HowExchangeRatesAreDetermined

2Introduction35yearsago,theinteractionsbetweenthefinancialmarketsintheU.S.economyandtherestoftheworldwerelargelyignoredToday,thesituationismuchdifferentcross-bordertradingofforeigncurrenciesandfinancialinstrumentsdenominatedinvariouscurrencieshasincreasedmuchfasterthanthemorevisibleexplosionofinternationaltradethevalueofthedollar(relativetoothercurrencies)changesdaily3DefiningExchangeRatesTheexchangerateisthenumberofunitsofforeigncurrency(money)thatcanbeacquiredwithoneunitofdomesticmoneyspecifiesthepurchasingpowerofacurrencyintermsofhowmuchitcanbuyofanothercurrency4DefiningExchangeRatesAcurrencyappreciatesifitsexchangeraterisesAcurrencydepreciatesifitsexchangeratefallsSuppliesofforeigncurrencyarecalledforeignexchange5DefiningExchangeRatesThepricepaidbyanimporterintheU.S.foraforeigngoodisequalto6DefiningExchangeRatesTheimporteranditscustomersareaffectedbychangesintheexchangerateThisimpliesthatchangesintheexchangeratewillhaverepercussionsinalldomesticandforeignmarketsiftheU.S.dollarappreciates,importstotheU.S.willriseandexportsfromtheU.S.willfalliftheU.S.dollardepreciates,importstotheU.S.willfallandexportsfromtheU.S.willrise7DefiningExchangeRatesTheexchangerateisdeterminedbysupplyanddemandintheforeign-exchangemarketthesupplyofdollar-denominatedfunds(dollars)comesfromthedemandbyU.S.residentsforforeigngoods,services,andfinancialclaimsthedemandfordollar-denominatedfunds(dollars)comesfromthedemandbyforeignersforU.S.goods,services,andfinancialclaims8TheForeignExchangeMarketUnitedStatesRestoftheWorldForeignExchangeMarketYenPerDollarDollarsSupplyDemand$YenU.S.SuppliesDollarsasForeignersSupplyYenU.S.DemandsYentoPayForeignersasForeignersDemandDollarstoPayU.S.U.S.Purchases(Demand)ForeignGoods,Services,andSecuritiesForeignersPurchase(Demand)U.S.Goods,Services,andSecurities9TheDemandforDollarsintheForeignExchangeMarketThedemandfordollarsininternationalfinancialmarketsoriginatesfromforeignpurchasesofU.S.goods,services,andsecurities10TheDemandforDollarsintheForeignExchangeMarketThequantitydemandedofdollarspermonthisinverselyrelatedtotheexchangerate11TheDemandforDollarsintheForeignExchangeMarketTheexchangerate(yen/dollar)willaffectforeigndemandforU.S.goodsyenpriceofU.S.goods=$priceofU.S.goods×exchangerateIfthedollarappreciates(yen/dollar),theyenpriceoftheU.S.goodrisesforeignerswillreducetheirquantitydemandedofU.S.goods12TheSupplyofDollarsintheForeignExchangeMarketIninternationalfinancialmarkets,thesupplyofdollarsoriginatesfromdomesticpurchasesofforeigngoods,services,andfinancialsecurities13TheSupplyofDollarsintheForeignExchangeMarketThequantitysuppliedofdollarspermonthisdirectlyrelatedtotheexchangerate14TheSupplyofDollarsintheForeignExchangeMarketTheexchangerate(yen/dollar)willaffectU.S.demandforforeigngoodsIfthedollarappreciates(yen/dollar),theU.S.priceoftheforeigngoodfallsU.S.residentswillincreasetheirquantitydemandedofforeigngoods15TheForeignExchangeMarketThereisaninverserelationshipbetweenthequantitydemandedofdollarsandtheexchangeratethedemandcurvewillhaveanegativeslopeThereisadirectrelationshipbetweenthequantitysuppliedofdollarsandtheexchangeratethesupplycurvewillhaveapositiveslope16TheMarketforDollarsYen/DollarQuantityofDollars/MonthDemandforDollarsSupplyofDollarsA100Equilibriumoccurswherequantitysupplied=quantitydemanded17ChangesintheSupplyofDollarsChangesinU.S.realincomepositiverelationshipwiththesupplyofdollarsasU.S.income↑,domestichouseholdsandfirmspurchasemoregoods,services,andsecurities(includingforeigngoods,services,andsecurities)Americanswillspendmoreonimports18ChangesintheSupplyofDollarsChangesinthedollarpriceofU.S.goodsrelativetothedollarpriceofforeigngoodspositiverelationshipwiththesupplyofdollarsasU.S.pricesrise,U.S.residentswilldemandmoreforeigngoods19ChangesintheSupplyofDollarsChangesinforeigninterestratesrelativetoU.S.interestratespositiverelationshipwiththesupplyofdollarsasforeigninterestratesrise,foreignsecuritiesbecomerelativelymoreattractiveU.S.residentswillbuymoreforeignsecurities20ChangesintheExchangeRate:TheRoleofChangesinSupplyYen/DollarExchangeRateQuantityofDollars/MonthDemandforDollarsASupplyofDollars10050BSupplyofDollarsafterRiseinU.S.Income21ChangesintheDemandforDollarsChangesinforeignrealincomepositivelyrelatedtothedemandfordollarsasforeignincomes↑,foreignhouseholdsandfirmspurchasemoregoods,services,andsecurities(includingU.S.goods,services,andsecurities)foreignresidentswillspendmoreonimports22ChangesintheDemandforDollarsChangesintheforeign(yen)priceofforeigngoodsrelativetotheforeignpriceofU.S.goodspositivelyrelatedtothedemandfordollarsastheyenpriceofJapanesegoodsrisesrelativetotheyenpriceofU.S.goods,foreignerswilldemandmoreU.S.goods23ChangesintheDemandforDollarsChangesinU.S.interestratesrelativetoforeigninterestratespositivelyrelatedtothedemandfordollarsasU.S.interestratesrise,U.S.securitiesbecomerelativelymoreattractiveforeignresidentswillbuymoreU.S.securities24ChangesintheExchangeRate:TheRoleofChangesinDemandYen/DollarExchangeRateQuantityofDollars/MonthDemandforDollarsASupplyofDollars10050BDemandforDollarsafterRiseinU.S.Prices25ExchangeRatesintheLongRunSupposethattheFederalReservepursuesanexpansionarymonetarypolicyU.S.interestratesfalltheattractivenessofU.S.securitiesfallsrelativetoforeignsecuritiesdemandfordollarsfallssupplyofdollarsrisestheexchangeratewillfallimports26ExchangeRatesintheLongRunSupposethatthisFedpolicycausesanaccelerationofinflationintheU.S.Inthelongrun,exchangerateswilladjusttodifferentinflationratesamongcountriessothattherelativepurchasingpowerofvariouscurrenciesisequalizedthisisthetheoryofpurchasingpowerparityafterfulladjustmentamongallcurrencies,onecurrencywillpurchasethesamemarketbasketineverycountry27ExchangeRatesintheLongRunThepurchasingpowerparitytheoryisbasedonmany,oftenunrealisticassumptionsallgoodsandservicesareidenticalandtradablenotransportationcostsnobarrierstotradeexchangeratesareonlyinfluencedbyrelativeinflationratesacrosscountries28ExchangeRatesintheLongRunThepurchasingpowerparitytheoryneglectsfactorsthatcauseexchangeratestovarysignificantlyovertimechangesinproductivityeconomicgrowthchangesinmarketstructureschangesintechnologiesacrosscountriesshiftsinfactorsuppliesthatcausecommodityshocks29ChoosingAmongDomesticandForeignFinancialInstrumentsWhencomparingfinancialinstrumentsdenominatedinthesamecurrency,investorsconsiderthereturn,thematurity,andthedefaultriskIfinstrumentsaredenominatedindifferentcurrencies,investorsandborrowersmustconsidertheexchangeraterisktheriskthattheexchangeratewillchangeandaltertherealreturnoftheinvestment30ChoosingAmongDomesticandForeignFinancialInstrumentsInglobalizedfinancialmarkets,financialmarketplayerscompareexpectedratesofreturnoninstrumentsdenominatedinvariouscurrenciesmustconvertallreturnstoanequivalentreturnintheirdomesticcurrency31ChoosingAmongDomesticandForeignFinancialInstrumentsThenominalrateofreturninadomesticcurrencyonaninvestmentthatisinaforeigncurrency(IUS)canbeshownasIUS=IFOR+E

whereIFORisthenominalforeigninterestrateandEistheexpectedpercentagechangeintheexchangerate(lessanadjustmentforriskthatresultsfromtheuncertaintyofthefutureexchangerate)32ChoosingAmongDomesticandForeignFinancialInstrumentsLenderscomparethenominalU.S.return(IUS)withtheU.S.interestrateandchoosetheonethatoffersthehighestreturnBorrowerscomparethenominalU.S.return(IUS)withtheU.S.interestrateandchoosetoborrowinthemarketthatoffersthelowestrate33ChoosingAmongDomesticandForeignFinancialInstrumentsInreality,borrowersandlenderswillmakedecisionsbasedontheexpectedrealreturntheexpectedrealreturnisthenominalreturnlessexpectedinflationRUS=IUS–PUS=IFOR+E–PUS

