appreciation

l 0)

o_

q E 1l 0)

o) c o E () x t!

l-: J:: J, r 1-j r. r, -l

Effect on the Foreign Exchange Market of an lncreased Demand for Euros

$1.27

1.25

Arbitrageurs-dealers who take advantage of any d.ifference in exchange rates belvreen markets by buying low and selling high-ensure this equality. Their actions help to equalize exchange rates across markets. For example, if one euro costs $r.24 in New York but $r.25 in Frankfurt, an arbitrageur could buy, say, $r,ooo,ooo worth of euros in New York and ai the same time sell them in Frankfurt for $r,oo8,o6o, thereby earning $8,o6o minus the transaction costs of the trades.

Because an arbitrageur buys and sells simulta- neousiy, little risk is invoived. In our example, the arbitrageur increased the demand for euros in New

York and increased the supply of euros in Frankfurt. These actions increased the doilar price of euros in New York and decreased it in Frankfurt, thereby squeezing down the difference in exchange rates. Exchange rates may still change because of market forces, but they tend to change in all markets simultaneously.

The demand and supply of foreign exchange arises from many sources-from import- ers and exporters, investors in foreign assets, central banks, tourists, arbitrageurs, and speculators. Speculaiors buy or sell foreign exchange in hopes of profiting by trad- ing the currency at a more favorable exchange rate iater.

By taking risks, speculators aim io profi.t from rnarket fluctuations-they try to buy lcv"' and sell high. In contrast, arbitrageurs take less risk, because they simultaneously buy currency in one market and sell it in another.

Finrlhr nannle in nnrrntrioc crrffo#no

from economic and political turmoil, such as occurred in Russia, Indonesia, and the Phiiippines, may buy hard currency as a hedge againsi the depreciation and insta- bility of their own currencies. The dollar has long been accepted as an international rnedium of exchange. It is also the currenry of choice in the world markets for oii and

six times easier to smuggie euro notes than U.S. notes of equal value.

Psdrchasimg Fcwren FarFty As iong as trade across borders is unrestricted and as long as exchange rates are allowed to adjust freely, the purchasing power parity {PPP} theoiV predicts that the exchange rate between two currencies wiil adjust in the long run to reflect price differerrces between the two currency regions. A given basket of internationally traded good.s should therefore sell for about the same around the world (except for differences reJlecting transportotion costs and the like). Suppose a basket of internationaily traded goods that seiis for $ro,ooo in the United States seils for 8,ooo euros in the euro area. According to the purchasing power parity theory the equiiibrium exchange rate should be $r.25 per euro. If this were not the case-if ihe exchange rate were, say, $r.2o per euro-then you could exchange $9,5oo for 8,ooo euros, with which you buy the basket of commodities in the euro area. You couid then se1l that basket ofgoods in the States for $ro,ooo, yielding you a profit of $4oo minus any transaction costs. Selling dollars and buying euros will also drive up the dollar price of euros.

The purchasing power parity theory is more of a long-run predictor than a day-to-day indicator of the reiationship between changes in the price level and the exchange rate. For example, a country's currency generaily appreciates when inflation is low com- pared with other countries and depreciates when infiation is high. Likewise, a country's currency gen- erally appreciates when its real interest rates are higher than those in the rest of the world, because

iilegai drugs. But the euro eventually rnay1 a challenge ihat dominance, in part because

800 820 Foreign exchange the largest euro dencrnination, the 5oo euro (millions of euros) note, is worth about six times the largest U.S.

denominaiion, ihe $roo note. So it rrould be

arbirrageur softreone tr*ho fakes aclvantege of tenrpoyary geographic differences in the exchange rate by sim$llaneously purehas- ing a curren*y in ene market and selling it in another rnarket

speeulator someono who buys or sells foreign exehange in hcpes of profiting frsm {luctuations in trhe exchange rate over tin'ie

purchasing p_ower parity (PPP) theory the idea that the exchange rate between two sountr;Bs will adiust in the long run to equaliae the ccrt be- tween the countrie* of a i:asket ol internationaliy traded goods

'il dr si :rli

iAi

:&

rt '+l

.11 -E

{' ir

,il

$; It

lr !

lt ir,

I

\

28O PART 4 hriernalional lr4;icroccoronricl:

l.

,f ii i!

