreign currency

5. Why do people demand or supply dollars?

a. People need dollars for two reasons:

(1) To be able to buy U.S. goods and services (U.S. exports)

(2) To be able to buy U.S. real and financial assets (U.S. financial inflows)

6. Factors that increase demand for U.S. exports and assets will increase demand for dollars,

shifting the demand curve to the right and increasing the nominal exchange rate

1. Look at how changes in real output or the real interest rate are linked to the exchange rate

and net exports, to develop an open-economy IS-LM model

2. Effects of changes in output (income)

a. A rise in domestic output (income) raises demand for goods and services, including

imports, so net exports decline

Data Application

How do movements in the value of the dollar affect U.S. firms’ ability to compete internationally?

3. Effects of changes in real interest rates

a. A rise in the domestic real interest rate (with the foreign real interest rate held constant)

causes foreigners to want to buy domestic assets, increasing the demand for domestic

currency and raising the exchange rate

1. A rise in domestic output (income) or the foreign real interest rate causes the exchange rate

to fall

2. A rise in foreign output (income), the domestic real interest rate, or the world demand for

domestic goods causes the exchange rate to rise

1. A rise in domestic output (income) or the domestic real interest rate causes net exports to fall

2. A rise in foreign output (income), the foreign real interest rate, or the world demand for

domestic goods causes net exports to rise

1. Note that we don’t use the AD-AS model because we need to know what happens to the real

interest rate, which has an important impact on the exchange rate

2. The IS curve is affected because net exports are part of the demand for goods

3. The IS curve remains downward sloping

4. Any factor that shifts the closed-economy IS curve shifts the open-economy IS curve in the

same way

5. Factors that change net exports (given domestic output and the domestic real interest rate)

shift the IS curve

1. The goods-market equilibrium condition is

Sd  Id  NX (13.4)

2. Plotting Sd  Id and NX illustrates goods-market equilibrium (Figure 13.4; like text

Figure 13.5)

Figure 13.4

a. Net exports can be positive or negative

3. To get the open-economy IS curve, we need to see what happens when domestic output

changes (Figure 13.5; like text Figure 13.6)

Figure 13.5

a. Higher output increases saving, so the S  I curve shifts to the right

1. Any factor that raises the real interest rate that clears the goods market at a constant level of

output shifts the IS curve up and to the right

a. An example is a temporary increase in government purchases (Figure 13.6; like text

Figure 13.7)

2. Anything that raises a country’s net exports, given domestic output and the domestic real

interest rate, will shift the open-economy IS curve up and to the right (Figure 13.7; like text