Professional Documents
Culture Documents
Email to Friend
Comments
5.1 - Introduction
Now that we have discussed everything you need to know regarding micro and macroeconomics, let's broaden
the scope to also include international trade, foreign exchange and the balance of payments.
• Its relative costs of producing various goods differ from other nations
• It specializes in producing goods in which the nation is relatively efficient at producing and uses the
proceeds from its output to produce goods for which it is relatively inefficient.
Note that these costs are relative to a country's opportunity costs. A country could have an absolute advantage in
producing (able to produce more) over another country for all goods and still benefit from trade. How nations
trade is determined by their comparative advantages.
• Better Quality of Goods - Domestic producers are forced to maintain and/or improve quality due to
competition from foreign producers.
• Lower Prices Due to Economies of Scale - Because producers have larger potential markets due to
international trade, they can sometimes achieve lower per-unit costs with large-scale production.
Consumers benefit by being able to purchase the lower-priced goods. Manufacturers often benefit by
being able to purchase parts at lower costs.
• Better Institutions and Government Policies - Global trade gives government policymakers incentive to
create constructive economic policy. A failure to do so, however, will cause capital and labor to flow
elsewhere
The domestic exchange rate within the U.S. for the two goods is 1:1; for each unit of steel produced, the U.S.
must give up producing one unit of wheat. We could say that the cost of one unit of steel within the U.S.,
assuming no international trade, would be one unit of wheat. Similarly, the cost of one unit of wheat would be
the loss of one unit of steel.
Great Britain would have a different domestic exchange rate. Its production possibility curve implies that the
cost of one unit of steel would be one-half of a unit of wheat. The cost of one unit of wheat would be two units
of steel. These costs can be obtained by looking at the slope of the production possibility curve.
If the U.S. and Great Britain both operated as autarkies (self-sufficient nations that do not trade), then each
country would operate somewhere on their production possibilities curve. The exact point of production would
depend on each country's supply and demand for the goods. For example, these points could be 35 units of
wheat and 15 units of steel for the U.S., and 10 units of wheat and 20 units of steel for Great Britain, as
illustrated in Figure 5.1.
In Figure 5.1, the U.S. is the low-cost producer for wheat, as it only gives up one unit of steel when it produces
one unit of wheat. Great Britain is the high-cost producer for wheat, as it must give up two units of steel for
each unit of wheat produced. However, Great Britain is the low cost producer for steel, as it gives up only one-
half of a unit of wheat for each unit of steel produced. Therefore, the U.S. has a comparative advantage in
producing wheat, while Great Britain has a comparative advantage in producing steel. According to the trade
efficiency rule, the world will be better off if Great Britain specializes in steel production and the U.S.
specializes in wheat production.
An easy way to determine which country has the comparative advantage is to compare the slopes of the
production possibility curves. Suppose you have production possibility curves for two countries with product Y
and X, and product Y is placed on the y-axis. The country with the most negative slope for product Y will have
the comparative advantage with product Y.
Suppose each country specialized in producing the good for which it had a comparative advantage. The U.S.
would produce 50 units of wheat per worker and Great Britain would produce 40 units of steel per worker. The
combined world output would be 50 units of wheat and 40 units of steel. With no trade, the combined wheat
output is 45 units and the combined steel output is 35 units. Clearly the two countries can benefit from trading
with one another – the quantity of wheat produced goes up by five units and the quantity of steel produced goes
up by five units. Trading offers more efficient production possibilities.
Suppose the terms of trade settle at 1.5 units of steel per unit of wheat. We can graph a trading possibilities
curve and relate that curve to the original production possibilities curve.
The slope of the trading possibilities curve will be -1.5 for each country. The original production possibilities
curve is shifted to the trading possibilities curve by specializing in the production of the good for which each
country has a comparative advantage and by then engaging in international trade. As the possible amount of
consumption increases for both countries, they will each enjoy a higher standard of living.
Recall that we assume that without trade, the U.S. will consume 35 units of wheat and 15 units of steel for the
U.S and that Great Britain will consume ten units of wheat and 20 units of steel. These points are shown as
Point A in both of the graphs above. With the trading possibilities at -1.5, the U.S. could specialize in wheat
production and then trade 12 units of wheat for 18 units of steel. The country would then end up with 18 units
of steel, and keep 38 units of its own wheat production. This point is described as Point B in the U.S. graph
above. Great Britain could benefit in a similar manner.