!:

foreigners are more wiliing to buy and hojd invest- ments denominated in that high-interest currency. As a case in point, the dollar appreciated during the first half of the t98os, when real U.S. interest rates were reiatively high, and depreciated during zooz to 2oo4, when real U.S. interest rates were relatively low. The dollar was expected to depreciate during zoog because of historicaliy low real interest rates, recession, and high government borrowing.

Because of trade barriers, central bank interven_ tion in exchange markets, and the fact that many products are not traded or are not comparable across countries, the purchasing power parity theory usualty does not explain exchange rates at a particular point in time that wei1. For example, if you went shopping in London tomorrow, you would soon notice a doiiar does not buy as much there as it does in the United States.

hS3 F{x*d and FiexibSe Exci:ange Rates FBsxib$e €xefueerge Rates For the mostparl, we have been discussing a sys- tem of flexil:le exeharige rates, urith rates deter- mined by demand and supply. Flexible, or Jloating, exchange rates adjust continually to the myr-iad forces that buffet foreign exchange markets. Consider how the exchange rate is linked to the balance-of-payments accounts. Debit entries in the current or financial accounts increase the demand for foreign exchange, resuiting in a depreciation of the dollar. Credit entries in these accounts increase the suppiy of foreign exchange, resuhing in an appreciation of the dollar.

Fixeei ffixehamge ffiates When exchange rates are flexible, governments usualiy have little direct role in foreign exchange markets. But if governments try to set exchange rates, active and ongoing central bank intervention is often necessary to establish and maintain these fixed excirange rates. Suppose the European Central Bank selects what it thinks is an appropriate rate of exchange between the dollar and the euro. It attempts to,fix, or to peg, the exchange rate within a narrow band around the particular value selected. If the euro threatens to climb above the maximum acceptable exchange rate, monetary authorities must sell euros and buy dollars, thereby keeping the dollar price of the euro down. Converseiy, if the euro threatens to drop below the minimum acceptable exchange rate, monetary authorities must sell dollars and

i t!

:

:

buy euros. This increased demand for the euro will keep its vaiue up relative to the dollar. Through such intervention in the foreign exchange market, monetary authorities try to stabilize the exchange rate, keeping it within the specified band.

If monetary officials must keep selling foreign exchange to keep the value of their domestic cuffency from fall- ing, they risk running out of foreign exchange resetves. Faced with this threat, the government has several options for eliminating the exchange rate disequilibrium. First, the pegged exchange rate can be increased, which is a clevaiuatio:r of the domes- tic currenry. (A decrease in the pegged exchange rate is called a revaluatjr:n.) Second, the government can reduce the domestic demand for foreign exchange directly by imposing restricLions on impcrts or on fi.nancial outflows. Many developing

exci:ange rate r*te det*tc:ined in loretgn ;p656n'39 maikqls &!, ?-l-xe i*r*es o{ **;esnqj *:'la! :*pply w i t i: + --; *.?nj**llte*t interve:lli+r

fixed *::rirar,g* ra:e raie o? *xi**::;* hof t+roon r - :.;*,: -+: pegs*d fr:ialix € n*i*;1t* range a ** r.6:r.:;g;i:s41 by the €fi::rai b*n+, s engcing p liiaei:.:i*ri ;{*; sales of curfEriial eurrencv devallra*6r: an increase ;n 1ti* t{- ficia! pegged pri+* *i foreign excha;:g* i",: terms af the dcflie:i.; c{.trrenf y

3l7YYAfr f\1tLq.reriqy

revaluaiion a red*ctioll ir: the ci- ficiel pegged p:ic* cl foreigc exehange :* terms of th* dcmestie turrency

gold stanrJarri an arrangemefit whereby the e urret-:cies of mcst countries al.* convertil-rle into gcid +t a fixed rate

countries do this. Third, the government can adopl policies to slow the domestic economy, increase inter- est rates, or reduce inflation relative to that of the country's trading partners, thereby indirectly decreas- ing the demand for foreign exchange and increasing the supply of foreign exchange. Several Asian econo- mies, such as South Korea and Indonesia, pursued such policies to stabiiize their currencies. Finally, the government can aliow the disequilibrium to persist and ration the avaiiable foreign reserves through some form offoreign exchange control.

This conciudes our introduction to the theories of internationai finance. Let's examine international finance in practice.

tG4 Develcnffrent *f theu&vf internatimxra3 &donetary Systen: From 1879 to r9r4, the internationaj finan- cial system operated under a goid siaridard, whereby the major currenfies were convertible

CHAPTf;R r9 ilii;ritatioii:ri finalce 281