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Part V International Finance and Monetary Policy Ch a p ter 19 PREVIEW The Foreign Exchange Market In the mid-1980s, American businesses became less competitive with their foreign counterparts; subsequently, in the 1990s and 2000s, their competitiveness increased. Did this swing in competitiveness occur primarily because American management fell down on the job in the 1980s and then got its act together afterwards? Not really. American business became less competitive in the 1980s because American dollars become worth more in terms of foreign currencies, making American goods more expensive relative to foreign goods. By the 1990s and 2000s, the value of the U.S. dollar had fallen appreciably from its highs in the mid-1980s, making American goods cheaper and American businesses more competitive. The price of one currency in terms of another is called the exchange rate. It affects the economy and our daily lives, because when the U.S. dollar becomes more valuable relative to foreign currencies, foreign goods become cheaper for Americans and American goods become more expensive for foreigners. When the U.S. dollar falls in value, foreign goods become more expensive for Americans and American goods become cheaper for foreigners. We begin our study of international finance by examining the foreign exchange market, the financial market where exchange rates are determined. As you can see in Figure 1, exchange rates are highly volatile. What factors explain the rise and fall of exchange rates? Why are exchange rates so volatile from day to day? To answer these questions, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market. Foreign Exchange Market www.ny.frb.org/Pihome /addpub/usfxm Get detailed information about the foreign exchange market in the United States. Most countries of the world have their own currencies: The United States has its dollar; the European Monetary Union, the euro; Brazil, its real; and India, its rupee. Trade between countries involves the mutual exchange of different currencies (or, more usually, bank deposits denominated in different currencies). When an American firm buys foreign goods, services, or financial assets, for example, U.S. dollars (typically, bank deposits denominated in U.S. dollars) must be exchanged for foreign currency (bank deposits denominated in the foreign currency). The trading of currency and bank deposits denominated in particular currencies takes place in the foreign exchange market. Transactions conducted in the foreign 435 436 PART V International Finance and Monetary Policy $ $ 1.00 2.00 0.90 1.80 Canadian dollar 0.80 1.60 0.70 1.40 0.60 1.20 0.50 1.00 1990 2000 1990 $ 1.20 Japanese yen 1.10 0.010 1.00 0.009 0.90 0.008 0.80 0.007 0.70 0.006 0.60 1990 2000 $ 0.012 0.011 British pound 2000 1990 Euro 2000 F I G U R E 1 Exchange Rates, 1990–2002 Dollar prices of selected currencies. Note that a rise in these plots indicates a strengthening of the currency (weakening of the dollar). Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist. exchange market determine the rates at which currencies are exchanged, which in turn determine the cost of purchasing foreign goods and financial assets. What Are Foreign Exchange Rates? http://quotes.ino.com/chart/ Go to this web site and click on “Foreign Exchange” to get market rates and time charts for the exchange rate of the U.S. dollar to major world currencies. There are two kinds of exchange rate transactions. The predominant ones, called spot transactions, involve the immediate (two-day) exchange of bank deposits. Forward transactions involve the exchange of bank deposits at some specified future date. The spot exchange rate is the exchange rate for the spot transaction, and the forward exchange rate is the exchange rate for the forward transaction. When a currency increases in value, it experiences appreciation; when it falls in value and is worth fewer U.S. dollars, it undergoes depreciation. At the beginning of 1999, for example, the euro was valued at 1.18 dollars, and as indicated in the “Following the Financial News” box, on February 5, 2003, it was valued at 1.08 dollars. The euro depreciated by 8%: (1.08  1.18)/1.18  0.08  8%. Equivalently, we could say that the U.S. dollar, which went from a value of 0.85 euros per dollar at the CHAPTER 19 The Foreign Exchange Market 437 Following the Financial News Foreign Exchange Rates Foreign exchange rates are published daily and appear in the “Currency Trading” column of the Wall Street Journal. The entries from one such column, shown here, are explained in the text. The first entry for the euro lists the exchange rate for the spot transaction (the spot exchange rate) on February 5, 2003, and is quoted in two ways: $1.0795 per euro and 0.9264 euros per dollar. Americans gen- erally regard the exchange rate with the euro as $1.0795 per euro, while Europeans think of it as 0.9264 euros per dollar. The three entries immediately below the spot exchange rates for some currencies give the rates for forward transactions (the forward exchange rates) that will take place one month, three months, and six months in the future. CURRENCY TRADING Wednesday, February 5, 2003 EXCHANGE RATES The foreign exchange mid-range rates below apply to trading among banks in amounts of $1 million and more, as quoted at 4 p.m. Eastern time by Reuters and other sources. Retail transactions provide fewer units of foreign currency per dollar. Currency U.S. $ Equivalent per U.S. $ Country Wed Tue Wed Tue Argentina (Peso)-y . . . . . Australia (Dollar) . . . . . . Bahrain (Dinar) . . . . . . . . Brazil (Real) . . . . . . . . . . Canada (Dollar) . . . . . . . 1-month forward . . . . . 3-months forward . . . . 6-months forward . . . . Chile (Peso) . . . . . . . . . . China (Renminbi) . . . . . . Colombia (Peso) . . . . . . . Czech. Rep. (Koruna) Commercial rate . . . . . Denmark (Krone) . . . . . . Ecuador (US Dollar) . . . . Hong Kong (Dollar) . . . . . Hungary (Forint) . . . . . . . India (Rupee) . . . . . . . . . Indonesia (Rupiah) . . . . . Israel (Shekel) . . . . . . . . Japan (Yen) . . . . . . . . . . 1-month forward . . . . . 3-months forward . . . . 6-months forward . . . . Jordan (Dinar) . . . . . . . . . Kuwait (Dinar) . . . . . . . . Lebanon (Pound) . . . . . . . Malaysia (Ringgit)-b . . . . Malta (Lira) . . . . . . . . . . Mexico (Peso) Floating rate . . . . . . . . New Zealand (Dollar) . . . Norway (Krone) . . . . . . . . .3160 .5901 2.6522 .2784 .6574 .6566 .6548 .6517 .001348 .1208 .0003372 .3160 .5915 2.6523 .2798 .6602 .6595 .6576 .6544 .001346 .1208 .0003378 3.1646 1.6946 .3770 3.5920 1.5211 1.5230 1.5272 1.5344 741.84 8.2781 2965.60 3.1646 1.6906 .3770 3.5740 1.5147 1.5163 1.5207 1.5281 742.94 8.2781 2960.33 .03398 .1453 1.0000 .1282 .004406 .02099 .0001128 .2050 .008336 .008344 .008363 .008391 1.4094 3.3479 .0006634 .2632 2.5690 .03438 .1463 1.0000 .1282 .004454 .02094 .0001127 .2049 .008353 .008362 .008381 .008408 1.4085 3.3523 .0006634 .2632 2.5861 29.429 6.8823 1.0000 7.8003 226.96 47.642 8865 4.8780 119.96 119.85 119.57 119.18 .7095 .2987 1507.39 3.7994 .3893 29.087 6.8353 1.0000 7.8003 224.52 47.756 8873 4.8804 119.72 119.59 119.32 118.93 .7100 .2983 1507.39 3.7994 .3867 .0920 .5494 .1434 .0913 .5496 .1448 10.8648 1.8202 6.9735 10.9481 1.8195 6.9061 Source: Wall Street Journal, Thursday, February 6, 2003, p. C12. Country U.S. $ Equivalent Wed Tue Pakistan (Rupee) . . . . . . .01719 .01723 Peru (new Sol) . . . . . . . . .2866 .2863 Philippines (Peso) . . . . . . .01852 .01853 Poland (Zloty) . . . . . . . . . .2606 .2622 Russia (Ruble)-a . . . . . . . 0.3142 0.3142 Saudi Arabia . . . . . . . . . . .2667 .2667 Singapore (Dollar) . . . . . . .5742 .5755 Slovak Rep. (Koruna) . . . .02579 .02607 South Africa (Rand) . . . . .1192 .1202 South Korea (Won) . . . . . .0008516 .0008529 Sweden (Krona) . . . . . . . .1169 .1177 Switzerland (Franc) . . . . . .7358 .7424 1-month forward . . . . . .7362 .7428 3-months forward . . . . .7371 .7437 6-months forward . . . . .7386 .7451 Taiwan (Dollar) . . . . . . . . .02881 .02881 Thailand (Baht) . . . . . . . . .02338 .02342 Turkey (Lira) . . . . . . . . . . .00000061 .00000061 U.K. (Pound) . . . . . . . . . . 1.6423 1.6485 1-month forward . . . . . 1.6391 1.6452 3-months forward . . . . 1.6322 1.6382 6-months forward . . . . 1.6221 1.6283 United Arab (Dirham) . . . .2723 .2723 Uruguay (Peso) Financial . . . . . . . . . . . .03500 .03550 Venezuela (Bolivar) . . . . . .000520 .000520 SDR . . . . . . . . . . . . . . . . Euro . . . . . . . . . . . . . . . 1.3741 1.0795 1.3697 1.0883 Currency per U.S. $ Wed Tue 58.173 3.4892 53.996 3.8373 31.827 3.7495 1.7416 38.775 8.3893 1174.26 8.5543 1.3591 1.3583 1.3567 1.3539 34.710 42.772 1639344 .6089 .6101 .6127 .6165 3.6724 58.038 3.4928 53.967 3.8139 31.827 3.7495 1.7376 38.358 8.3195 1172.47 8.4962 1.3470 1.3463 1.3446 1.3421 34.710 42.699 1639344 .6066 .6078 .6104 .6141 3.6724 28.571 1923.08 28.169 1923.08 .7277 .9264 .7301 .9189 Special Drawing Rights (SDR) are based on exchange rates for the U.S., British, and Japanese currencies. Source: International Monetary Fund. a-Russian Central Bank rate. b-Government rate. y-Floating rate. 438 PART V International Finance and Monetary Policy beginning of 1999 to a value of 0.93 euros per dollar on February 5, 2003, appreciated by 9%: (0.93  0.85)/0.85  0.09  9%. Why Are Exchange Rates Important? Exchange rates are important because they affect the relative price of domestic and foreign goods. The dollar price of French goods to an American is determined by the interaction of two factors: the price of French goods in euros and the euro/dollar exchange rate. Suppose that Wanda the Winetaster, an American, decides to buy a bottle of 