Chapter 26 - Exchange rates, international trade & capital flows

Exchange rates

• Nominal exchange rate: rate at which two currencies can be traded for each other.

• Appreciation: increase in the value of a currency relative to other currencies.

• Depreciation: decrease in the value of a currency relative to other currencies.

• Flexible exchange rate: exchange rate whose value is not officially fixed but varies according to the supply and demand for the currency in the foreign exchange market.

• Foreign exchange market: market on which currencies of various nations are traded for one another.

• Fixed exchange rate: exchange rate whose value is set by official government policy.

Exchange rate determination in the short run

• Market equilibrium value of the exchange rate: exchange rate that equates the quantities of the currency supplied and demanded in the foreign exchange market.

• Supply and demand analysis is a useful tool for studying the short-run determination of the exchange rate. U.S. households and firms supply dollars to the foreign exchange market to acquire foreign currencies, which they need to purchase foreign goods, services, and assets. Foreigners demand dollars in the foreign exchange market to purchase U.S. goods, services, and assets. The market equilibrium exchange rate equates the quantities of dollars supplied and demanded in the foreign exchange market.

• An increased preference for foreign goods, an increase in U.S. real GDP, an increase in the real interest rate on foreign assets, or a decrease in the real interest rate on U.S. assets will increase the supply of dollars on the foreign exchange market, lowering the value of the dollar. An increased preference for U.S. goods by foreigners, an increase in real GDP abroad, an increase in the real interest rate on U.S. assets, or a decrease in the real interest rate on foreign assets will increase the demand for dollars, raising the value of the dollar.

• A tight monetary policy raises the real interest rate, increasing the demand for dollars, reducing the supply of dollars, and strengthening the dollar. A stronger dollar reinforces the effects of tight monetary policy on aggregate spending by reducing net exports, a component of aggregate demand. Conversely, an easy monetary policy lowers the real interest rate, weakening the dollar.

Exchange rate determination in the long run

• Real exchange rate: price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency.

• Law of one price: if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations.

• Purchasing power parity (PPP): theory that nominal exchange rates are deter mined as necessary for the law of one price to hold.

International capital flows and the balance of trade

• Trade balance = net exports: value of a country's exports less the value of its imports in a particular period (quarter or year).

• Trade surplus: when exports exceed imports, the difference between the value of a country's exports and the value of its imports in a given period.

• Trade deficit: when imports exceed exports, the difference between the value of a country's imports and the value of its exports in a given period.

• International capital flows: purchases/sales of real and financial assets across international borders.

• Capital inflows: purchases of domestic assets by foreign households and firms.

• Capital outflows: purchases of foreign assets by domestic households and firms.

• Net capital inflows: capital inflows minus capital outflows.