F.  International Issues in the Macro Economy

1.  Exchange rates

• Value of one country's currency in terms of another currency

• Also known as the bilateral exchange rate or cross rate

• Pacific Exchange Rate Service

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a.  Changes in the exchange rate

• Currency appreciation - value of currency increases

• Currency depreciation - value of currency decreases

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b.  Real exchange rate

• Nominal exchange rate adjusted for the price levels in different countries

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c.  Foreign exchange market

• Nominal exchange rate is determined

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(1) Demand

• Currency demanded when purchasing goods from or investing (financial or real) in a country

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(2)  Supply

• Currency supplied when other country's currency demanded

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(3)  Equilibrium

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d.  Changes in exchange rates

(1)  Changes in relative international price levels

• Prices more expensive in one country than in another

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(2)  Changes in relative international real GDP

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(3)  Changes in relative international interest rates / returns

• Both lenders and borrowers affected

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2.  Exchange rate systems

a.  Fixed exchange rates

• Exchange rate maintained at a particular level against a key currency (usually US$)

• Requires intervention by central bank or other monetary authority

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(1)  Benefits:

• Reduces power of central bank to engage in inflationary monetary policy

• Reduces risks and costs to traders and investors

- Used primarily by small, developing countries

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(2)  Impossible trilogy

• Impossible to have all of the following:

- Fixed exchange rate

- Free and open international trade and capital markets

- Monetary independence

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(3)  Sterilized intervention

• Take action to counteract impact of intervention on money supply

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b.  Fixed band exchange rate system

• Exchange rate varies within a predetermined range

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c.  Crawling peg

• Exchange rate fixed for a period, then adjusted according to a predetermined formula

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d.  Managed float

• Exchange rate is usually flexible, but central bank can intervene to reduce volatility or achieve some macroeconomic goal

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e.  Flexible exchange rates

• Exchange rate determined by market forces

• Benefits:

  - Protects against inflation in another country

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- Country can determine own monetary policy

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