ECONOMICS

POLICY
MAKING
CHAPTER 9
DEC 5028 MACROECONOMICS
OBJECTIVES
₴ Explain how the exchange rate is determined
₴ Explain the alternative exchange rate policies and explain their effects
₴ Explain how the balance of payments is calculated.
₴ Describe the balance of payments accounts and explain what causes an
international deficit
THE FOREIGN
EXCHANGE
MARKET
The Foreign Exchange Market
• To buy goods and services produced in another country we
need money of that country.
• Foreign bank notes, coins, and bank deposits are called
foreign currency.
• We get foreign currency in the foreign exchange market.
The Foreign Exchange Market
Trading Currencies
 We get/buy foreign currency (ie: USD) and foreigners get/buy
Malaysia Ringgit (MYR) in the foreign exchange market.
 The foreign exchange market is the market in which the currency
of one country is exchanged for the currency of another.
 The foreign exchange market is made up of thousand of people like
importers, exporters, banks, international travellers, so on.
The Foreign Exchange Market
Exchange Rates
 The price at which one currency exchanges for another is called a
foreign exchange rate.
 The exchange rate fluctuates. Sometimes it rises and sometimes it
falls.
 A fall in the value of one currency in terms of another currency is
called currency depreciation.
 A rise in value of one currency in terms of another currency is
called currency appreciation.

**Exchange rate can be expressed as the units of foreign currency per RM (25 yen per MYR)
or as RM per unit of foreign currency (MYR4.62 per Euro).
The Foreign Exchange Market
• EXAMPLE:
22nd SEPT 2015
MYR4.90 per euro
21st SEPT 2016
MYR4.60 per euro

Which currency appreciate and depreciate?

The Foreign Exchange Market
An Exchange Rate Is a Price
 An exchange rate is the price—the price of one currency in terms
of another.
 Like all prices, an exchange rate is determined in the foreign
exchange market.
 The Ringgit Malaysia (MYR) is demanded and supplied by thousands
of traders every hour of every day.
 With many traders and no restrictions, the foreign exchange market is
a competitive market.
The Foreign Exchange Market
The Demand for One Money Is the Supply of Another Money
 When people who are holding one money want to exchange it for
Ringgit Malaysia (MYR), they demand MYR and they supply that
other country’s money.
 So the factors that influence the demand for MYR also influence the
supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese
yen.
 And the factors that influence the demand for another country’s
money also influence the supply of MYR.
The Foreign Exchange Market (Demand)
FACTOR THAT INFLUENCE THE DEMAND FOR CURRENCY
The quantity of MYR that traders plan to buy (demand of currency) in the
foreign exchange market during a given period depends on:
 The exchange rate (between the two countries)
 World demand for exports
 Interest rates in the Malaysia and other countries
 The expected future exchange rate
FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
THE EXCHANGE RATE.
The Law of Demand for Foreign Exchange
 The demand for currency (for example: MYR) is a derived demand.
 People buy MYR so that they can buy Malaysian-produced goods and services or
Malaysian assets.
 Other things remaining the same, the higher the exchange rate, the smaller is the
quantity of MYR demanded in the foreign exchange market. (vice versa)
 Example: Higher exchange rate means MYR expensive.

USD5 per MYR is higher than USD2 per MYR

It means that foreigner prefer to buy MYR when the exchange rate is lower.
FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
THE EXCHANGE RATE.
The Law of Demand for Foreign Exchange
 The exchange rate influences the quantity of currency demanded for two reasons:
 Exports effect
 Expected profit effect

 Exports Effect
The larger the value of Malaysian exports, the greater is the quantity of MYR
demanded on the foreign exchange market.
The lower the exchange rate, the greater is the value of Malaysian exports, so the
greater is the quantity of MYR demanded.
FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
THE EXCHANGE RATE.
The Law of Demand for Foreign Exchange
 Expected Profit Effect
The larger the expected profit from holding MYR, the greater is the quantity of MYR
demanded today.
But expected profit depends on the exchange rate.
The lower today’s exchange rate, other things remaining the same, the larger is the
expected profit from buying MYR and the greater is the quantity of MYR demanded
today.
FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
The Demand Curve for

Exchange rate (USD per MYR)

Malaysian Ringgit
Figure 9.1 illustrates the Other things remain the
same, a rise in the
demand curve for Malaysian exchange rate decreases
Ringgit (MYR) on the foreign the quantity of MYR
demanded.
exchange market.

