Key Concepts Last Week: Open Economy

Exchange Rate Between the Dollar and the Indicated Currency

Units of Foreign Currency U.S. Dollars per Unit

Currency per U.S. Dollar of Foreign Currency Balance on
Canadian dollar 1.03 0.97 Current Account
Japanese yen 96.23 0.01
= - Balance on
Financial
Mexican peso 12.62 0.08
Account
British pound 0.65 1.55
Euro 0.75 1.33

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What would we learn from the course?
GDP Inflation Unemployment
(Production/ Income)
 Measuring Unemployment and Inflation
 GDP: Measuring Total Production and Income
 Economic Growth, the Financial System, and Business Cycles
 Long-Run Economic Growth: Sources and Policies

Short-Run Fluctuations/
Business Cycle Key Markets for Analysis
 Aggregate Expenditure and Output - Demand
in the Short Run - Supply
 Aggregate Demand and Aggregate - Equilibrium: Price & Quantity
Supply Analysis - Dynamics

Macroeconomic Policy
to Reduce Short-Run
Fluctuations International Economy
 Money, Banks, and the Federal Reserve System
 Monetary Policy  Macroeconomics in an Open Economy
 Fiscal Policy ❑ The International Financial System
 Inflation, Unemployment, and Federal Reserve Policy
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Lecture
CHAPTER

The International Financial System

10
Outline
1 Exchange Rate Systems
2 The Current Exchange Rate System
3 Practice Exercises
4 More Practice for the Course

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International investments gain despite strong dollar - USA Today, April 9

Your eyes probably glaze over

when you read the
headline: Dollar index up
more than 10% since June.
Who cares, you think.

Then you look at how your

international fund has been
doing. Money flows to where it
can get the best return.

- The strong dollar presents a quandary for U.S. investors in international

stocks and mutual funds.
- The muscular greenback hurts overseas investments as they’re converted
back to dollars.
- But the swelling dollar also bolsters euro zone and other foreign exports
by making them less expensive for U.S. consumers, boosting the fortunes
of overseas corporations and their stocks.
- What’s an investor to do?
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1. Exchange Rate Systems
In the previous chapter, we assumed exchange rates were
determined by the market.
• A floating currency is the outcome of a country allowing its
currency’s exchange rate to be determined by demand and supply.

But allowing the relative values of currencies to be determined by

demand and supply is just one type of exchange rate system, or
agreement among countries about how exchange rates should be
determined.
• The present-day exchange rate system is best described as a
managed float exchange rate system, under which the value of
most currencies is determined by demand and supply, with
occasional government intervention.

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Fixed Exchange Rate System
A fixed exchange rate system is one under which countries agree to
keep the exchange rates among their currencies fixed for long
periods.
• From the 19th century until the 1930s, countries’ currencies were
redeemable for fixed amounts of gold—a system known as the
gold standard. The amount of gold each for which currency was
redeemable determined the exchange rates.

After the Great Depression of the 1930s, most countries abandoned

the gold standard. In 1944, a conference in Bretton Woods, NH
established the Bretton Woods system:
• The U.S. pledged to buy or sell gold at $US 35 per ounce
• Other member countries agreed to a fixed exchange rate between
their currency and the U.S. dollar
We will examine these systems further in this chapter’s appendix.
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2. The Current Exchange Rate System
The current exchange rate system has three important aspects:
i. The U.S. allows the dollar to float against other major currencies.
ii. Seventeen countries in Europe have adopted a single European
currency, the euro.
iii. Some countries have attempted to keep their currencies’
exchange rates fixed against the $US or some other currency.

Each of these aspects has important consequences, and we will

examine them in turn.

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i. The Floating Dollar

Figure 19.1 Canadian dollar-U.S. dollar and Yen-U.S. dollar

exchange rates, 1973-2013

Since 1973 the value of the $US (in terms of how many units of foreign
currency one U.S. dollar can buy) has floated.
One U.S. dollar buys about as many Canadian dollars as it did in 1973.
But it only buys about a third as many Japanese yen.

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What Determines Exchange Rates in the Long Run?
Why has the value of the U.S. dollar fallen so much against the
Japanese yen, and yet risen then fallen to about the original level
against the Canadian dollar?
In the short run, the two most important influences on exchange rates
are:
• Relative interest rates
• Expectations about future values of currencies

But over the long run, it seems reasonable that exchange rates
should move to equalize the purchasing powers of different
currencies. This is known as the theory of purchasing power parity.

