Exchange Rate Determination and Open Economy Macroeconomics
Recall fiscal policy mainly works through consumption spending (C) and government spending (G). Monetary policy has a major impact on investment spending (I).
Question: What is the major factor influencing net export?
1. Exchange Rates
An exchange rate is the # of units of one currency trading for one unit of another currency.
Example: Assume that 4 Euros (€) trade for 1 U.S. Dollar (USD). The exchange rate would be 4€/1USD = 4.
Today: €4 = 1USD or €1 = 0.25USD
Tomorrow: €2 = 1USD or €1 = 0.50USD
When we can obtain more € per USD, the USD is said to appreciate against the €, or ...view middle of the document...
Determinants of exchange rates
Any factor that changes the demand or supply for a currency will cause a change in the exchange rate.
Question: What factors cause changes in exchange rates?
There are long-run factors, medium-run factors, short-run factors, and very short-run factors that can cause changes in exchange rates.
a) Long-run factors:
Relative price levels between countries (Purchasing Power Parity (PPP)).
Assume that a Big Mac costs $2.00 in the U.S. and costs €8 in France. €8 = $2 or €4 = $1
Exchange rate = Price level in France / Price level in U.S.
As PU.S. relative to PFrance demand for U.S. goods falls demand for $ $ depreciates
Point: If our economy experiences an inflation rate which is higher than our trading partners, our currency will depreciate.
b) Medium-run factors:
Level of economic activity as measured by real GDP (Y)
Assume that YU.S. Disposable income in the U.S. Consumption in the U.S. U.S. imports U.S. residents demand more French francs and hence supply more dollars $ depreciates
Point: If our economy grows faster than our trading partners, our currency will depreciate.
c) Short-run factors:
Relative interest rates (i)
Assume that iU.S. international investors will find investing in the U.S. more attractive Demand for $ $ appreciates
This also results in a capital inflow.