Exchange Rates and International Capital Flows

This is Unit Thirteen of Principles of Macroeconomics: exchange rates and international capital flows. Unit twelve ended on what a central bank can and cannot do. This unit takes one of its channels and follows it out into the world. Carry one idea through. The words strong and weak describe a direction and carry no verdict at all. Every movement in a rate helps three groups and hurts three others, every time, and the capstone takes the language apart deliberately because it is what stops people seeing that. By the end you will convert at a rate before and after a move, name which curve shifts and which way, choose between the market rate and purchasing power parity, work a peg set away from the market, and classify a regime by the trade it has accepted.

Four entries on the market itself: what the price is, who is on each side, and the words for its movements.

What the price is.

MAC 1201 An Exchange Rate Is a Price

An exchange rate is the price of one currency in another, so supply and demand apply to it as to any price, and the foreign exchange market is the largest financial market in the world. Not every country has its own currency: some adopt another's and some share one. Most of the trading is financial rather than payment for goods.

Who is on each side.

MAC 1202 Who Demands and Who Supplies a Currency

Demand for a currency comes from its exporters converting earnings, from foreign visitors, and from foreigners buying its assets. Supply comes from importers, travellers abroad, and residents buying foreign assets. Each side has a goods, travel and asset reason. The asset reasons are the larger, which is why interest rates move rates fast.

The other side of every trade.

MAC 1203 Every Trade Is Two-Sided

Demanding one currency means supplying another, because every exchange has two sides, so the market for dollars in pesos and the market for pesos in dollars are one market drawn twice. Ten pesos per dollar is the same fact as ten cents per peso, so a rise in one is a fall in the other.

Naming the movements.

MAC 1204 Appreciation and Depreciation

A currency appreciates, or strengthens, when it buys more of another currency, and depreciates, or weakens, when it buys less. One currency's appreciation is always another's depreciation. If the dollar moves from ten pesos to twelve and a half, it has appreciated and the peso has depreciated. These words describe direction only and carry no verdict.

Three entries on doing the arithmetic, seeing who it helps, and the word that misleads.

Doing the arithmetic.

MAC 1205 Converting at a Rate, Before and After

Convert at a given rate, recompute after the rate moves, and say who is better off, working in the buyer's currency throughout. Take the dollar from ten pesos to twelve and a half. A machine priced at four thousand dollars cost forty thousand pesos before and fifty thousand after, so it became dearer for the Mexican buyer. An item priced at six hundred pesos cost sixty dollars before and forty-eight after, so it became cheaper for the American buyer. One movement did both at once. Keep the direction of the quotation fixed, because pesos per dollar and dollars per peso move opposite ways, and switching between them mid-problem is the reliable way to get the answer backwards.

Who that helps and hurts.

MAC 1206 Who Gains and Who Loses from a Stronger Currency

A stronger home currency hurts its exporters, hurts its residents holding foreign assets, and hurts foreign visitors. It helps foreign exporters selling in, helps its own travellers abroad, and helps foreigners holding its assets. A weaker currency reverses all six. Three groups gain and three lose from the same movement, every time.

The word that misleads.

MAC 1207 Stronger Is Not Better

The word strong suggests health and the word weak suggests trouble, and neither meaning transfers. A stronger currency is good for some and bad for others in the same economy at the same moment: an exporter and a holiday-maker want opposite movements. This is why no government can call a rate correct without saying correct for whom.

Six entries on what actually moves a rate, and on the money that crosses borders to do it.

Two kinds of money crossing.

MAC 1208 Direct and Portfolio Investment

Foreign direct investment means buying a large stake in a firm or building one, conventionally ten percent or more, with a management role. Portfolio investment is purely financial and below that threshold. The first is slow to reverse and the second can leave in days, and that difference makes a sudden stop possible, as unit seven showed.

Removing the risk.

MAC 1209 Hedging

A firm expecting a foreign payment can lock in today's rate for a future date using a financial contract, paying a fee for it. That is hedging, and it removes exchange rate risk from the transaction. The fee buys certainty, not a better rate. This course describes hedging and recommends nothing.

