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Week 11: Exchange rates - Balance of Payments (Nominal exchange rates…
Week 11: Exchange rates - Balance of Payments
Nominal exchange rates
Definition: the rate at which two currencies
can be traded
for each other
Nominal exchange rate (
e
): the number of units of the foreign currency that the domestic currency will buy
Appreciation: an increase in the value of currency relative to other currencies
Depreciation: a decrease in the value of currency relative to other currencies
Flexible exchange rate: varies according to the supply and demand for the currency in the
foreign exchange market
Fixed exchange rate: set by official
government policy
. It included overvalued, undervalued, devaluation and revaluation
Real exchange rates
Definition: price of the
average
domestic
good or service relative to the price of the
average foreign
good or service (in common currency)
P: domestic price level and Pf: foreign price level
Real exchange rate = P/ (Pf/e)
= P(e)/ Pf
High real exchange rate
=> domestic goods are more expensive => net exports are likely to be low and vice versa for low real exchange rate
Supply and demand analysis
The supply of the dollar
Suppliers of Australian dollar to the foreign exchange market are Australian households and firms
higher exchange rate => more Australian dollars will be supplied
Shift in supply of Australian dollar
An increase in interest rate of foreign assets => attractive to Australians
An increase in preference of foreign goods or services
An increase in Australian real GDP (part of in might be on foreign goods or services)
An increase in supply of a dollar => lower its value
The demand for the dollar
Demanders of Australian dollar are foreign households and firms
lower exchange rate => more Australian dollars will be demanded
Shifts in demand for the Australian dollar
An increase in Australian preference goods or services
An increase in
real GDP abroad
(part of it might be spent on Australian goods or services)
An increase in interest rate of Australian assets
Equilibrium value of the dollar
quantities of the currency supplied = demanded
Monetary policy and the exchange rate
Monetary policy increase the interest rate => make Australian assets more attractive to foreigners => shift the demand curve up => increase the
equilibrium exchange rate
Low interest rate => low exchange rate
An overvalued exchange rate: balance of payments deficit
Balance of payments deficit: net decline in a country's stock of
international reserves
over a year
Balance of payments surplus: net increase in a country's stock of
international reserves
over a year
Monetary policy and fixed exchange rates
Increase interest rate => increase demand and fall in supply for the currency => eliminating overvaluation
Speculative attacks (page 441)
Fixed versus flexible exchange rate
Fixed refers to long- term, a flexible strengthens the impact of monetary policy on AD curve
Fixed provides a certain level of certainty
The balance of payments
Capital accounts
Financial Account
Net capital transfers + Net acquisition/ disposal of non- produced, non- financial assets
Current accounts
Net services = domestic spends - foreign spends
Net income
Net exports
Current account surplus
Current account deficits