IMT - Lecture 11 Exchange Rates

Exchange Rate Determination

  • Understanding Exchange Rates

    • Exchange rates can be determined by supply and demand for currencies in the foreign exchange market.

    • Two main types of exchange rate systems:

    • Flexible Exchange Rate System: Rates fluctuate based on supply and demand without intervention.

    • Fixed Exchange Rate System: Government or central bank sets the exchange rate and intervenes to maintain it.

Market Dynamics

  • Market for Dollars

    • Demand for Dollars:

    • Primarily from Chinese buyers wanting U.S. goods, services, or assets.

    • Supply of Dollars:

    • From U.S. citizens purchasing Chinese goods or services.

  • Graphical Representation:

    • Y-axis: Price of the dollar (in yuan).

    • X-axis: Quantity of dollars.

    • Equilibrium is where demand meets supply.

  • Shifting Curves:

    • Increase in Demand: Rightward shift of the demand curve leads to a higher dollar price (appreciation).

    • Increase in Supply: Rightward shift of the supply curve leads to a lower dollar price (depreciation).

Effects of Demand Changes

  • Decreased Demand for Dollars:

    • Demand curve shifts left, leading to a new equilibrium at a lower dollar price.

    • Under a flexible system, this causes depreciation of the dollar.

    • Under a fixed system, the central bank must buy dollars to maintain the exchange rate, causing potential balance of payments surplus.

Flexibility vs. Fixed Exchange Systems

  • Flexible Exchange Rate System:

    • Exchange rates fluctuate freely based on market conditions.

    • Balance of payments usually equals zero, as there's no intervention.

  • Fixed Exchange Rate System:

    • Government intervenes in the market to maintain a set rate.

    • Can lead to surplus or deficit in the balance of payments, depending on market forces.

    • Example:

    • If demand for the yuan increases, the central bank needs to sell yuan to keep the currency fixed.

Challenges in Fixed Exchange Rates

  • Setting a fixed rate too high can lead to a balance of payments deficit.

  • Maintaining this system long-term can be problematic if foreign reserves run low.

Depreciation and Appreciation Context

  • Depreciation of Currency:

    • Makes foreign goods more expensive and domestic goods cheaper abroad.

  • Appreciation of Currency:

    • Makes foreign goods cheaper and domestic goods more expensive for foreign consumers.

Types of Exchange Rates

  • Bilateral Exchange Rate:

    • The price of one currency in terms of another (e.g., USD to JPY).

  • Effective Exchange Rate:

    • A weighted average of bilateral exchange rates, representing currency strength relative to multiple trade partners.

  • Real Exchange Rate:

    • Adjusted exchange rate that considers price level differences between countries. A higher real exchange rate indicates a relative increase in national price levels.

Trade Implications

  • Real Effective Exchange Rate:

    • Affects overall trade competitiveness. An increasing rate means domestic goods are more expensive compared to foreign goods, likely reducing exports and increasing imports.

Conclusion

  • Understanding both types of exchange rate systems and their implications can help analyze international trade impacts and currency movements effectively.

  • Awareness of bilateral, effective, and real exchange rates is crucial for assessing currency strength and international competitiveness.