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Purchasing Power Parity
Suppose that candy bars sell for £2 in the United Kingdom, and for $1
in the United States.
If the exchange rate were £1 = $1, then a clever entrepreneur could:
• Buy a million candy bars in the U.S. for $1,000,000
• Transport them to the U.K. and sell them for £2,000,000
• Exchange that currency for $2,000,000: a profit of $1,000,000,
minus the cost of shipping.
If many people did this, there would be an increase in the supply of
British pounds, offered to purchase U.S. dollars; so we would expect
the exchange rate to appreciate.
If it appreciated to £2 = $1, currency would have equal purchasing
power in each location, and there would be no more pressure on the
exchange rate to change.

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What Stops Purchasing Power Parity from Occurring?

When you travel, you will notice that some goods and services are
cheaper overseas than here, and some are more expensive.
Why doesn’t purchasing power parity stop this from happening?
1. Not all products can be traded internationally (especially
services).
2. Products and consumer preferences are different across
countries; prices are determined by supply, but also by demand.
3. Countries impose barriers to trade, like tariffs (taxes on imports)
and quotas (numerical limits on imports).
Example: the U.S. sugar quota ensures that purchasing power
parity cannot reduce the price of sugar in the U.S. to the “world
price”.

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The Big Mac Theory of Exchange Rates
The Economist magazine collects the prices of Big Macs in
different countries.
In July 2011, the average price of a Big Mac was $4.56 in the
United States.
Comparing this to the average prices of Big Macs in other
countries offers a (light-hearted) test of purchasing power parity:
COUNTRY BIG MAC PRICE IMPLIED EXCHANGE RATE ACTUAL EXCHANGE RATE
Mexico 37 pesos 8.11 pesos per dollar 12.94 pesos per dollar
Japan 320 yen 70.18 yen per dollar 100.11 yen per dollar
United Kingdom 2.69 pounds 0.59 pound per dollar 0.67 pound per dollar
Switzerland 6.5 Swiss francs 1.43 Swiss francs per dollar 0.97 Swiss francs per dollar
Indonesia 27,939 rupiahs 6,127 rupiahs per dollar 9,965 rupiahs per dollar
Canada 5.53 Canadian dollars 1.21 Canadian dollars 1.05 Canadian dollars
per U.S. dollar per U.S. dollar
China 16 yuan 3.51 yuan per dollar 6.13 yuan per dollar

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Example
Calculating Purchasing Power Parity Exchange Rates Using Big Macs
Fill in the missing values in the following table. Remember that the implied exchange rate
shows what the exchange rate would be if purchasing power parity held for Big Macs.
Assume that the Big Mac is selling for $4.07 in the United States. Explain whether the U.S.
dollar is overvalued or undervalued relative to each currency and predict what will happen
in the future to each exchange rate. Finally, calculate the implied exchange rate between
the Polish zloty and the Brazilian real (plural: reais) and explain which currency is
undervalued in terms of Big Mac purchasing power parity.
IMPLIED ACTUAL
COUNTRY BIG MAC PRICE EXCHANGE RATE EXCHANGE RATE
Brazil 9.50 reals 1.54 reals per dollar
Poland 8.63 zlotys 2.80 zlotys per dollar
South Korea 3,700 won 1,056 won per dollar
Malaysia 7.20 ringgits 2.97 ringgits per dollar

Solving the Problem

Step 1: Review the chapter material.

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Example
Calculating Purchasing Power Parity Exchange Rates Using Big Macs
Step 2: Fill in the table. To calculate the purchasing power parity exchange rate, divide
the foreign currency price of a Big Mac by the U.S. price.
IMPLIED ACTUAL
COUNTRY BIG MAC PRICE EXCHANGE RATE EXCHANGE RATE
Brazil 9.50 reais 2.33 reais per dollar 1.54 reais per dollar
Poland 8.63 zlotys 2.12 zlotys per dollar 2.80 zlotys per dollar
South Korea 3,700 won 909 won per dollar 1,056 won per dollar
Malaysia 7.20 ringgits 1.77 ringgits per dollar 2.97 ringgits per dollar
Step 3: Explain whether the U.S. dollar is overvalued or undervalued against the
other currencies. The dollar is overvalued if the actual exchange rate is greater than the
implied exchange rate, and it is undervalued if the actual exchange rate is less than the
implied exchange rate.

Step 4: Calculate the implied exchange rate between the zloty and the real. The
implied exchange rate between the zloty and the real is 8.63 zlotys/9.50 reais, or 0.91
zlotys per real. We can calculate the actual exchange rate by taking the ratio of zlotys per
dollar to reais per dollar: 2.80 zlotys/1.54 reais, or 1.82 zlotys per real. Therefore, the zloty
is undervalued relative to the real because our Big Mac purchasing power parity
calculation tells us that it should take fewer zlotys to buy a real than it actually does.

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Determinants of Exchange Rates in the Long Run

Relative price levels

Purchasing power parity explains some exchange rate movements.
Relative rates of productivity growth
A country with relatively high productivity growth will have less
expensive products; demand for these products from foreigners will
cause the domestic currency to appreciate
Preferences for domestic and foreign goods
If consumers in Canada increase their demand for U.S. goods, they
increase their demand for U.S. dollars, and hence appreciate the
value of the $US.
Tariffs and quotas
High tariffs or restrictive quotas reduce the demand for foreign goods,
and hence cause the domestic currency to appreciate.
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ii. The Euro
In part to encourage international trade, 12 European countries
decided to adopt a common currency—the euro—in 1999.
• Their exchange rates of their currencies—the French franc, the
Spanish peseta, the German mark, etc.—were permanently fixed
against one another.

In 2002, the euro currency went into circulation, and the domestic
currencies were withdrawn from circulation.
• By 2013, 17 of the European Union nations had adopted the euro
as their currency.

A new European Central Bank (ECB) was also established; the ECB
became responsible for monetary policy throughout the Euro zone.

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Countries Adopting the Euro
Yellow shaded
countries are
members of the
European Union.

Countries with red

stripes have
adopted the euro
as their currency.

Figure 19.2
Countries adopting
the euro

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Can the Euro Survive?
For the first few years of the euro, all seemed well: relative economic
stability through most of Europe, expanding employment and
production, and easier foreign transactions for firms and consumers.

But the recession of 2007-2009 hit Europe as well, and a weakness

of the shared currency became apparent: individual countries using
the euro could not pursue their own monetary policies.
• The inability to use monetary policy was one of the reasons
countries abandoned the gold standard.
The countries did use expansionary fiscal policy, but the debts
incurred lead to sovereign debt crises for several Euro zone nations.
The European Debt Crisis Visualized
https://www.youtube.com/watch?v=j4_tyEl84IQ
While the euro is useful for facilitating trade, a flexible exchange rate
can have important advantages, such as allowing domestic currency
to depreciate.

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iii. Pegging against the Dollar
Some developing countries have attempted to keep their exchange
rates fixed against the $US or other currencies, an action known as
pegging.

Advantages:
• Easier planning for firms
• A more credible commitment to fighting inflation

Disadvantages:
• Needing to support an under- or over-valued currency
• Potential for destabilizing speculation if speculators believe the
currency will eventually appreciate or depreciate
• Difficulty in pursuing an independent monetary policy

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The East Asian Exchange Rate Crisis of the Late 1990s

In the 1990s, the

Thai baht was
pegged to the
$US at a rate of
1 baht = $0.04.
But by 1997, the
market
equilibrium value
of Thai baht was Figure 19.3 By 1997, the Thai baht was
only $0.03. overvalued against the dollar

This created a persistent surplus of Thai baht on foreign exchange

markets. To support the pegged rate, the Bank of Thailand had to buy
baht with its U.S. dollar reserves. It also raised Thai interest rates to
attract investors, but that further depressed the Thai economy.
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Destabilizing Speculation against the Baht
The Thai difficulties did
not go unnoticed.
People believed that
the Bank of Thailand
would not be able to
maintain the high value
of its currency, so they
sold off Thai currency
as quickly as possible.
Figure 19.4 Destabilizing speculation against the baht

This further depressed the market equilibrium exchange rate,

increasing the motivation to sell off Thai currency.
• In July 1997 Thailand allowed its currency to float, but now firms
had debt denominated in $US, and with their earnings in Thai baht,
they found it even harder to repay their loans.
• Many firms went bankrupt, leading to a deep Thai recession.
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The Decline in Pegging
Several other East Asian countries experienced similar speculative
attacks on their currencies—including South Korea, Indonesia, and
Malaysia—leading them to abandon pegged exchange rates.
• Today, many countries have followed this trend, allowing a
managed float of their currencies instead.