The fastest mover.

MAC 1210 Expectations Move the Rate First

What people expect the rate to be shortly is the fastest mover. Expecting appreciation raises demand and cuts supply at once, so the rate moves immediately on the expectation. Both curves shift together, so the price effect is certain and the quantity effect is not. Expectations are self-reinforcing, since acting on them helps bring them about.

The next fastest.

MAC 1211 Relative Rates of Return

Money moves toward the higher return. If interest rates rise here relative to abroad, foreign funds come in, so demand for the home currency rises and its supply falls, and it appreciates. Unit twelve built this link: monetary policy reaches the exchange rate through interest rates. What matters is the rate relative to elsewhere, not the rate alone.

The slower mover.

MAC 1212 Relative Inflation

Over a medium horizon, a country with higher inflation than its trading partners sees its currency depreciate, because each unit buys less at home and so is worth less abroad. Inflation erodes buying power, and the exchange rate eventually reflects that. This works slowly, over years rather than the minutes expectations take.

Naming the shifts.

MAC 1213 Which Way Does the Currency Move

From an event, name which curve or curves shift, in which direction, and what happens to the rate, working in one currency's market and keeping it fixed. The three shifters run fastest to slowest: expectations, then relative returns, then relative inflation. Domestic interest rates rise relative to abroad, so demand rises and supply falls, both pushing the same way, and the currency appreciates. Domestic inflation runs above the partner's for years, so demand falls and supply rises, and it depreciates. Traders come to expect a depreciation next month, so the depreciation happens now. In this market the two curves often shift together rather than one at a time, unlike unit two's goods markets, and then the direction is certain while the quantity traded is not.

Two entries on where rates settle over the very long run, and which rate a question actually needs.

The long-run anchor.

MAC 1214 Purchasing Power Parity

Purchasing power parity is the exchange rate that would make a basket of traded goods cost the same in two countries, and arbitrage pushes market rates toward it slowly and imperfectly over many years. It is a long-run anchor, not a prediction of next month's rate. It applies to goods that can be traded: haircuts and rents do not travel.

Choosing between the two.

MAC 1215 Market Rate or PPP: Which to Use

Use the market rate for anything actually converted — a payment, a tourist's budget, an exporter's receipts — and the purchasing power parity rate for comparing living standards or output across countries, because market rates swing for financial reasons that have nothing to do with what a currency buys at home. Suppose a basket costs a hundred dollars in the United States and nine hundred pesos in Mexico: the parity rate is nine pesos per dollar. Now let turmoil drive the market rate to twelve while Mexican prices, wages and output are unchanged. Measured at market rates, Mexican GDP in dollars has fallen sharply; measured at parity, nothing happened, because nothing did. Neither rate is the true one — they answer different questions.

Two entries on what a rate does to total demand, and what a sharp move does to banks.

What rates do to demand.

MAC 1216 Exchange Rates and Aggregate Demand

A weaker home currency makes exports cheaper abroad and imports dearer at home, so net exports rise and aggregate demand shifts right, and a stronger currency does the reverse. This is the exchange-rate channel unit twelve put in the transmission chain. Imports are not a loss: the currency spent abroad returns as demand for goods or assets.

What a sharp move does.

MAC 1217 The Currency Mismatch

A bank borrows in a foreign currency, converts, and lends at home in the local one. If the local currency then falls sharply, borrowers repay in full locally while the bank cannot cover its foreign debt. Nothing went wrong with the loans: the mismatch alone did the damage. When many large banks fail together, a deep recession follows.

Four entries on the arrangements governments choose, and what it costs to hold a rate away from the market.

The arrangements available.

MAC 1218 Four Exchange Rate Regimes

Regimes sit on a spectrum. Floating leaves the rate to the market. A soft peg lets it float while the central bank leans against rapid moves. A hard peg fixes it. A merged currency abandons a separate currency entirely. Floating is self-regulating and unpredictable; fixing is predictable and demanding. Some texts group these as three, folding pegs and boards together.

