F.  International Issues in the Macro Economy

1.  Exchange rate determination

• Exchange rate - 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

.

a.  Changes in the exchange rate

• Currency appreciation - value of currency increases

• Currency depreciation - value of currency decreases

.

b.  Foreign exchange market

• Nominal exchange rate is determined

.

(1) Demand

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

.

(2)  Supply

• Currency supplied when other country's currency demanded

.

(3)  Equilibrium

.

.

.

.

.

.

.

.

.

.

c.  Changes in exchange rates

(1)  Changes in relative international price levels

• Prices more expensive in one country than in another

.

.

.

.

.

.

.

.

.

.

(2)  Changes in relative international real GDP

.

.

.

.

.

.

.

.

.

.

(3)  Changes in relative international interest rates / returns

• Both lenders and borrowers affected

.

.

.

.

.

.

.

.

.

.

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

.

.

.

.

.

.

.

.

.

.

(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

.

(2)  Impossible trilogy

• Impossible to have all of the following:

- Fixed exchange rate

- Free and open international trade and capital markets

- Monetary independence

.

(3)  Sterilized intervention

• Take action to counteract impact of intervention on money supply

.

.

.

b.  Fixed band exchange rate system

• Exchange rate varies within a predetermined range

.

c.  Crawling peg

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

.

d.  Managed float

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

.

e.  Flexible exchange rates

• Exchange rate determined by market forces

• Benefits:

  - Protects against inflation in another country

.

.

.

- Country can determine own monetary policy

.