Note that the above analysis assumes that relative production costs are constant, which allows for straight lines
to be used as a production possibilities curve. In reality, as more and more of a good is produced, relative
production costs increase because less efficient resources will be used as production increases. As a result, we
expect that production possibility curves will be curved lines. Therefore, specialization will not be an all-or-
nothing type of situation. Even if the U.S. is a relatively inefficient producer of steel, some steel production will
still occur in the United States. Similarly, while Great Britain will mostly be producing steel, some wheat
production will still occur in Great Britain.
Domestic producers of goods that are produced relatively cheaply will be able to get higher prices in the world
market. Suppose the U.S. is a relatively efficient producer of wheat. In the Figure 5.3 below, the quantity
demanded and the quantity supplied would be equal at domestic price Pdw. However, U.S. wheat producers
would prefer to export their goods at the world price Pww. By doing so, they will achieve higher
profits. Consumers will lose out because they will have to pay higher world prices.
However, for goods produced relatively inefficiently by the U.S., consumers will benefit by paying lower
prices. Using shirts as an example, we can see that without international trade, consumers would pay price Pds
for shirts. By allowing imports, consumers can pay the lower price Pws. Producers are hurt because they will
have to take the lower world price.
Quotas
Quotas are numerical limits imposed on imported goods. Consumers are harmed by quotas, while domestic and
foreign producers benefit by receiving higher prices. In the graph below, the market initially clears at P0, Q0.
The supply curve Sd+i0 represents the quantity supplied by both domestic and foreign producers before the
imposition of the quota. D0 is the domestic demand curve. After the quota, the supply curve looks like Sd+i1.
Both foreign and domestic producers receive higher prices while consumers lose out.
"Hidden" Methods
Hidden methods of limiting imports include special regulations and licensing requirements that restrict imports.
For instance, the Japanese government imposes special quality requirements on food to restrict food imports and
protect Japanese farmers.
Beneficiaries of a tariff include the government, which collects the tariff, and domestic producers within the
affected industry (or industries). The general public (consumers) loses.
• National Defense - Foreign producers should not be relied upon for production of defense goods, even
if the goods can be produced at a lower cost abroad.
• Infant Industries - Start-up industries in a country may not be able to effectively compete against
foreign producers because of their small size. An argument can be made that these industries should be
protected until suitable economies of scale can be achieved. If the economies of scale are such that the
domestic industry achieves a comparative advantage over foreign companies, the temporary protection
will help to achieve better economic efficiency
• Anti-Dumping - The claim is often made that foreign producers "dump" their goods on the domestic
market. The term dumping is applied when foreign producers are thought to be selling goods at prices
below their production costs, or below the prices charged in their home market. Retaliatory measures
may include the imposition of tariffs, quotas or fines against foreign producers. The fear is that this
"unfair" practice will drive domestic producers out of business and that the foreign producers will then
impose monopoly pricing. One argument against this fear is that when prices are raised at a later time,
domestic producers can reenter the market. Deliberately driving other producers out by selling at a loss
usually does not work. Another argument against "anti-dumping" is that the country as a whole benefits
when foreign-made goods are sold at lower prices than domestic ones. The reasons for which the prices
are lower should not be a primary concern.
• Short-Sightedness - In the short-run, the imposition of a tariff may help to preserve jobs in the relevant
domestic industry. The effort to avoid unemployment in the affected industry also makes for good
politics. However, in the long-run, those workers will find other jobs and the economy will be operating
at full employment in a more efficient manner.
• Special Interests – Special interests can use their powers to put trade restrictions in place. Although free
trade benefits the general public, it does not necessarily benefit all groups within the economy.
Management and workers in an industry impacted by foreign goods will not willingly go through
dislocation and adjustments (such as retraining) that may be necessitated by foreign competition
• Economic Ignorance - Ignorance also contributes to the creation of trade restrictions. Most members of
the general public are not aware of the harm created by trade restrictions.
