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Exchange Rates and


The Open Economy

By: Group 4
Open and Closed Economies

A closed economy is one that


does not interact with other
economies in the world.
 There are no exports, no imports, and
no capital flows.
Open and Closed Economies

An open economy is one that


interacts freely with other
economies around the world.
An Open Economy
An open economy interacts with
other countries in two ways.
 It buys and sells goods and services in
world product markets.
 It buys and sells capital assets in world
financial markets.
Exchange Rates
The value of one currency relative
to another currency as the number
of units of one currency required
to purchase one unit of the other
currency.
Foreign Exchange
All currencies other than the
domestic currency of a given
country.
Foreign Exchange Market
The market on which currencies of
various nations are traded for one
another.
Has no central trading floor where
buyers and sellers meet.
Nominal Exchange Rates
The rate at which two currencies
can be traded for each other.
Nominal Exchange Rates for the U.S. Dollar
Country Foreign Dollar/Foreign
currency/dollar Currency
United Kingdom (pound) 0.645481 1.54923
Canada (Canadian dollar) 1.06088 0.942614
Mexico (peso) 13.0948 0.0763662
Japan (yen) 84.7479 0.0117997
Switzerland (Swiss Franc) 1.02289 0.977622
South Korea (won) 1196.82 0.000835548

Source: www.x-rates.com/d/USD/table.html, August 27,2010


Nominal Exchange Rates
Currency Appreciation – an
increase in the value of a currency
relative to other currencies.
Currency Depreciation – a
decrease in the value of a
currency relative to other
currencies.
Flexible VS Fixed Exchange Rates
Flexible Exchange Rate - an
exchange rate whose value is not
officially fixed but varies according
to the supply and demand for the
currency in the foreign exchange
market.
Fixed Exchange Rate – an
exchange rate whose values is set
by official government policy.
The Real Exchange Rate
If the nominal exchange rate tells
us the price of the domestic
currency in terms of a foreign
currency, the real exchange rate
tells us the price of the average
domestic good or service in terms
of the average foreign good or
service.
The Real Exchange Rate
The price of the average foreign
good or service relative to the
price of the average foreign good
or service, when prices are
expressed in terms of a common
currency.
Real Exchange Rate = eP
Pf
Strong Currency = Strong
Economy?
Contrary to popular impression,
there is no simple connection
between the strength of country’s
currency and the strength of its
economy.
One reason is that an appreciating
currency tends to raise the real
exchange rate, which may hurt a
country’s net exports.
Strong Currency = Strong
Economy?
An increase in the real exchange
rate implies that domestic goods
are becoming more expensive
relative to foreign goods, which
tends to reduce exports and
stimulate imports. Conversely, a
decline in the real exchange rate
tends to increase in net exports.
Determination of Exchange Rate
Purchasing-Power Parity theory is
the simplest and most widely
accepted theory explaining the
variation of currency exchange
rates or how nominal exchange
rates are determined.
Purchasing-Power Parity
The theory of purchasing-power
parity is based on a principle
called the law of one price.
According to the law of one price,
a good must sell for the same
price in all locations.
Purchasing-Power Parity
If the law of one price were not
true, unexploited profit
opportunities would exist.
The process of taking advantage
of differences in prices in different
markets is called arbitrage.
Purchasing-Power Parity
If arbitrage occurs, eventually
prices that differed in two markets
would necessarily converge.
According to the theory of
purchasing-power parity, a
currency must have the same
purchasing power in all countries
and exchange rates move to
ensure that.
Limitations of PPP
Many goods are not easily traded
or shipped from one country to
another.
Tradable goods are not always
perfect substitutes when they are
produced in different countries.
Determination of Exchange Rate
Supply and Demand Analysis is
more useful for studying exchange
rates short-run behavior.
The equilibrium exchange rate is
the value of the dollar that
equates the number of dollars
supplied and demanded in the
foreign exchange market.
The Supply of Dollars
Anyone who holds dollars, from an
international bank to a Russian
citizen, is a potential supplier of
dollars to the foreign exchange
market.
There are two major reasons why
would a U.S. household or firm want
to supply dollars in exchange for
foreign currency.
Supply of Dollars: Two Major Reasons

A U.S. household or firm may


need foreign currency to
purchase foreign goods or
services.
A U.S. household or firm may
need foreign currency to
purchase foreign assets.
The Supply and Demand of Dollars

Supply of Dollars

Yen/Dollar Exchange Rate


e*

Demand of Dollars
Quantity of dollars traded
The Demand of Dollars
In the yen-dollar foreign exchange
market, demanders of dollars are
those who wish to acquire dollars
in exchange for yen.
There are two major reasons why
demand dollars.
Demand of Dollars: Two Major Reasons