1961 (a very good year) Château Lafite Rothschild to complete her wine cellar. If the price of the wine in France is 1,000 euros and the exchange rate is $1.08 to the euro, the wine will cost Wanda $1,080 ( 1,000 euros  $1.08/euro). Now suppose that Wanda delays her purchase by two months, at which time the euro has appreciated to $1.20 per euro. If the domestic price of the bottle of Lafite Rothschild remains 1,000 euros, its dollar cost will have risen from $1,080 to $1,200. The same currency appreciation, however, makes the price of foreign goods in that country less expensive. At an exchange rate of $1.08 per euro, a Compaq computer priced at $2,000 costs Pierre the Programmer 1,852 euros; if the exchange rate increases to $1.20 per euro, the computer will cost only 1,667 euros. A depreciation of the euro lowers the cost of French goods in America but raises the cost of American goods in France. If the euro drops in value to $0.90, Wanda’s bottle of Lafite Rothschild will cost her only $900 instead of $1,080, and the Compaq computer will cost Pierre 2,222 euros rather than 1,852. Such reasoning leads to the following conclusion: When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. Appreciation of a currency can make it harder for domestic manufacturers to sell their goods abroad and can increase competition at home from foreign goods, because they cost less. From 1980 to early 1985, the appreciating dollar hurt U.S. industries. For instance, the U.S. steel industry was hurt not just because sales abroad of the more expensive American steel declined, but also because sales of relatively cheap foreign steel in the United States increased. Although appreciation of the U.S. dollar hurt some domestic businesses, American consumers benefited because foreign goods were less expensive. Japanese videocassette recorders and cameras and the cost of vacationing in Europe fell in price as a result of the strong dollar. How Is Foreign Exchange Traded? You cannot go to a centralized location to watch exchange rates being determined; currencies are not traded on exchanges such as the New York Stock Exchange. Instead, the foreign exchange market is organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. Because these dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently from a centralized market. An important point to note is that while banks, companies, and governments talk about buying and selling currencies in foreign exchange markets, they do not take a fistful of dollar bills and sell them for British pound notes. Rather, most trades involve the buying and selling of bank deposits denominated in different currencies. So when CHAPTER 19 The Foreign Exchange Market 439 we say that a bank is buying dollars in the foreign exchange market, what we actually mean is that the bank is buying deposits denominated in dollars. The volume in this market is colossal, exceeding $1 trillion per day. Trades in the foreign exchange market consist of transactions in excess of $1 million. The market that determines the exchange rates in the “Following the Financial News” box is not where one would buy foreign currency for a trip abroad. Instead, we buy foreign currency in the retail market from dealers such as American Express or from banks. Because retail prices are higher than wholesale, when we buy foreign exchange, we obtain fewer units of foreign currency per dollar than exchange rates in the box indicate. Exchange Rates in the Long Run Like the price of any good or asset in a free market, exchange rates are determined by the interaction of supply and demand. To simplify our analysis of exchange rates in a free market, we divide it into two parts. First, we examine how exchange rates are determined in the long run; then we use our knowledge of the long-run determinants of the exchange rate to help us understand how they are determined in the short run. Law of One Price The starting point for understanding how exchange rates are determined is a simple idea called the law of one price: If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world no matter which country produces it. Suppose that American steel costs $100 per ton and identical Japanese steel costs 10,000 yen per ton. For the law of one price to hold, the exchange rate between the yen and the dollar must be 100 yen per dollar ($0.01 per yen) so that one ton of American steel sells for 10,000 yen in Japan (the price of Japanese steel) and one ton of Japanese steel sells for $100 in the United States (the price of U.S. steel). If the exchange rate were 200 yen to the dollar, Japanese steel would sell for $50 per ton in the United States or half the price of American steel, and American steel would sell for 20,000 yen per ton in Japan, twice the price of Japanese steel. Because American steel would be more expensive than Japanese steel in both countries and is