** When exchange rate change,

the quantity demanded of MYR
will move along the curve. Other things remain the
Demand curve will not shift. same, a fall in the
exchange rate increases D
the quantity of MYR
demanded.

Quantity (trillions of MYR per day)

FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
CHANGES IN THE DEMAND FOR CURRENCY
(FACTOR THAT SHIFT THE CURRENCY DEMAND CURVE)
A change in any influence on the quantity of MYR that people plan to buy,
(other than the exchange rate) brings a change in the demand for MYR.

These other influences are:

 World demand for Malaysia exports

 Malaysia interest rate relative to the foreign interest rate
 The expected future exchange rate
 FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY
CHANGES IN THE DEMAND FOR CURRENCY
 World Demand for Malaysian Exports
At a given exchange rate, if world demand for Malaysian exports increases, the
demand for Malaysian currency increases and the demand curve for MYR shifts
rightward.
 Malaysia Interest Rate Relative to the Foreign Interest Rate
The Malaysia interest rate minus the foreign interest rate is called the Malaysia
interest rate differential.
If Malaysia interest differential rises, the demand for MYR increases and the
demand curve for MYR shifts rightward.
 The Expected Future Exchange Rate
At a given current exchange rate, if the expected future exchange rate for MYR rises,
the demand for MYR increases and the demand curve for MYR shifts rightward.
FACTOR THAT INFLUENCE THE DEMAND FOR
CURRENCY

Exchange rate (USD per MYR)

Figure 9.2 shows how the
demand curve for MYR shifts
in response to changes in Demand for MYR

 Malaysian exports increase, demand

curve shift to right

 The Malaysia interest rate

differential
 The expected future
exchange rate
Demand for D1
MYR decrease,
demand curve D0
shift to left
D2

Quantity (trillions of MYR per day)

 The Foreign Exchange Market (Supply)
FACTOR THAT INFLUENCE THE SUPPLY FOR CURRENCY
The quantity of Malaysian currency (MYR) supplied in the foreign
exchange market is the amount that traders plan to sell during a given
time period at a given exchange rate.
This quantity depends on many factors but the main ones are:
 The exchange rate (between the two countries)
 Malaysia demand for imports
 Interest rates in the Malaysia and other countries
 The expected future exchange rate
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
THE EXCHANGE RATE.
The Law of Supply for Foreign Exchange
 Malaysian citizens supply MYR so that they can buy imported goods and services or
foreign assets.
 Other things remaining the same, the higher the exchange rate, the bigger is the
quantity of MYR supplied in the foreign exchange market. (vice versa)
 Example: Higher exchange rate means MYR expensive.

USD5 per MYR is higher than USD2 per MYR

**It means that Malaysian prefer to buy USD when the exchange rate is high because RM1
can buy more USD compare to lower exchange rate.
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
THE EXCHANGE RATE.
The Law of Supply for Foreign Exchange
Other things remaining the same, the higher the exchange rate, the
greater is the quantity of Malaysian currency (MYR) supplied in the
foreign exchange market.
The exchange rate influences the quantity of MYR supplied for two
reasons:
 Imports effect
 Expected profit effect
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
 Imports Effect
The larger the value of Malaysian imports, the larger is the quantity of MYR supplied on
the foreign exchange market.
The higher the exchange rate, the greater is the value of Malaysian imports, so the
greater is the quantity of MYR supplied.

 Expected Profit Effect

For a given expected future Malaysia currency exchange rate, the lower the current
exchange rate, the greater is the expected profit from holding MYR, and the smaller is
the quantity of MYR supplied on the foreign exchange market.
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
The Supply Curve for

Exchange rate (USD per MYR)

Malaysian Ringgit Other things remain the S
same, a rise in the
Figure 9.3 illustrates the exchange rate increases
supply curve for Malaysian the quantity of MYR
supplied.
Ringgit (MYR) on the foreign
exchange market.