• Visibility - The benefits of trade restrictions are large and highly visible for small, select groups of
people. The benefits of free trade are dispersed across the general population and are, therefore, harder
to see. It is easy to note jobs lost to foreign competition; it is not easy to see that those displaced labor
resources will be reallocated to more efficient jobs.
If, for example, interest rates in the United States are higher than those of other countries, foreigners will want
to convert their currencies to dollars in order to earn a higher rate of return. Their actions will cause a reduction
in the supply of dollars.
Expectations about future exchange rates will also impact current quantities demanded and supplied for
currencies. For example, suppose the current exchange rate for euros and dollars is $1.20 per euro and an
importer of European goods expects the euro to depreciate next month to $1.1 per euro. That importer will hold
off on converting dollars to euros thereby decreasing the current quantity demanded for euros and the quantity
supplied for dollars.
A central bank will intervene in the foreign exchange market because it wishes to reduce volatility, and/or it has
a specific target exchange rate. Suppose the Fed wants the euro and dollar to trade 1:1, with an allowable range
of 2% in either direction. If the exchange rate rose to above 1.02 euros per dollar, the Fed would sell dollars; if
the exchange rate fell below .98 euros per dollar, it would buy dollars.
With the indirect method of foreign exchange quotation, the exchange rate is expressed as the number of units
of the pertinent foreign currency needed to acquire one (1.0) unit of the domestic currency. In the U.S., this
method is referred to as quoting the exchange rate in foreign terms.
Look Out!
¬1.00 = $1.2830
The indirect quote between the U.S. dollar and the euro would then be calculated as the reciprocal (1 / 1.2830), and we get the
following indirect quote for the U.S. dollar:
$0.7794 = ¬1.00
Suppose you have the following indirect foreign exchange quote for the Japanese yen and U.S. dollar, from a Japanese
perspective:
¥109.38 = $1.00
The direct exchange quote for the Japanese yen to U.S. dollar, from a Japanese perspective, will be the reciprocal of (1 /
109.38), and we then get:
$0.009142 = ¥1.00
The difference between the two is called the bid-ask spread. Foreign currency dealers will quote both a bid and
an ask for a particular currency. The average of the bid and ask (ask plus bid divided by two) is referred to as
the midpoint price. The bid-ask spread is usually given as a percentage and it is calculated as:
Formula 5.1
Bid Ask
Answer:
Then the bid-ask spread will be 100 × (0.8041 – 0.8038) / 0.8041 = 0.0373%, which is about 4 bps.
• Trading Volume - The higher the volume, or the more active a market, the lower the bid-ask spread.
• Currency Rate Volatility - With higher volatility, currency dealers are exposed to higher risk. Spreads
will increase with higher volatility.
• Perceived Economic/Political Risks - Risks such as political instability, higher inflation and changing
economic conditions will affect the spreads associated with a particular currency. The higher the
uncertainty, the greater the expected spread.
Note that if a dealer has an overly large position in a currency relative to the desired net position, the dealer will
alter the midpoint of the spread rather than adjust the spread. For instance, a dealer with a shortage of a
particular currency will move the midpoint of the direct quote up. Competition is also an important factor for
spreads. A dealer with an overly large spread will not be making trades.
In general, in calculating cross-rates, bid and ask prices will need to be dealt with.
This makes the calculation only slightly more difficult. The following equations should be kept in mind:
Formula 5.2
Where FCa and FCb are the two foreign currencies and DC is the domestic currency.
Similar equations are used when calculating FCb to FCa exchange rates.
Suppose you are given the following bid/ask quotations for two foreign currencies against the domestic
currency, the U.S. dollar:
Bid Asked
¬/$ 0.9002 0.9023
¥/$ 109.38 109.40
We want to calculate what the ¥ / ¬ bid and ask quotations will be.
Answer:
The ¥ / ¬ bid price will be the number of yen the dealer is willing to pay in order to buy one euro. This
transaction would be the equivalent of selling yen to purchase dollars (at the bid rate of 109.38), and
simultaneously reselling the dollars to purchase euros (at the ask rate of 0.9023). The bid ¥ / ¬ would be
calculated as 109.38/0.9023 = 121.22.
The ¥ / ¬ ask price would be the number of yen the dealer wants to receive in exchange for selling one euro.
