Self-Check Questions
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 fluctuations can happen through the banking system,” if banks borrow from abroad to lend domestically. Why is this less likely to be a problem for the U.S. banking system? 6 . A booming economy can attract inflows, which promote further growth. However, capital can just as easily flow out of the country, leading to economic recession. Is a country whose economy is booming because it decided to stimulate consumer spending more or less likely to experience capital flight than an economy whose boom is caused by economic investment expenditure? 7 . How would a contractionary monetary policy affect the exchange rate, net exports, aggregate demand, and aggregate supply? 8 . A central bank can allow its currency to fall indefinitely, but it cannot allow its currency to rise indefinitely. Why not? 9 . Is a country for which imports and exports comprise a large fraction of the GDP more likely to adopt a flexible exchange rate or a fixed (hard peg) exchange rate?
Review Questions
10 . What is the ? 11 . Describe some buyers and some sellers in the for U.S. dollars. 12 . What is the difference between foreign direct investment and ? 13 . What does it mean to a financial transaction? 14 . What does it mean to say that a currency appreciates? Depreciates? Becomes stronger? Becomes weaker? 15 . Does an expectation of a stronger in the future affect the in the present? If so, how? 16 . Does a higher rate of return in a nation’s economy, all other things being equal, affect the of its currency? If so, how? 17 . Does a higher rate in an economy, other things being equal, affect the of its currency? If so, how? 18 . What is the purchasing power parity ? 19 . What are some of the reasons a is likely to care, at least to some extent, about the ? 20 . How can an unexpected fall in exchange rates injure the financial health of a nation’s banks? 21 . What is the difference between a floating exchange rate, a soft peg, a hard peg, and dollarization? 22 . List some advantages and disadvantages of the different exchange rate policies.
Critical Thinking Questions
23 . Why would a nation “”—that is, adopt another country’s currency instead of having its own? 24 . Can you think of any major disadvantages to dollarization? How would a work in a country that has dollarized? 25 . If a country’s currency is expected to appreciate in value, what would you think will be the impact of expected exchange rates on yields (e.g., the paid on government bonds) in that country? Hint: Think about how expected changes and interest rates affect a currency's and supply. 26 . Do you think that a country experiencing is more or less likely to have an
Text from Principles of Macroeconomics 3e, OpenStax, licensed CC BY-NC-SA 4.0. Access for free at openstax.org.
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