Households or firms that hold yen


will demand dollars so that they
can purchase U.S. goods or
services.
Households or firms demand
dollars in order to purchase
U.S. assets.
Changes in the Supply of Dollars
Factors that affect the desire of
U.S. households and firms to
acquire Japanese goods, services,
and assets will therefore affect the
supply of dollars to the foreign
exchange market.
Changes in the Supply of Dollars
Factors that will increase the
supply of dollars, shifting the
supply curve for dollars to the
right, include:
1.An increased preference for
Japanese goods.
2.An increase in U.S. real GDP.
3.An increase in the real interest
rate on Japanese assets.
Changes in the Supply of Dollars
Conversely, reduced demand for
Japanese goods, a lower U.S.
GDP, or lower real interest rate on
Japanese Assets will reduce the
number of yen Americans need, in
turn reducing their supply of
dollars to the foreign exchange
market and shifting the supply
curve for dollars to the left.
Changes in the Demand of Dollars
Factors that will increase the
demand for dollars include:
1.An increased preference for U.S.
goods.
2.An increase in real GDP abroad.
3.An increase in the real interest
rate on U.S. assets, which would
make those assets more attractive
to foreign savers.
Monetary Policy and Exchange Rate

Monetary policy affects the


exchange rate primarily through
its effects on the real interest
rate.
Monetary Policy and Exchange Rate

A tight monetary policy raises the


real interest rate, increasing the
demand for dollars and
strengthening the dollar. A
stronger dollar reinforces the
effects of tight monetary on
aggregate spending by reducing
net exports, a component of
aggregate demand.
Monetary Policy and Exchange Rate

Conversely, an easy monetary


policy lowers the real interest rate,
weakening dollar.
Fixed Exchange Rates
When nominal exchange rate is
fixed rather than flexible, one
important difference is that when
a country maintains a fixed
exchange rate, its ability to use
monetary policy as a stabilization
tool is greatly reduced.
How to Fix an Exchange Rate
In contrast to a flexible exchange
rate, whose value is determined
solely by supply and demand in
the foreign exchange market, the
value of a fixed exchange rate is
determined by the government.
How to Fix an Exchange Rate
Today, the value of a fixed
exchange rate is usually set in
terms of a major currency, or
relative to a “basket” of
currencies, typically those of the
country’s trading partners.
How to Fix an Exchange Rate
Devaluation – a reduction in the
official value of a currency.
*depreciation of a flexible exchange
rate
Revaluation – an increase in the
official value of a currency
*appreciation of a flexible exchange
rate
How to Fix an Exchange Rate
Overvalued exchange rate
– an exchange rate that has an
officially fixed value greater than
its fundamental value
Undervalued exchange rate
– an exchange rate that has an
officially fixed value less than its
fundamental value
How to Fix an Exchange Rate
To maintain an overvalued
exchange rate the government
can use the following approach:
1.Simply devalue its currency
2.Restrict international transactions
3.The government to become a
demander of its own currency.
How to Fix an Exchange Rate
To be able to purchase its own
currency and maintain an
overvalued exchange rate, the
government (usually the central
bank) must hold foreign currency
assets, called international
reserves, or reserves
How to Fix an Exchange Rate
Balance-of-payments deficit
– the net decline in a country’s
stock of international reserves
over a year
Balance-of-payments surplus
– the net increase in a country’s
stock of international reserves
over a year
Speculative Attacks
It involves a massive selling of
domestic currency assets by
financial investors.
It is most likely to occur when
financial investors fear that an
overvalued currency will soon be
devalued.
Monetary Policy and Fixed Exchange Rate

A tight monetary policy, which


increases the real interest rate,
raises the demand for the
currency and hence its
fundamental value.
Monetary Policy and Fixed Exchange Rate

By raising a currency’s


fundamental value to its official
value, tight monetary policy can
eliminate the problem of
overvaluation and stabilize the
exchange rate
Monetary Policy and Fixed Exchange Rate

However, if monetary policy is


used to set the fundamental value
of the exchange rate, it is no
longer available for stabilizing the
domestic economy.
Fixed or Flexible Exchange Rates?

Two major issues to compare two


systems:
1.The effects of the exchange rate
system on monetary policy.
2.The effects of the exchange rate
system on trade and economic
integration.
Fixed or Flexible Exchange Rates?

 A flexible exchange rate actually


strengthens the impact of
monetary policy on aggregate
demand.
 A fixed exchange rate prevents
policymakers from using
monetary policy to stabilize the
economy.
Fixed or Flexible Exchange Rates?

 Proponents of fixed exchange


rates argue that fixed rates
promote international trade and
cross-border economic
cooperation by reducing
uncertainty about future
exchange rates.
Fixed or Flexible Exchange Rates?

 Under a flexible-exchange-rate
regime, the value of the home
currency fluctuates with changes
in supply and demand and is
therefore difficult to predict far in
advance.
Group 4
Almazan, Rona
Anduyan, Ramela
Bautista, Mel Rose
Cornejo, Geraldine
Manalo, Irene
Marasigan, Jane
Matencio, Marjearey
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