This transaction would be the equivalent of buying yen with dollars (at the 109.40 ask rate) and at the same time
buying those dollars with euros, at the 0.9002 bid rate. The transaction could be expressed mathematically as:
Ask ¥ / ¬ = 109.40 / 0.9002 = 121.53
¥ / ¬ = 121.22 – 121.53
Exam Tip!
1. The Spot Currency Exchange Market – This market involves trades of currencies for immediate
delivery. Settlement usually occurs two days after the trade date. Participants in this market want to
convert to the other currency relatively quickly. Transactions in the spot market are often used for
investments, or to settle commercial purchases of goods.
2. The Forward Currency Exchange Market – This market involves contracts for currency exchange in
which settlement will take place more than two days after the trade date. While settlement dates are
negotiable, standard foreign currency forward contracts usually settle 30, 90 or 180 days after the trade
date. If a dealer quotes the 90-day ¥ / $ exchange rate at 109.80-109.83, that means the dealer is willing
to commit today to buying dollars for 109.80 yen in 90 days, or to selling dollars at 109.83 yen per
dollar 90 days from today.
The reasons that spreads vary with forward foreign currency quotations are similar to the reasons for the
variability of spreads with spot foreign currency
quotations. The unique factor associated with spreads for
forward foreign currency quotations is that spreads will
widen as the length of time until settlement increases.
Currency exchange rates would be expected to have a
higher range of fluctuations over longer periods of time,
which increases dealer risk. Also, as time increases, fewer
dealers are willing to provide quotes, which will also tend
to increase the spread.
Answer:
Similarly, to calculate the discount for the Japanese yen, we first want to calculate the forward and spot rates for
the Japanese yen in terms of dollars per yen. Those numbers would be (1/109.50 = 0.0091324) and (1/109.38 =
0.0091424), respectively.
So the annualized forward discount for the Japanese yen, in terms of U.S. dollars, would be:
((0.0091324 – 0.0091424) ÷ 0.0091424) × (12 ÷ 3) ×
100% = -0.44%
Example:
Assume the following data for the euro (¬) and the
U.S. dollar ($):
A speculator could borrow dollars at 5%, convert them into euros and invest the euros at 7%. The speculator
would be making a profit of 2%.
However, at the end of the time period, euros will need to be converted to dollars so that the initial borrowing
can be repaid. The speculator runs the risk that dollars may have depreciated relative to the euro during that
time period.
The speculator's position can potentially be made into a risk-free one by purchasing a forward exchange
contract so that the exchange rate used to convert euros back to dollars is a known one.
Over one year, the speculator would experience the following exchange rate loss:(0.901 – 0.909) ÷ 0.901 =
-0.9%
Because of the 2% interest rate differential, the speculator makes a net profit of 1.1% for each dollar borrowed.
This is a certain gain, as all exchange and interest rates were fixed and known at the beginning of the trade, and
no capital had to be invested in the position either!
If such rates existed in the real world, enormous swaps of capital would be made to take advantage of such a
risk-free arbitrage. To prevent this from occurring, the forward discount rate would have to equal the difference
in interest rates. Note that if the discount forward rate is greater than the interest rate differential, the arbitrage
will be made in the other direction.
The actual mathematical relationship is slightly more complicated than what was specified above because a
perfect arbitrage would require that the forward contract cover both the initial principal borrowed plus the
accrued interest. For the rates discussed above, the speculator would actually need to hedge, for every dollar
borrowed, 0.901 (1.07) = 0.964.
The interest rate parity relationship between two currencies can be expressed (using indirect quotes) as:
Formula 5.4
(Forward rate – Spot rate) ÷ Spot rate = (rfc – rdc) ÷ (1 + rdc),
or (F – S) ÷ S= (rfc – rdc) ÷ (1 + rdc)
Where rdc is the risk-free interest rate of the domestic currency, rfc is the risk-free interest rate of the foreign
currency and the exchange rates quoted are indirect quotes expressed as the number of units of the foreign
currency used to obtain one unit of the domestic currency.
Look Out!
We would then expect that at that exchange rate, more U.S. dollars are available than are demanded. The
exchange rate of the U.S. dollar would be expected to go down until a new equilibrium is achieved. Shifts in
supply and demand for a nation's currency will cause the nation's currency to appreciate or depreciate.