How a rate gets moved.

MAC 1219 Two Ways a Central Bank Moves the Rate

A central bank has two levers. Monetary policy, since lower rates weaken a currency and higher rates strengthen it. Or direct intervention, selling its own currency or spending reserves to buy it. Buying its own currency requires reserves, and reserves run out. Using monetary policy on the rate means not using it on inflation or recession.

Holding a rate away from the market.

MAC 1220 A Peg Away from the Market Rate

A peg set away from the equilibrium rate creates an imbalance, exactly as a price control does in unit two, so find which side exceeds which, then say what the central bank must do. Take the peso priced in dollars with equilibrium at ten cents. Peg it above, at twelve and a half: quantity supplied exceeds quantity demanded, so there is a surplus, and the bank must buy it with foreign reserves, which drain. Peg it below, at eight cents: quantity demanded exceeds quantity supplied, so there is a shortage, and the bank supplies its own currency, accumulating reserves. The two directions do not cost the same. A bank holding its currency down can create it without limit, though that is inflationary. A bank holding its currency up spends reserves it has to have, so that peg has a hard stop — and when traders judge the reserves nearly gone they sell, breaking it suddenly rather than gradually.

Naming a regime.

MAC 1221 Classifying a Regime

From a description of what a government does, name the regime and the trade it has accepted, asking whether the rate moves with the market and whether the country still runs its own monetary policy. A government that lets the rate swing is floating, and keeps monetary policy for domestic use. One that sells its currency when it climbs too fast is running a soft peg. One that fixes its rate by law and backs every unit it issues with foreign assets has a hard peg through a currency board, and has given up most of its monetary independence; one economy ran such a board through the nineteen nineties and abandoned it in two thousand and two when it needed a policy the board forbade. One that adopts another's currency has a merged currency and no monetary policy of its own. No regime is best, and the anchor says so: each trades predictability against independence, and the price becomes visible only when a country needs the policy it gave up.

One entry to close the unit: taking the language apart, and tracing one appreciation through a whole economy.

Reading a movement whole.

MAC 1222 Why a Strong Currency Is Not Good News for Everyone

Here the unit's governing idea is at work. A currency that strengthens is described in the words used for health, and one that weakens in the words used for illness, and neither meaning survives contact with the model. An appreciation is a movement in a price: it helps whoever is buying at that price and hurts whoever is selling, so the same three groups gain and the same three lose, and a depreciation reverses all six exactly. Trace one through. A currency appreciates by a quarter. Domestic exporters lose orders and some cut output and employment. Domestic buyers of imports gain. Net exports fall, shifting aggregate demand left, so output falls and the price level falls a little. Set against that, cheaper imported inputs lower costs for producers who use them, pushing short-run supply the other way. The net result depends on how much the economy exports and how much it imports, and the model does not decide that for you. Three cautions. The danger is usually not the level but the speed: a large fast move breaks the currency mismatch of any bank that borrowed abroad and lent at home, and when several fail together a currency problem becomes a recession — across East Asia in nineteen ninety-seven, and again in one South American economy in two thousand and two. Second, a government that prefers a stable rate may still want a weaker one to fight a recession or a stronger one to fight inflation. Third, the six groups do not have equal voice: exporters are concentrated and organised while import buyers are dispersed, so the political account rarely matches the economic one — a fact about who is heard, not about who is right.

Look at what you can now do. You can convert at a rate before and after a move, keeping the quotation fixed so the answer does not come out backwards. You can name which curve shifts and which way, and say when both moved together so the quantity is indeterminate. You can choose between the market rate and purchasing power parity, knowing neither is the true one and each answers a different question. You can work a peg set away from the market, and say which direction has a hard stop and why it breaks suddenly. And you can classify a regime by the trade it accepted, and read a currency movement whole. Unit fourteen turns to what a government spends and how it pays for it.