CHAPTER 17
EXCHANGE RATES
AND MACROECONOMIC POLICY
MASTERY GOALS
The objectives of this chapter are to:
1. Describe what a foreign exchange market is.
2. Explain what an exchange rate is, and why it is helpful to define the exchange rate as
“dollars per unit of foreign currency.”
3. Explain why the demand curve for a foreign currency is downward sloping.
4. List the variables that cause the demand curve for a currency to shift, and describe
whether changes in these variables shift the demand curve rightward or leftward.
5. Explain why the supply curve for a foreign currency is upward sloping.
6. List the variables that cause the supply curve for a currency to shift, and describe whether
changes in these variables cause the supply curve to shift rightward or leftward.
7. Describe how floating exchange rates are determined, using the concepts of excess
supply and excess demand.
8. Define the terms currency appreciation and currency depreciation.
9. Describe how hot-money movements lead to exchange rate changes over the very
short run.
10. Describe how economic fluctuations lead to exchange rate changes over the short run.
11. Use the purchasing power parity (PPP) theory to describe long-run exchange rate
adjustments, and explain why adjustment to purchasing power parity is less than
complete.
12. Discuss why the currency of a country with a higher inflation rate will depreciate against
the currency of a country whose inflation rate is lower.
13. Explain why a country’s central bank might intervene in foreign exchange markets to
influence floating exchange rates under a “managed float.”
14. Describe how a country achieves a fixed exchange rate, and the problems created when
the exchange rate is fixed above the equilibrium rate for a long period.
15. Describe the concept of moral hazard and use this concept to explain why intervention by
the International Monetary Fund (IMF) to help countries recover from foreign currency
crises is controversial.
16. Explain how changes in exchange rates affect equilibrium GDP.
17. Explain why monetary policy effectiveness is enhanced by exchange rate changes.
18. Explain how a net financial inflow can lead to a trade deficit.
THE CHAPTER IN A NUTSHELL
This chapter examines the markets where Americans exchange dollars for other currencies, and
expands the text’s analysis of the macroeconomy to include trading with other nations. It
explores the relationship between foreign exchange markets and our economy, and the effects of
monetary policy in an open economy.
One country’s currency is traded for that of another in a foreign exchange market. The exchange
rate is the rate at which one currency is traded for another. So that we can think of the exchange
rate as the price (in dollars) of foreign currency, this chapter always defines the exchange rate as
“dollars per unit of foreign currency.”
This chapter develops a model of supply and demand for British pounds, under the assumption
that American households and businesses are the only buyers of pounds, and British households
and businesses are the only sellers of pounds. The demand curve for British pounds is downward
sloping because as the exchange rate falls British goods and services are less expensive to
American buyers. The lower the price of the pound, the more British goods Americans will buy,
and the more pounds they will need to make their purchases. This demand curve will shift in
response to changes in U.S. real GDP, the U.S. price level relative to the British price level,
Americans’ tastes for British goods, relative interest rates in the United States, and expectations
about future exchange rates.
The supply curve for British pounds is upward sloping because as the exchange rate rises the
British will get more dollars for each pound traded. This makes U.S. goods less expensive to
British buyers. As they buy more American goods, they will need to supply more pounds in order
to get dollars. The variables that will shift the supply curve include real GDP in Britain, the U.S.
price level relative to the British price level, British tastes for U.S. goods, relative interest rates in
the United States, and expectations about changes in the interest rate.
A floating exchange rate is freely determined by the forces of supply and demand, without
government intervention to change it or keep it from changing. When the exchange rate floats,
equilibrium occurs at the price where the quantity of foreign currency (pounds) demanded equals
the quantity supplied.
An increase in the demand for pounds or a decrease in the supply of pounds leads to an
appreciation of the pound (and a depreciation of the dollar). A decrease in the demand for pounds
or an increase in the supply of pounds leads to a depreciation of the pound (and an appreciation
of the dollar).
There are three types of exchange rate movements: very short-run changes, short-run changes,
and long-run trends.
Decisions by banks and other large financial institutions to move billions of dollars from one
country to another are responsible for exchange rate changes in the very short run. These
decisions to move “hot money” are made in split seconds in response to changes in relative
interest rates and expectations of future exchange rates.
Economic fluctuations are the main cause of short-run exchange rate changes. Generally, a
country whose GDP rises relatively rapidly will experience a depreciation of its currency, and
vice versa.
In the long run, according to the purchasing power parity (PPP) theory, an exchange rate will
adjust until the average price of goods is roughly the same in both countries. The existence of
non-tradable goods, high transportation costs, and artificial trade barriers all limit such perfect
price adjustment. An important implication of PPP theory is that the currency of a country with a
higher inflation rate will depreciate against the currency of a country whose inflation rate is
lower.
Governments sometimes intervene in foreign exchange markets involving their currency. They
may choose to intervene in foreign exchange markets when high exchange rates are harming
export-oriented industries, when falling exchange rates are leading to a general rise in domestic
prices, and when volatile exchange rates are making trading arrangements risky. Under a
managed float, a country’s central bank buys its own currency to prevent a depreciation, and sells
its own currency to prevent an appreciation. A more extreme form of intervention is a fixed
exchange rate, in which a government declares a particular value for its exchange rate with
another country and then, through its central bank, commits itself to intervene anytime the
equilibrium exchange rate differs from the fixed rate.