One advantage of a floating exchange rate system is that it reflects existing economic fundamentals. Another
advantage is that governments are not forced to defend some particular exchange rate (or range of rates), and
are free to adopt fiscal or monetary policies that are independent of the exchange rate.
If you are baffled by exchange rates, or if you are just curious about why some currencies fluctuate while others
don't, the following article has the answers:
The following page will prime you for the topics discussed in this chapter:
Floating and Fixed Exchange Rates
With regard to balance-of-payments accounts, there are three major types of accounts:
1.The Current Account – This type of account records transactions with foreign countries for all current
transactions that take place as part of normal business. The current account is specifically made up of:
·Imports and exports, which is also called the trade balance or balance of merchandise trade
·Services, such as accounting and insurance
·Factor payments, such as interest and dividends paid
·Current transfers such as gifts, which do not have an associated exchange factor
2.The Financial Account – Also known as a balance-on-capital account, this account covers changes in
ownership of financial and real investments. Parts of this account include:
·Net foreign purchases of long-term domestic assets, such as bonds, stock, real estate and other business assets,
netted against similar purchases of foreign assets made by the country's citizens
·Private transfers of financial assets such as cash and other forms of payments made by domestic entities to
foreigners in order to settle balances owed to the foreigners, netted with similar transfers of financial assets
from foreigner to domestic entities.
3.The Official Reserve Account – This account keeps track of all transactions made by monetary authorities.
The sum of the current and financial accounts, which is called the overall balance, should be equal to zero. The
central bank can use some of its reserves when the overall balance is negative. If the overall balance is positive,
the central bank can choose to add to its reserves.
Look Out!
The following page will prime you for the topics discussed in this section:
What is the Balance of Payments?
Trade balances are also affected by capital flows. If a nation's economy offers investment opportunities that are
relatively better than other nations, then capital will flow into the country. With flexible exchange rates, this
capital inflow will tend to increase the value of the nation's currency.
·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their
currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary
policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange
rates involve the currencies of two countries. If a nation's central bank is pursuing an expansionary monetary
policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency
of that nation is expected to appreciate relative to the currencies of its trading partners.
·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation).
Suppose the price level increases by 40% in the U.S., while the price levels of its trading partners remain
relatively stable. U.S. goods will seem very expensive to foreigners, while U.S. citizens will increase their
purchase of relatively cheap foreign goods. The U.S. dollar will depreciate as a result. If the U.S. inflation rate
is lower than that of its trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate
adjustments permit nations with relatively high inflation rates to maintain trade relations with countries that
have low inflation rates.
·Income Changes - Suppose that the income of a major trading partner with the U.S., such as Great Britain,
greatly increases. Greater domestic income is associated with an increased consumption of imported goods. As
British consumers purchase more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity
supplied and the U.S. dollar will appreciate.
We would then expect the following sequence of events to occur with regard to the price effect:
With a program of expansionary (easy) monetary policy, the following sequence of events would be expected to
occur with regard to the income effect:
In summary, the income effect of expansionary monetary policy tends to lower the domestic currency exchange
rate, weaken the current account and work to improve the financial account. A restrictive monetary policy tends
to cause the opposite due to the income effect. The domestic currency exchange rate increases, the current
account improves and the financial account weakens.
As both price and the income effects of monetary policy move in the same direction regarding their impact on
the exchange rate, it is clear that expansionary (restrictive) monetary policy will lower (raise) the country's
exchange rate. The effect of monetary policy on the current and financial accounts is not so clear because the
price and income effects move in opposite directions. For example, the price effect of easy money on the
current account tends to strengthen it, while the income effect tends to weaken the current account. Since the
effects move in opposite directions, it is not immediately clear what the ultimate impact will be.
We should note that investors can buy and sell financial assets such as stocks and bonds more quickly than
producers and consumers can sell and buy physical goods. So initially, interest rate (substitution) effects would
be expected to dominate. An unanticipated increase in the money supply will cause the exchange rate to go
down, the financial account to weaken and current account to gain strength. Over time, the income effect will
come into play. A rising GDP will cause both the trade balance and financial account to weaken.