wherePUSistheexpectedU.S.inflationrate34ChoosingAmongDomesticandForeignFinancialInstrumentsTheexpectedrealforeignreturncanbeexpressedthesamewayRFOR=IFOR–PFORSubstitutingforIFORintotheearlierequation,wegetRUS=RFOR+PFOR+E–PUS35ChoosingAmongDomesticandForeignFinancialInstrumentsIfcapitalismobile,therealU.S.andforeigninterestrateswilltendtobeequalizedafterdifferencesinexpectedinflationandexpectedchangesintheexchangerate(andtheuncertaintyofthesechanges)havebeentakenintoaccount36TheBalanceofPaymentsThebalanceofpaymentsfortheU.S.istherecordoftransactionsbetweentheU.S.anditstradingpartnersarecordoftheinternationalflowoffundsforpurchasesandsalesofgoods,services,andsecurities37TheBalanceofPaymentsTheaccountingprocedureunderlyingthebalanceofpaymentsisbasedonastandarddouble-entrybookkeepingschemereceiptswillequalpayments38TheBalanceofPaymentsAlltransactionsthatresultinpaymentsbyforeignerstoAmericansarerecordedasreceiptscredititemsexamplesincludemerchandiseexports,foreignpurchasesofU.S.securities,andexpendituresbyforeigntouristsintheU.S.39TheBalanceofPaymentsAlltransactionsthatresultinpaymentsbyAmericanstoforeignersarerecordedaspaymentsdebititemsexamplesincludemerchandiseimports,U.S.purchasesofforeignsecurities,andexpendituresbyU.S.touriststravelingabroad40AHypotheticalandSimplifiedBalanceofPaymentsfortheU.S.EconomyintheYear2005(inBillionsofDollars)41TheCurrentAccountThecurrentaccountbringstogethertransactionsthatinvolvecurrentlyproducedgoodsandservicesexportsimportsnettransferpayments(netunilateraltransfers)42TheCurrentAccountAcountry’stradebalanceismeasuredbythedifferencebetweenmerchandiseexportsandimportswhenmerchandiseimports>exports,thecountryhasatradedeficitwhenmerchandiseexports>imports,thecountryhasatradesurplus43TheCurrentAccountWhennetexportsofservicesareaddedtothetradebalance,wegetthebalanceofgoodsandservicesalsoreferredtoasnetexportsNettransferpaymentsarethedifferencebetweentransfersreceivedfromforeignersandtransfersmadetoforeignersaddingnettransferpaymentstothebalanceofgoodsandservicesyieldsthebalanceoncurrentaccount44TheCapitalAccountThecapitalaccountsummarizesthefinancialflowoffundsandsecuritiesbetweentheU.S.andtherestoftheworldborrowingfromforeignsourcesbyU.S.residentsresultincapitalinflowsintotheU.S.borrowingfromU.S.sourcesbyforeignresidentsresultincapitaloutflowsfromtheU.S.45TheBalanceofPaymentsThecurrentaccountandthecapitalaccountmustbalancethesumoftheitemsinthereceipts-from-foreignerscolumnisequaltothesumoftheitemsinthepayments-to-foreignerscolumn46TheBalanceofPaymentsAllitemsinthereceiptscolumnrepresentforeigndemandforU.S.goods,services,andsecuritiesitemsthatdeterminethedemandfordollarsAllitemsinthepaymentscolumnrepresentU.S.demandforforeigngoods,services,andsecuritiesitemsthatdeterminethesupplyofdollars47TheBalanceofPaymentsAssumingthattheexchangerateisflexible,itwillmovetoensurethatthequantityofdollarsdemandedisequaltothequantityofdollarssuppliedthismeansthatthesumoftheitemsinthereceiptscolumnmustbeequaltothesumoftheitemsinthepaymentscolumn48SummaryofMajorPointsTheexchangerateisthenumberofunitsofforeignmoneythatcanbeacquiredwithoneunitofdomesticmoneyiftheexchangeraterises,thedollarissaidtohaveappreciatedrelativetoothercurrenciesiftheexchangeratefalls,thedollarhasdepreciated49SummaryofMajorPointsThedollarpriceofforeigngoodsisequaltotheforeignpriceofforeigngoodsdividedbytheexchangerateTheforeignpriceofU.S.goodsisequaltothedollarpriceofU.S.goodsmultipliedbytheexchangerate50SummaryofMajorPointsAdepreciationwilllowerthepriceofU.S.goodsinforeignmarketsandraisethepriceofforeigngoodsintheU.S.AnappreciationwillraisethepriceofU.S.goodsinforeignmarketsandlowerthepriceofforeigngoodsintheU.S.51SummaryofMajorPointsTheexchangerateisaprice–thepriceofonecurrencyintermsofanother–andisdeterminedbysupplyanddemandthedemandfordollarsreflectsthedemandbyforeignresidentsforU.S.goods,services,andfinancialclaimsthesupplyofdollarscomesfromthedemandbyU.S.residentsforforeigngoods,services,andfinancialclaims52SummaryofMajorPointsThequantityofdollarsdemandedisinverselyrelatedtotheexchangerateThedemandfordollarsispositivelyrelatedtochangesinforeignincomechangesintheforeignpriceofforeigngoodsrelativetotheforeignpriceofU.S.goodschangesinU.S.interestratesrelativetoforeigninterestrates53SummaryofMajorPointsThequantityofdollarssuppliedispositivelyrelatedtotheexchangerateThesupplyofdollarsispositivelyrelatedtochangesinU.S.incomechangesinthedollarpriceofU.S.goodsrelativetothedollarpriceofforeigngoodschangesinforeigninterestratesrelativetoU.S.interestrates54SummaryofMajorPointsAdepreciationofthedollarcanresultfromoneormoreofthefollow