April 21st lecture econ 102

Currency and Exchange Rate Effects

• Currency Valuation Impact:

  • When a currency is valued higher, exports from that country become more expensive to foreign consumers, leading to decreased demand for those exports.

  • Conversely, imports become cheaper.

Purchasing Power Parity (PPP)

• Definition: Purchasing Power Parity is the economic theory that argues that in a state of equilibrium, the price of goods should equalize across different countries when exchange rates are considered.

• Formula: The price of a Big Mac in the EU can be represented as:
  ext{Price of Big Mac in EU} = ext{Price of Big Mac in US} imes rac{ ext{Euro}}{ ext{US Dollar}}

• Implication: In equilbrium, prices should align such that purchasing managers would be indifferent about purchasing in different currencies.

Real Exchange Rate

• Real Exchange Rate Calculation:

  • The real exchange rate (denoted as E) is calculated as:
    E = rac{ ext{Nominal Exchange Rate}}{ ext{Prices in Europe}}

• Equality in Equilibrium: At equilibrium, this real exchange rate should equal one, signifying no profit opportunities exist from arbitrage.

Adjustments in Real and Nominal Exchange Rates

• Out of Equilibrium: Exchange rates can deviate from equilibrium, leading to unexpected profit opportunities in trade.

  • A drop in the real exchange rate increases demand for US dollars as exports become cheaper, leading to eventual inflation counterbalancing the depreciation.

• Pass-Through Period: This refers to the duration needed for changes in exchange rates to reflect in price levels.

  • The pass-through period is crucial for determining when PPP will hold true again.

Inflationary Effects and Currency Depreciation

• Impact of Inflation: If the US experiences higher inflation than Europe, the nominal exchange rate typically depreciates.

• Cycle of Changes: Initial depreciation leads to increased prices in the US, which can proceed to further changes in the effective exchange rates.

Temporal Effects of Exchange Rate Changes

• Short Run vs Long Run: Monetary policy changes affect exchange rates and markets temporarily without immediate effect on prices. As time progresses, those effects normalize and modify economic activity based on changing prices.

• Long Term Stability: Long-term inflation rates can be affected by inconsistent monetary policies, leading to fluctuating economic growth.

Monetary versus Fiscal Policy

• Monetary Policy:

  • Expansionary monetary policy tends to lead to lower interest rates, prompting a depreciation of the currency, boosting exports and net exports while imports rise.

• Fiscal Policy:

  • Expansionary fiscal policy, requiring increased government borrowing, results in higher interest rates, leading to currency appreciation. Consequently, exports become more expensive and imports cheaper, worsening trade balances.

Trade Balances and Currency Demand

• Twin Deficits: Rising government deficits via expansionary fiscal policies typically lead to trade deficits, disrupting economic equilibrium.

• Deterioration of Demand: Heightened tariffs can reduce the demand for foreign currency, leading to a potential appreciation of domestic currency.

Effects of Currency Appreciation/Depreciation

• Consumption and Export Dynamics:

  • When the domestic currency appreciates, domestic consumers tend to buy more imports, leading to deterioration in the trade balance, while currency depreciation has the opposite effect.

Real-World Applications and Risk Factors

• Currency Fluctuations: Recent fluctuations in the US dollar value against other currencies (e.g., gold as a safe asset during economic uncertainty) can impact economic indicators.

• Case Studies: Looking at Argentina’s efforts to maintain a pegged exchange rate illustrates the challenges of managing exchange rates in fluctuating markets.

Conclusion of Chapter Insights

• Understanding distinctions between real and nominal exchange rates is crucial.

• Chart patterns from current currency demand signify larger implications on economic growth and international trade dynamics.

• Global investor sentiment can drastically shift currency valuations based on perceived economic stability.