identical to Japanese steel, the demand for American steel would go to zero. Given a fixed dollar price for American steel, the resulting excess supply of American steel will be eliminated only if the exchange rate falls to 100 yen per dollar, making the price of American steel and Japanese steel the same in both countries. Theory of Purchasing Power Parity One of the most prominent theories of how exchange rates are determined is the theory of purchasing power parity (PPP). It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an application of the law of one price to national price levels rather than to individual prices. Suppose that the yen price of Japanese steel rises 10% (to 11,000 yen) relative to the dollar price of American steel (unchanged at $100). For the law of one price to hold, the exchange rate must rise to 110 yen to the dollar, a 10% appreciation of the dollar. Applying the law of one price to the price levels in the two countries produces the theory of purchasing power parity, which maintains that if the Japanese price level rises 10% relative to the U.S. price level, the dollar will appreciate by 10%. www.oecd.org/EN/home /0,,EN-home-513-15-no-no-no -0,00.html The purchasing power parities home page includes the PPP program overview, statistics, research, publications, and OECD meetings on PPP. 440 PART V International Finance and Monetary Policy As our U.S./Japanese example demonstrates, the theory of PPP suggests that if one country’s price level rises relative to another’s, its currency should depreciate (the other country’s currency should appreciate). As you can see in Figure 2, this prediction is borne out in the long run. From 1973 to the end of 2002, the British price level rose 99% relative to the U.S. price level, and as the theory of PPP predicts, the dollar appreciated against the pound; though by 73%, an amount smaller than the 99% increase predicted by PPP. Yet, as the same figure indicates, PPP theory often has little predictive power in the short run. From early 1985 to the end of 1987, for example, the British price level rose relative to that of the United States. Instead of appreciating, as PPP theory predicts, the U.S. dollar actually depreciated by 40% against the pound. So even though PPP theory provides some guidance to the long-run movement of exchange rates, it is not perfect and in the short run is a particularly poor predictor. What explains PPP theory’s failure to predict well? Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates F I G U R E 2 Purchasing Power Parity, United States/United Kingdom, 1973–2002 (Index: March 1973 = 100.) The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests on the assumption that all goods are identical in both countries and that transportation costs and trade barriers are very low. When this assumption is true, the law of one price states that the relative prices of all these goods (that is, the relative price level between the two countries) will determine the exchange rate. The assumption that goods are identical may not be too unreasonable for American and Japanese steel, but is it a reasonable assumption for American and Japanese cars? Is a Toyota the equivalent of a Chevrolet? Because Toyotas and Chevys are obviously not identical, their prices do not have to be equal. Toyotas can be more expensive relative to Chevys and both Americans and Japanese will still purchase Toyotas. Because the law of one price does not hold for all goods, a rise in the price of Toyotas relative to Chevys will not necessarily mean Index 250 Source: www.statistics.gov.uk/statbase /tsdataset2.asp. 200 Relative Price Levels (CPIUK /CPIUS) 150 Exchange Rate (£/ $) 100 1973 1983 1993 2003 CHAPTER 19 The Foreign Exchange Market 441 that the yen must depreciate by the amount of the relative price increase of Toyotas over Chevys. PPP theory furthermore does not take into account that many goods and services (whose prices are included in a measure of a country’s price level) are not traded across borders. Housing, land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods. So even though the prices of these items might rise and lead to a higher price level relative to another country’s, there would be little direct effect on the exchange rate. Factors That Affect Exchange Rates in the Long Run Our analysis indicates that in the long run, four major factors affect the exchange rate: relative price levels, tariffs and quotas, preferences for domestic versus foreign goods, and productivity. We examine how each of these factors affects the exchange rate while holding the others constant. The basic reasoning proceeds along the following lines: Anything that increases the demand for domestic goods relative to foreign goods tends to appreciate the domestic currency because domestic goods will continue to sell well even when the value of the domestic currency is