Introductory Macroeconomics Lecture 19: Exchange Rates I PDF

Introductory Macroeconomics Lecture 19: Exchange Rates I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Exchange Rates I (1) nominal vs. real exchange rates (2) fixed vs. floating rate regimes (3...

Introductory Macroeconomics Lecture 19: Exchange Rates I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Exchange Rates I (1) nominal vs. real exchange rates (2) fixed vs. floating rate regimes (3) exchange rates in the long run: purchasing power parity (4) exchange rates in the short run: supply & demand BOFAH Chapter 17 2  Importance of Exchange Rates The “single most important price” in an economy? Determines the relative value of a country’s exports and imports Changes GDP through changing quantities of exports and imports Expected changes in exchange rates connect interest rates across countries, thereby influencing international capital flows For countries that adopt fixed exchange rates, monetary policy is less effective at stabilising domestic demand 3 Nominal vs. Real Exchange Rates 4  (1) (Bilateral) Nominal Exchange Rate Relative price of one currency in terms of another Two conventions: – Direct Quote Domestic currency per unit foreign currency – Indirect Quote Foreign currency per unit of domestic currency (We tend to use this convention) Example (indirect quote): If 0.75 USD buys one AUD, the bilateral USD/AUD nominal exchange rate is E = 0.75 USD per AUD An increase in E is an appreciation of the AUD against the USD (⇔ depreciation of the USD against the AUD) 5 Nominal Exchange Rates 6 Nominal Exchange Rates 7  Real Exchange Rates Relative price of one consumption basket in terms of another If P is the domestic price level, price of consumption basket of real goods and services in terms of currency, the real exchange rate is P EP RER = = P f /E Pf where P f is foreign price level in foreign currency, P f /E is foreign price level in domestic currency When RER > 1, foreign goods seem cheap in real terms When RER < 1, foreign goods seem expensive in real terms 8  Real Appreciations and Depreciations Increase in RER (appreciation). Makes foreign goods cheaper and domestic goods more expensive Increases imports and/or decreases exports, decreasing net exports Decrease in RER (depreciation). Makes foreign goods more expensive and domestic goods cheaper Decreases imports and/or increases exports, increasing net exports Note RER can change either because of (i) changes in nominal exchange rate E and/or (ii) changes in relative price levels P/P f 9  Real Appreciations and Depreciations Specifically, change in real exchange rate is gRER = gE + gP − gP f = gE + π − π f where gE is change in nominal exchange rate and π − π f is the inflation differential RER can adjust even if nominal exchange rate is fixed! 10 Exchange Rate Regimes 11  (2) Exchange Rate Regimes Exchange rate regime is a macroeconomic policy choice Nominal exchange rate may be floating or fixed Floating: market-determined relative price of currency – supply and demand for currency – but ’clean’ vs. ’dirty’ or managed floats Fixed: policy-makers set price of currency – currency standard (price fixed in terms of foreign currency) – commodity standard (price fixed in terms of gold, say) A currency union is a strong form of currency standard 12 Exchange Rate Regimes 13  Exchange Rate Regimes: Australia Various nominal exchange rates — fixed or ’hard peg’ to 1972, ’crawling peg’ against a basket of currencies to 1983, and then floating since 1983. 14  Fixed Exchange Rates How is a fixed exchange rate maintained? – policy-makers must be willing to take the other side of the market – buy/sell foreign currency if currency standard – buy/sell commodity (gold) if commodity standard – exchange rate regime collapses if reserves exhausted Crisis occurs when current exchange rate regime is not credible Much more on this next lecture 15 Exchange Rates in the Long-Run: Purchasing Power Parity 16  (3) Law of One Price Key idea: tradeable goods should sell for the same price everywhere, once prices denominated in a common currency For traded goods i = 1, 2,... with domestic prices p, in domestic currency and foreign prices pfi in foreign currency pi = pfi /E (if not, buy low and sell high) 17  Purchasing Power Parity (PPP) Absolute PPP hypothesis is the idea that the law of one price holds for the whole consumption basket P = P f /E If so, real purchasing power is the same in both countries. Since RER = EP/P f , this hypothesis is equivalently that RER = 1 Relative PPP requires gRER = 0, which implies: gE = π f − π Changes in nominal exchange rate gE equal to inflation differential π f − π so that real exchange rate remains constant 18  Implications for Nominal Exchanges Rate If Relative PPP holds, then: Domestic currency appreciates gE > 0 if foreign inflation greater than domestic inflation π f > π Domestic currency depreciates gE < 0 if foreign inflation less than domestic inflation π f < π Absolute PPP implies Relative PPP Relative PPP does not imply Absolute PPP 19  Long Run vs. Short Run In the long run, nominal exchange rate E mostly reflects price level differences P/P f and real exchange rate ≈ constant – PPP provides a good guide to long-run exchange rate dynamics (and when a country is experiencing high inflation) But in the short run, changes in the real exchange rate mostly due to changes in the nominal exchange rate E – PPP provides a poor guide to short-run exchange rate dynamics, especially for countries with low and stable inflation rates 20 In the Short Run 21  Variation in RER at Lower Frequencies With floating nominal exchange rate, close co-movement of nominal and real exchange rates (typical for countries with low and stable inflation). With fixed nominal exchange rate, real exchange rate still varies but is much less volatile. 22 Nominal Exchange Rates in the Short-Run: Supply and Demand 23  (4) Supply & Demand for Foreign Exchange Currencies are traded in foreign exchange markets (’forex’) Supply of domestic currency – domestic households and firms that want foreign currencies to buy foreign goods, services, and assets Demand for domestic currency – foreign households and firms that want domestic currency to buy domestic goods, services, and assets Equilibrium nominal exchange rate where supply equals demand 24  Supply & Demand for YEN/AUD Supply of dollars from Australian households and firms that want to buy Japanese goods, services and assets. Demand for dollars from Japanese households and firms that want to buy Australian goods, services and assets. 25  Supply of Domestic Currency Increased demand for foreign goods and services, – changing tastes – the invention of new goods or services – higher national GDP, leading to changing patterns of expenditure Increased demand for foreign assets – higher real returns abroad – flight to safety in times of market turbulence 26 Shift in Supply of AUD 27  Demand for Domestic Currency Increased demand for domestic goods and services, – changing tastes – the invention of new goods or services – higher national GDP, leading to changing patterns of expenditure Increased demand for domestic assets – higher real returns locally – flight to safety in times of market turbulence 28 Shift in Demand for AUD 29  Learning Outcomes 1 Understand and explain nominal and real exchange rates and the connection between the two. Understand and explain the concepts appreciation and depreciation. 2 Understand and explain broadly different exchange rate regimes. 3 Understand and explain purchasing power parity (PPP). 4 Understand and explain exchange rate determination using a supply and demand model. 30  New Formula(s) and Notation Change in real exchange rate (from definition of real exchange rate) gRER = gE + gP − gP f   EP E nominal exchange rate = f P RER real exchange rate {·}f denotes foreign variable 31  Next Lecture Exchange Rates II – monetary policy and the exchange rate – fixed exchange rate regimes – speculative attacks – the policy ’trilemma’ BOFAH Chapter 17 32