Some argue that for an economy with a foreign sector, monetary policy can create cyclical movements that tend
to destabilize an economy. Unanticipated expansionary monetary policy initially causes the trade balance to
improve, but as time progresses, it causes the trade balance to become more negative. It initially causes the
capital account to weaken due to lower interest rates, but then later tends to improve it. In the long run, the main
effect of the expansionary monetary policy is a lowering of the nation's currency exchange rate, which is the
international equivalent to the long-run effect of expansionary monetary policy, inflation. Empirical evidence
indicates that countries with high rates of monetary supply growth experience both inflation and declining
currency exchange rates. An important point to consider is the exchange rates of two countries - their relative
rates of money supply growth will help determine how the exchange rate changes.
Fiscal policy changes will produce both price (substitution) and income effects for exchange rates and balance
of payments. Suppose government policymakers enact a program of unanticipated fiscal stimulus. This would
be expected to cause the following sequence of events to occur with regard to the price effect:
·Greater government budget deficits caused by tax cuts and/or increased spending will increase the demand for
investable funds, which will cause interest rates to rise.
·The increase in interest rates will cause capital inflows (foreigners will purchase more domestic financial
assets). As a result, the capital account will strengthen (become more positive or less negative).
·Foreign investors will need to exchange their currency for the domestic currency. The increased demand for the
domestic currency will cause its exchange rate to increase.
·If there is no government intervention with the balance-of-payments, the current account will need to become
more negative (or less positive). The trade balance will weaken as imports increase and/or exports decrease.
This makes sense because the strengthening of the nation's currency will make its exports relatively less
attractive to foreigners and imports will be less expensive relative to the country's consumers and domestic
businesses.
To summarize, the price effect of a stimulative fiscal policy is to raise the value of the domestic currency,
strengthen the capital account and weaken the current account. A restrictive fiscal policy would have the
opposite effects: a weaker domestic currency, a weaker capital account (there would be net capital outflows)
and a stronger current account.
With a program of fiscal stimulus, the following sequence of events would be expected to occur with regard to
the income effect:
·The tax cuts and/or increase in government spending associated with the fiscal policy, and the associated
multiplier effect, will increase GDP.
·The rise in GDP will cause the demand for imports to increase and the current account will be weakened
(become more negative or less positive).
·More domestic currency will need to be converted into foreign currencies to purchase the increased quantity of
imports. The increased supply of domestic currency on the international markets will cause the exchange rate to
decline.
·With no government intervention, the financial account will need to become more positive (or less negative) in
order to compensate for the weakening of the current account. Foreigners will be holding more of the domestic
currency and are therefore in a position to purchase more of the nation's financial assets. Also, as the domestic
economy is improving, they may find it more attractive as a place to invest.
To summarize, the income effect associated with fiscal stimulus will tend to lower the exchange rate of the
country's currency, weaken the current account (trade balance) and strengthen the financial account.
Fiscal policy price and income effects move in the same direction with regard to their impact on the financial
and current accounts. Stimulating fiscal policy will clearly weaken the current account (balance of trade) and
strengthen the capital account. Restrictive fiscal policy will strengthen the current account (balance of trade)
and weaken the capital account.
The impact of fiscal policy on exchange rates is not so clear because the price and income effects work in
opposite directions. The income effect tends to weaken the currency exchange rate, while the price effect will
tend to strengthen the currency exchange rate. Because foreign investors can trade financial assets (such as
stocks and bonds) more quickly and easily than consumers and producers can alter the purchase and sale of
physical assets, the price effect would be expected to have the larger initial effect. Over time, the income effect
will increasingly come into play.
So initially, the fiscal stimulus should cause the domestic currency to appreciate. Over time, as the demand for
imports is stimulated, the domestic currency will weaken. If the fiscal stimulus is associated with inflation, there
will be a further weakening of the domestic currency. Note that the fiscal stimulus will also have the effect of
worsening the balance of trade and increasing the financial account in both the short and long run.
A stimulative fiscal policy is good for the economy when it is operating below full employment levels. There
are a couple of factors that will mitigate the positive effects. One factor is that government deficits will work to
increase interest rates, which can crowd out private investment. Another factor is that after foreign capital
comes in (due to higher interest rates), the domestic currency exchange rate rises. This leads to a rise in imports,
which reduces GDP. These two factors lessen the positive effects of fiscal policy stimulus.
Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be
allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the
target exchange rate may be modified.
Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they may need to
resort to central bank intervention, the imposition of tariffs or quotas, or the placement of restrictions on capital
flow. If the pegged exchange rate is too far from the actual market rate, it will be costly to defend and it will
probably not last. Currency speculators may benefit from such a situation.Advantages of pegged exchange rates
include a reduction in the volatility of the exchange rate (at least in the short-run) and the imposition of some
discipline on government policies. One disadvantage is that it can introduce currency speculation.
Formula 5.5
S= P ÷ P*
Where Sis the spot exchange rate between two countries (the rate of the amount of foreign currency needed to
trade for the domestic currency), P is the price index for a domestic country and P* is the price index for a
foreign country. Note that the exchange rate used here is an indirect quote.
The following conditions must be met for this relationship to be true:
1.The goods of each country must be freely tradable on the international market.
2.The price index for each of the two countries must be comprised of the same basket of goods.
Even if the law of one price holds for each individual good across countries, differences in weighting will cause
absolute purchasing power parity. Determining comparable average national price levels is actually quite
difficult and is rarely attempted. Analysts usually examine changes in price levels (indexes), which are easier to
calculate; this gets around some of the problems of comparability.
Formula 5.6
S1 / S0 = (1 + Iy) ÷ (1 + Ix)
Where,
S0 is the spot exchange rate at the beginning of the time
period (measured as the "y" country price of one unit of
currency x)
S1 is the spot exchange rate at the end of the time period.
Iy is the expected annualized inflation rate for country y,
which is considered to be the foreign country.
Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.
Look Out!
Note that the spot exchange rate used must be the quantity of
currency y (the foreign currency) needed to purchase one unit
of currency x (the domestic currency). If we want the spot
value of the U.S. dollar in British pounds, the quote must be
0.6667 British pounds per dollar, not $1.50 per British pound.
Example 1:
Suppose that Mexico's expected annual rate of inflation is equal to 6% per year, while the expected annual
inflation rate for the U.S. is 3%. As an approximation, we would expect that the Mexican peso would depreciate
at the rate of 3% per year (or we could say that the U.S. dollar should appreciate at the rate of 3% per year.
Example 2:
Suppose that the annual inflation rate is expected to be 8% in the Eurozone and 2% in the U.S. The current
exchange rate is $1.20 per euro (¬1.00 = $1.20). What would the expected spot exchange rate be in six months
for the euro?
Answer:
So the relevant equation is:
So the expected spot exchange rate at the end of six months would be $1.1662 per euro.
Example 3:
Assume that the U.S. is the foreign country and that Japan is the domestic country. The current spot exchange
rate is S0 = 115 yen per dollar ($1 per ¥115.00). The expected annual inflation rate for the U.S. is 4.89%, and
the annual expected Japanese inflation rate is 6.23%. Compute the approximate expected spot rate and the
expected spot rate one year from now.
Answer:
Because Japan is the domestic country we have:
S0 = 115 yen per dollar. (1 + Iy) is 1.0489, and (1 + Ix) is equal to 1.0623.
The approximation method would indicate that the yen should decline against the dollar by: (Iy – Ix)
=(1.0489 – 1.0623) = -0.0134 = -1.34%
So the value of the yen relative to the dollar would be expected to decline to
Suppose that a financial asset from Mexico has an annual rate of return of 10% in Mexican pesos. Assume that
Mexico has an annual inflation rate of 4%, the U.S. has an annual inflation rate of 2% and that the U.S. dollar is
appreciating by 2% a year, as predicted by purchasing power parity.
By the approximation method, U.S. investors would be earning about 8% per year in terms of Mexican pesos.
Their real rate of return would be approximately 6% per year after U.S. inflation is taken into account. This is
equal to what Mexican investors are earning, which is about 6% (10% nominal rate of return - 4% inflation). All
investors are getting the same real rate of return on specific assets.
Note that purchasing power parity is a theoretical concept that may not be true in the real world, especially in
the short run.
Exam Tip!