** When exchange rate change,

the quantity supplied of MYR
will move along the curve.
Other things remain the
Supply curve will not shift. same, a fall in the
exchange rate decreases
the quantity of MYR
supplied.

Quantity (trillions of MYR per day)

 FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
CHANGES IN THE SUPPLY FOR CURRENCY
(FACTOR THAT SHIFT THE CURRENCY SUPPLY CURVE)
A change in any influence on the quantity of MYR that people plan to sell,
(other than the exchange rate) brings a change in the supply for MYR.

These other influences are:

 Malaysia demand for imports.

 Malaysia interest rate relative to the foreign interest rate
 The expected future exchange rate
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
 Malaysia Demand for Imports
At a given exchange rate, if the Malaysia demand for imports increases, the supply of
MYR on the foreign exchange market increases and the supply curve of MYR shifts
rightward.
 Malaysia Interest Rate Relative to the Foreign Interest Rate
If the Malaysia interest differential rises, the supply of MYR decreases and the supply
curve of MYR shifts leftward.
 The Expected Future Exchange Rate
At a given current exchange rate, if the expected future exchange rate for MYR rises, the
supply of MYR decreases and the supply curve of MYR shifts leftward.
FACTOR THAT INFLUENCE THE SUPPLY FOR
CURRENCY
S2

Exchange rate (USD per MYR)

Figure 9.4 shows how the
S0
supply curve for MYR shifts in
S1
response to changes in: Supply for MYR
decrease,
supply curve

 Malaysian imports shift to left

 The Malaysia interest rate

differential
 The expected future
Supply for MYR
exchange rate increase, supply
curve shift to right

Quantity (trillions of MYR per day)

The Foreign Exchange Market Equilibrium
Market Equilibrium

Exchange rate (yen per MYR)

Figure 9.5 shows how
demand and supply in
the foreign exchange
market determine the
exchange rate.

Quantity (trillions of MYR per day)

The Foreign Exchange Market Equilibrium
If the exchange rate is too high, a Surplus

Exchange rate (yen per MYR)

surplus of U.S. dollars drives it
down.
If the exchange rate is too low, a
shortage of U.S. dollars drives it
up.
The market is pulled (quickly) to
the equilibrium exchange rate at
which there is neither a shortage
nor a surplus.

Shortage

Quantity (trillions of MYR per day)

 FIGURE 9.6 Exchange Rates Respond to
Changes in Relative Prices

The higher price level in the United

States makes imports relatively less
expensive.
U.S. citizens are likely to increase their
spending on imports from Britain,
shifting the demand for pounds to the
right, from D0 to D1.
At the same time, the British see U.S.
goods getting more expensive and
reduce their demand for exports from
the United States.
The supply of pounds shifts to the left,
from S0 to S1.
The result is an increase in the price of
pounds.
The pound appreciates, and the dollar
is worth less.
 Relative Interest Rates
 FIGURE 9.7 Exchange Rates Respond to
Changes in Relative Interest Rates

If U.S. interest rates rise relative to British

interest rates, British citizens holding
pounds may be attracted into the U.S.
securities market.
To buy bonds in the United States, British
buyers must exchange pounds for dollars.
The supply of pounds shifts to the right,
from S0 to S1.
However, U.S. citizens are less likely to be
interested in British securities because
interest rates are higher at home.
The demand for pounds shifts to the left,
from D0 to D1.
The result is a depreciated pound and a
stronger dollar.
BALANCE OF
PAYMENT
The Balance of Payments
 Foreign exchange - All currencies other than the domestic currency of a given country.

 Balance of payments - The record of a country’s transactions in goods, services, and

assets with the rest of the world; also the record of a country’s sources (supply) and
uses (demand) of foreign exchange.

