Key Concepts and Summary
Key Terms
when a currency is worth more in terms of other currencies; also called “strengthening” the process of buying a good and selling goods across borders to take advantage of international differences when a currency is worth less in terms of other currencies; also called “weakening” a country that is not the United States uses the U.S. dollar as its currency a country lets the determine its currency's value foreign direct investment (FDI) purchasing more than ten percent of a or starting a new enterprise in another country the in which people use one currency to buy another currency an exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate hedge using a financial transaction as protection against risk international capital flows flow of financial capital across national boundaries either as portfolio investment or direct investment merged currency when a nation chooses to use another nation's currency portfolio investment an investment in another country that is purely financial and does not involve any management responsibility purchasing power parity (PPP) the exchange rate that equalizes the prices of internationally traded goods across countries soft peg an exchange rate policy in which the government usually allows the market to set the exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene Tobin taxes see international capital flows
Key Concepts and Summary
16.1 How the Foreign Exchange Market Works
In the , people and firms exchange one currency to purchase another currency. The for dollars comes from those U.S. export firms seeking to convert their earnings in foreign currency back into U.S. dollars; foreign tourists converting their earnings in a foreign currency back into U.S. dollars; and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the for the trading of U.S. dollars are foreign firms that have sold in the U.S. economy and are seeking to convert their earnings back to their home currency; U.S. tourists abroad; and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, then currency A has strengthened or appreciated relative to B. When currency A can buy less of currency B, then currency A has weakened or depreciated relative to B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate with regard to currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.
16.2 Demand and Supply Shifts in Foreign Exchange Markets
In the extreme , ranging from a few minutes to a few weeks, speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker influence exchange rates. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively , differences in rates of return influence markets. Countries with relatively high real rates of return (for example, high interest rates) will tend to experience stronger currencies as they attract from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies. In the medium run of a few months or a few years, rates influence markets. Countries with relatively high will tend to experience less for their currency than countries with lower , and thus currency . Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the such that the prices of internationally tradable goods in different countries, when converted at the PPP to a common currency, are similar in all economies.
16.3 Macroeconomic Effects of Exchange Rates
A will be concerned about the for several reasons. Exchange rates will affect and , and thus affect aggregate in the economy. Fluctuations in exchange rates may cause difficulties for many firms, but especially banks. The may accompany unsustainable flows of international .
16.4 Exchange Rate Policies
In a fixed policy, a government determines its country’s in the . In a policy, the usually determines a country's , but the government sometimes intervenes to strengthen or weaken it. In a policy, the government chooses an . A can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. It also can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face tradeoffs. A exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether. A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment, and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes: (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule based policy designed to keep the money supply stable and predictable.
Self-Check Questions
1 . How will a stronger euro affect the following economic agents? a. A British exporter to Germany. b. A Dutch tourist visiting Chile. c. A Greek bank investing in a Canadian government . d. A French exporter to Germany. 2 . Suppose that political unrest in Egypt leads financial markets to anticipate a in the Egyptian pound. How will that affect the for pounds, supply of pounds, and for pounds compared to, say, U.S. dollars? 3 . Suppose U.S. interest rates decline compared to the rest of the world. What would be the likely impact on the for dollars, supply of dollars, and for dollars compared to, say, euros? 4 . Suppose Argentina gets under control and the Argentine rate decreases substantially. What would likely happen to the for Argentine pesos, the supply of Argentine pesos, and the peso/ U.S. dollar ? 5 . This chapter has explained that “one of the most economically destructive effects of
Text from Principles of Macroeconomics 3e, OpenStax, licensed CC BY-NC-SA 4.0. Access for free at openstax.org.
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