Some countries maintain pegged exchange rates:

• Several Caribbean countries peg against the $US
• Several former French colonies in Africa pegged against the
French franc and now do against the euro
Most of these countries are small, and primarily trade with the country
to whose currency they peg.

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3. Practice Exercises
3.1: According to the theory of purchasing power
parity, if the inflation rate in Canada is higher than
the inflation rate in the U.S., what should happen to
the exchange rate between the Canadian dollar and
the U.S. dollar? Briefly explain.

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3.2 The Euro

3.2: Will the use of the euro help increase economic

growth in countries in the European Union? Will it
help individual countries using the euro in times of
recession? Explain.

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3.3 The Chinese Experience with Pegging
In the 1990s, China pegged its currency against the $US, at a rate of
$0.12 = 1 yuan. This brought predictability for Chinese firms trading
with American firms. The graph below shows the demand and supply
of Chinese yuan for U.S. dollars:
i. According to the graph, is there
a surplus or shortage of
Chinese yuan in exchange for
U.S. dollars? Briefly explain.
ii. To maintain the pegged
exchange rate, will the Chinese
central bank need to buy yuan
in exchange for dollars or sell
yuan in exchange for dollars?
What is the quantity of yuan the
Chinese central bank would
have to buy or sell?

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3.4 Exchange Rates
3.4: When the euro was introduced in January 1999, the
exchange rate was $1.19 per euro. In September 2013, the
exchange rate was $1.35 per euro. #1: Was this exchange in
the dollar-euro exchange rate good news or bad news for U.S.
firms exporting goods and services to Europe? #2: Was it good
news or bad news for European consumers buying goods and
services imported from the United States? Briefly explain.

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4. More Practice for Final
4.1: Consider an economy without economic growth.
The economy is initially in a long-run macroeconomic
equilibrium. Suppose that oil prices increase
substantially and the production costs that many firms
incur increase. Investigate:
#1: what would happen to the economy in the short run
#2: what would happen to the economy in the long run
Answer this question by using a graph(s) that is used
for the aggregate demand and aggregate supply
analysis.

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4.2 Multiple Choice Questions
#1: If cyclical unemployment is eliminated in the economy, then
A) the economy is considered to be at full employment.
B) the unemployment rate is below the natural rate of
unemployment.
C) the unemployment rate is above the natural rate of
unemployment.
D) the economy has no unemployment.

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#2: If the real GDP in China doubles between 2005 and 2015,
what is the average annual growth rate of the real GDP in
China?
A) 5%
B) 7%
C) 10%
D) 15%

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#3: Using the Taylor rule, if the current inflation rate rises above
target inflation rate and real GDP rises above potential GDP
while all else remains constant, then the federal funds target rate
A) will increase.
B) will decrease.
C) remains unchanged.
D) may increase or decrease.

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4.3 Money
4.3 Briefly explain whether each of the following is
counted in M1.
#1: The coins in your pocket
#2: The funds in your checking account
#3: The funds in your savings account
#4: The traveler’s checks that you have left over
from a trip
#5: Your Citibank Platinum MasterCard

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4.4 Fiscal Policy
4.4 Briefly explain whether each of the following is an example
of a discretionary fiscal policy, an automatic stabilizer, or not a
fiscal policy.
#1: The federal government increases spending on rebuilding
the New Jersey shore following a hurricane.
#2: The Federal Reserve sells Treasury securities.
#3: The total the federal government pays out for
unemployment insurance decreases during an expansion.
#4: The revenue the federal government collects from the
individual income tax declines during a recession.
#5: The federal government changes the required gasoline
mileage for new cars.
#6: Congress and the president enact a temporary cut in
payroll taxes.
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4.5 Macroeconomics in an Open Economy
4.5: Use the graph to answer the following questions.
#1: Briefly explain whether the US dollar appreciated or
depreciated against the yen.
How would each of the
following events shift the
demand of the US dollar?
#2: Interest rates in the United
States have declined.
#3: Income rises in Japan.
#4: Speculators begin to
believe the value of the dollar
will be higher in the future.

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