 There are three balance of payments accounts:

 Current account
 Capital and financial account
 Official settlements account
The Current Account
Balance of trade A country’s exports of goods and services minus its
imports of goods and services.
Trade deficit Occurs when a country’s exports of goods and services
are less than its imports of goods and services.
Balance on current account The sum of income from exports of goods
and services and income from investments and transfers minus
payments for imports of goods and services and payments for
investments and transfers.
 Current Account
The current account records :

 Receipts from exports of goods and services sold abroad,

 Payments for imports of goods and services from abroad,
 Net interest paid abroad, and
 Net transfers (such as foreign aid payments).

current accounts balance = exports - imports + net interest income + net transfers

**trade deficit can occurs when a country’s exports of goods and services are less than its imports of
goods and services.
 Current Account
Current Account RM Billions
(1) Goods exports 1,635.1
(2) Goods imports −2,370.9
(3) Exports of services 709.4
(4) Imports of services −478.3
(5) Balance on trade: (1) − (2) + (3) − (4) −504.7
(6) Investment income 819.7
(7) Investment payments −601.8
(8) Transfer income 127.1
(9) Transfer payments −250.9
(10) Balance on current account: (5) + (6) − (7) + (8) − (9) −410.6
 Capital Account
The capital account records :
 the sum of the following the change in private assets abroad,
 the change in foreign private within country,
 the change in government assets abroad, and
 the change in foreign government assets within country.

 Official Settlement Account

The official settlements account records the change in official reserves.
Official reserves are the government’s holdings of foreign currency.
If official reserves increase, the official settlements account is negative.
The sum of the balances of the three accounts always equals zero.
Capital Account RM Billions

(10) Balance on current account: (5) + (6) − (7) + (8) − (9) −410.6

(11) Change in net Malaysia liabilities 88.1

(12) Net receipts from financial derivatives 53.5

(13) Statistical discrepancy 269.0

(14) Balance of payments: (10) + (11) + (12) + (13) 0.0

**Item (11) is the change in foreign assets in the Malaysia minus the change in Malaysia assets abroad. In
2014 this number was positive, which means that there was an increase in net Malaysia liabilities.
 United States Balance of Payments, 2011
All transactions that bring foreign exchange into the United States are credited (+) to the current account; all
transactions that cause the United States to lose foreign exchange are debited (−) to the current account

Current Account Billions of dollars

Goods exports 1,497.4
Goods imports −2,235.8
(1) Net export of goods −738.4
Exports of services 606.0
Imports of services −427.4
(2) Net export of services 178.6
Income received on investments 744.6
Income payments on investments −517.6
(3) Net investment income 227.0
(4) Net transfer payments −133.1
(5) Balance on current account (1 + 2 + 3 + 4) −465.9
Capital Account
(6) Change in private U.S. assets abroad (increase is −) −364.1
(7) Change in foreign private assets in the United States 789.2
(8) Change in U.S. government assets abroad (increase is −) −119.5
(9) Change in foreign government assets in the United States 211.8
(10) Balance on capital account (6 + 7 + 8 + 9) 517.4
(11) Net capital account transactions and financial derivatives 37.7
(12) Statistical discrepancy −89.2
(13) Balance of payments (5 + 10 + 11 + 12) 0
Equilibrium Output (Income) in an Open Economy
The International Sector and Planned Aggregate Expenditure

Planned aggregate expenditure in an open economy:

AE ≡ C + I + G + EX − IM

**net exports of goods and services (EX − IM) The difference between a country’s
total exports and total imports.
The Open Economy with Flexible Exchange
Rates
 Floating, or market-determined, exchange rates Exchange rates that are
determined by the unregulated forces of supply and demand.

The Market for Foreign Exchange

The Supply of and Demand for Pounds

Governments, private citizens, banks, and corporations exchange pounds for dollars
and dollars for pounds every day.

Those who demand pounds are holders of dollars seeking to exchange them for
pounds.

Those who supply pounds are holders of pounds seeking to exchange them for dollars.
Factors That Affect Exchange Rates

Purchasing Power Parity: The Law of One Price

purchasing-power-parity theory: A theory of international exchange

holding that exchange rates are set. So that, the price of similar goods
in different countries is the same.

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.