A foreign currency crisis is a loss of faith that a country can prevent a drop in its exchange rate,
and leads to a rapid depletion of its foreign currency. Thailand’s financial crisis of 1997-1998 is
explained using the concept of a foreign currency crisis. The International Monetary Fund (IMF)
resolved this crisis—an organization formed in large part to help nations avoid such foreign
currency crises and help them recover when crises occur. Such a rescue is controversial,
however, since it creates a moral hazard problem. Moral hazard occurs when a decision maker
expects to be rescued in the event of an unfavorable outcome, and then changes their behavior so
that the unfavorable outcome is more likely. The problem of moral hazard helps explain the
IMF’s response to Argentina’s foreign currency crisis of 2001-2002.
Exchange rates can have important effects on the macroeconomy—largely through their effect on
net exports. A dollar depreciation causes net exports to rise and leads to an increase in real GDP
in the short run. A dollar appreciation does just the opposite. When we include the impact on
exchange rates and net exports, we find that monetary policy has a stronger effect on the
economy than initially described.
A country’s trade deficit measures the extent to which its imports exceed its exports. When
exports exceed imports, a nation has a trade surplus.
The United States has a trade deficit with the rest of the world since the early 1980s because of a
massive capital inflow that arose in the early 1980s and has grown larger since. A rise in U.S.
interest rates relative to interest rates abroad, coupled with America’s lead in exploiting the
Internet, led to this net financial inflow. The net financial inflow has contributed to an
appreciation of the dollar. This appreciation causes exports to fall and imports to rise, leading to
an increase in the trade deficit.
DEFINITIONS
Foreign exchange market: The market in which one country’s currency is traded for
another country’s.
Exchange rate: The amount of one country’s currency that is traded for one unit of another
country’s currency.
Demand curve for foreign currency: A curve indicating the quantity of a specific foreign
currency that Americans will want to buy, during a given period, at each different exchange rate.
Supply curve for foreign currency: A curve indicating the quantity of a specific foreign
currency that will be supplied, during a given period, at each different exchange rate.
Floating exchange rate: An exchange rate that is freely determined by the forces of supply
and demand.
Appreciation: An increase in the price of a currency in a floating-rate system.
Depreciation: A decrease in the price of a currency in a floating-rate system.
Purchasing Power Parity (PPP) theory: The idea that the exchange rate will adjust in the
long run so that the average price of goods in two countries will be roughly the same.
Managed “oat: A policy of frequent central bank intervention to move the exchange rate.
Fixed exchange rate: A government-declared exchange rate maintained by central bank
intervention in the foreign exchange market.
Devaluation: A change in the value of a currency from a higher fixed value to a lower fixed
value.
Foreign currency crisis: a loss of faith that a country can prevent a drop in its exchange
rate, leading to a rapid depletion of its foreign currency (e.g. dollar) reserves.
Trade deficit: The excess of a nation’s imports over its exports during a given period.
Trade surplus: The excess of a nation’s exports over its imports during a given period.
Net financial in”ow: An inflow of funds equal to a nation’s trade deficit.
TEACHING TIPS
1. Visit http://www.xe.com for up to the minute exchange rates.
2. Warn students that a lot of confusion about exchange rates results from a failure to
understand what is being sold in currency exchange transactions. Explain that currency
markets operate exactly like the markets for, say, oranges. Remind them that they learned
how to graph demand and supply curves for goods like oranges in Chapter 3. Ask them to
take a minute to draw the market for oranges and label the axes. At this point in the
course, they will be able to do this fairly effortlessly. Ask them which currency they are
using to measure the price per orange. They will, of course, assume that the price is stated
in U.S. dollars (assuming that your class is held in the U.S.). This assumption comes very
naturally to students, and once they understand that they are making this assumption,
they can apply it to the market for currency markets. At this point, show students the
following graphs and explain that this is how they should always think of currency
markets.
3. For a real-world example of how hot money can affect exchange rates and economies, see
David Roman, “Asian Countries to Tackle Fund Inflows Cautiously,” The Wall Street
Journal, November 25, 2009.
4. Motivate the discussion on managed float by talking about the Plaza Accord of 1985 and
the Louvre Accord of 1987. In both instances, the finance ministers of the five major
industrialized countries [the Group of Five (G5): France, Germany, Japan, the United
Kingdom, and the United States] decided to actively manage exchange rates. In 1985 a
strong U.S. dollar had contributed to a large U.S. trade deficit, and was undermining the
competitiveness of American corporations in the world market. In response to growing
American sentiment for protectionist policies, the G5 met at the Plaza Hotel in New York
and agreed to manipulate exchange rates to lower the value of the dollar. By 1987, the
dollar had depreciated to such an extent that the G5 met again (at the Louvre Museum in
Paris) and agreed to take steps to prevent its further decline.
5. Some students have a difficult time understanding why currencies don’t all have the same
value, that is, why 1 dollar ≠ 1 peso ≠ 1 baht, etc. Explain to them that each currency was
developed in a different time and place, just like pounds and kilograms were developed in
different locales. But all currencies are used to express prices, just like pounds and
kilograms are used to express weights. A measurement in one currency can be converted
to a measurement in a different currency, just like a measurement in kilograms can be
converted to a measurement in kilograms.
DISCUSSION STARTERS
1. The Mexican peso crisis of 1994–95 is useful for classroom discussion, because it
involves examples of many of the exchange rate concepts discussed in Chapter 29.
Students can read about this crisis in the January/February 1996 issue of the Atlanta Fed’s
Economic Review (available online at
http://www.frbatlanta.org/filelegacydocs/Espin811.pdf ).
2. Use the New York Fed’s foreign exchange operations news Web site at
http://www.ny.frb.org/markets/foreignex.html as the basis for a discussion of current
developments in foreign exchange markets.