higher. Similarly, anything that increases the demand for foreign goods relative to domestic goods tends to depreciate the domestic currency because domestic goods will continue to sell well only if the value of the domestic currency is lower. Relative Price Levels. In line with PPP theory, when prices of American goods rise (holding prices of foreign goods constant), the demand for American goods falls and the dollar tends to depreciate so that American goods can still sell well. By contrast, if prices of Japanese goods rise so that the relative prices of American goods fall, the demand for American goods increases, and the dollar tends to appreciate, because American goods will continue to sell well even with a higher value of the domestic currency. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country’s relative price level causes its currency to appreciate. Trade Barriers. Barriers to free trade such as tariffs (taxes on imported goods) and quotas (restrictions on the quantity of foreign goods that can be imported) can affect the exchange rate. Suppose that the United States increases its tariff or puts a lower quota on Japanese steel. These increases in trade barriers increase the demand for American steel, and the dollar tends to appreciate because American steel will still sell well even with a higher value of the dollar. Increasing trade barriers cause a country’s currency to appreciate in the long run. Preferences for Domestic Versus Foreign Goods. If the Japanese develop an appetite for American goods—say, for Florida oranges and American movies—the increased demand for American goods (exports) tends to appreciate the dollar, because the American goods will continue to sell well even at a higher value for the dollar. Likewise, if Americans decide that they prefer Japanese cars to American cars, the increased demand for Japanese goods (imports) tends to depreciate the dollar. Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate. 442 PART V International Finance and Monetary Policy Productivity. If one country becomes more productive than other countries, businesses in that country can lower the prices of domestic goods relative to foreign goods and still earn a profit. As a result, the demand for domestic goods rises, and the domestic currency tends to appreciate. If, however, its productivity lags behind that of other countries, its goods become relatively more expensive, and the currency tends to depreciate. In the long run, as a country becomes more productive relative to other countries, its currency appreciates.1 Study Guide The trick to figuring out what long-run effect a factor has on the exchange rate is to remember the following: If a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate, and if a factor decreases the relative demand for domestic goods, the domestic currency will depreciate. See how this works by explaining what happens to the exchange rate when any of the factors in Table 1 decreases rather than increases. Our long-run theory of exchange rate behavior is summarized in Table 1. We use the convention that the exchange rate E is quoted so that an appreciation of the currency corresponds to a rise in the exchange rate. In the case of the United States, this means that we are quoting the exchange rate as units of foreign currency per dollar (say, yen per dollar).2 SUMMARY Table 1 Factors That Affect Exchange Rates in the Long Run Factor Domestic price level† Trade barriers† Import demand Export demand Productivity† Change in Factor Response of the Exchange Rate, E* ↑ ↑ ↑ ↑ ↑ ↓ ↑ ↓ ↑ ↑ *Units of foreign currency per dollar: ↑ indicates domestic currency appreciation; ↓ , depreciation. †Relative to other countries. Note: Only increases ( ↑ ) in the factors are shown; the effects of decreases in the variables on the exchange rate are the opposite of those indicated in the “Response” column. 1 A country might be so small that a change in productivity or the preferences for domestic or foreign goods would have no effect on prices of these goods relative to foreign goods. In this case, changes in productivity or changes in preferences for domestic or foreign goods affect the country’s income but will not necessarily affect the value of the currency. In our analysis, we are assuming that these factors can affect relative prices and consequently the exchange rate. 2 Exchange rates can be quoted either as units of foreign currency per domestic currency or alternatively as units of domestic currency per foreign currency. In professional writing, many economists quote exchange rates as units of domestic currency per foreign currency so that an appreciation of the domestic currency is portrayed as a fall in the exchange rate. The opposite convention is used in the text here, because it is more intuitive to think of an appreciation of the domestic currency as a rise in the exchange rate.