Econ 1202 1st edition Lecture 26 Outline of Last LectureI. LinkagesII. Flow of Goods: TermsIII. The Internationalization of the U.S. EconomyIV. Factors that Might Influence a Country’s Exports, Imports, and Net ExportsV. Flow of Financial Assets: TermsVI. Variables that Influences Net Capital FlowVII. Balance of PaymentsVIII. Composition of Balance of PaymentsIX. Current AccountX. Financial AccountsXI. Capital AccountXII. Relationship Between Goods and AssetsXIII. Net Export DeficitXIV. Net Export SurplusXV. The Case of the U.S.XVI. Exchange RatesXVII. Exchange Rates: Basic TermsXVIII. Demand and Supply for the U.S. DollarXIX. Two Versions of the Exchange Rate are Reciprocals of Each OtherOutline of Current LectureI. Fiscal Policy in an Open EconomyII. Fed vs. ECBIII. Monetary Policy in an Open EconomyIV. “At Last, Eurozone Gets Growth in Gear”V. Quantity Theory of Money ConnectionVI. Why Doesn’t the PPP Hold True? VII. Theory of Purchasing Power ParityVIII. What are Some Significant Determinants of Exchange Rates?IX. Real Exchange RatesX. Let’s Take A Step BackXI. Impact of Exchange Rate Movements on Aggregate DemandCurrent LectureThe International Economy (continued)I. Let’s Take A Step Backa. Anything (apart from the exchange rate itself) effecting the demand for foreign exchange will shift the demand curve to the right for an increase in demand or to the left for a decrease in demandb. This might result from:i. Changes in the demand for U.S produced goods and services relative to foreign produced goods and servicesii. Changes in the desire to invest in the U.S. relative to foreign countriesiii. Changes in the expectations of currency traders about the likely future value of the U.S. dollar relative to foreign currenciesc. The supply of the U.S. dollar for yen is the same as the demand for yen with U.S. dollar, so the same factors that change demand also change supplyII. Impact of Exchange Rate Movements on Aggregate Demanda. When the U.S. dollar appreciates, the dollar price of foreign imports fallsi. Similarly, the foreign currency price of U.S. exports risesb. Assume the exchange rate between the U.S. dollar and euro is $1=1 euroi. An iPhone with a U.S. price of $200 will cost 200 euros to a French person, but if the U.S. dollar appreciates, the exchange rate is now $1=1.20 euros and the same iPhone will now cost the French person 240eurosii. We would expect French people to buy fewer iPhones and because French wine has become cheaper for Americans to buy, we would expect American’s would demand more French wineiii. In the end, NX would fall causing a decline in aggregate demandc. Just the reverse happens when a currency depreciatesi. If the U.S. dollar depreciates, the dollar price of foreign imports rises and the foreign currency price of U.S. exports fallsii. In the end, NX would rise causing an increase in aggregate demandIII. Real Exchange Ratesa. Real Exchange Rate-corrects the nominal exchange rate for differences in prices of goods and services between countries; the price of domestic goods in terms of foreign goodsb. Suppose initially $1=1 pound and the U.S. and British price levels are both 100i. The real exchange rate between the U.S. dollar and British pound is 1 pound/dollarc. Assume the U.S. dollar appreciates so the new exchange rate is $1=1.10 pounds and simultaneously, the price level in the U.S. rises to 105 (5% inflation) wile price levels stay constant in the UKi. The real exchange rate is now 1.15 pound/dollarii. Prices of U.S. goods are now 15% higher than they were relative to the prices of British goodsd. More Formally: the real exchange rate is the rate at which a person can trade goods and services of one country for goods and services of anothere. Real Exchange Rate=(e*P)/P’i. e=nominal exchange rate between the U.S. dollar and foreign currenciesii. P=price index for U.S. basketiii. P’=price index for foreign basketIV. What are Some Significant Determinants of Exchange Rates?a. Short-run:i. Relative interest ratesii. Expectations about future values of currencies (which is often about expected interest rates)b. Long-run:i. Exchanges rates should move to equalize the purchasing powers of different currencies1. This is known as the Theory of Purchasing Power Parityii. Greater rates of inflation, greater depreciationV. Theory of Purchasing Power Paritya. Nominal exchange rate between the currencies of two countries must reflect theprice levels in those countriesb. Basic logic of purchasing power parityi. Based on the law of one price that a good must sell for the same price inall locationsVI. Why Doesn’t the PPP Hold True? a. Not all products are or can be services traded internationallyb. Producer and consumer preferences are different across countries; prices are determined by supply and demandi. Not all tradable goods have perfect or near perfect substitutesc. Barriers to trade like tariffs ad quotas can ensure that purchasing power parity will not equalize the domestic price to any single “world price”d. But…i. Purchasing power parity explains some exchange rate movements1. As domestic price vs. foreign prices change, you would expect nominal exchange rate movementii. This is tied to relative rates of productivity growth because a country with relatively high productivity growth will have less expensive products; demand for these products from foreigners will cause the domestic currency to appreciateiii. In addition to trade restrictions and productivity, preferences for domestic and foreign goods drive long-term exchange rate movements1. 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 U.S. dollarVII. Quantity Theory of Money Connectiona. Quantity Theory of Money-long-run impact of money supply on price levelb. PPP-long-run impact of price level on nominal exchange ratesc. Higher rates of monetary growth, greater depreciation as domestic currency fallsin value (inflation), and thus, large and persistent movements in nominal exchange rates typically reflect changes in price levels at home and abroadVIII. “At Last, Eurozone Gets Growth in Gear”a. IMF Revising Eurozone Growth Upwardsi. ECB: aggressive bond purchases lowering interest ratesii. “End of Austerity”: fiscal policy implicationsiii. Banks are lending and the money supply is growingiv. Structural reformb. Think Through the Mechanismsi. Aggregate Demand: