appreciation

 

ESSAY (200-300 words):

Explain the difference between appreciation and depreciation of a nation’s currency. How do these changes affect the foreign exchange market?

 

McEachern, W.A (2009). Econ for Macroeconomics. (2010-2011 ed, pp.277-281). Mason, OH: South-Western Pub.

No wiki, dictionary.com or cited work not posted.

   

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from holding foreign assets, and from unilateral
transfers falls short of the amount needed to pay
for imports, pay foreigners for their U.S. assets, and
make unilateral transfers. If the current account is in
deficit, the necessary foreign exchange must come
from a net inflow in the financial account. Such an
inflow in the financial account could stem from bor-
rowing from foreigners, selling domestic stocks and
bonds to foreigners, selling a steel plant in Pittsburgh
or a ski lodge in Aspen to foreigners, and so forth.

If a country runs a current account surplus, the
foreign exchange received from exports, from hold-
ing assets abroad, and from unilateral transfers
exceeds the amount needed to pay for imports, to
pay foreign hoiders for U.S. assets, and to make uni-
laterai transfers. If the current account is in surplus,
this excess foreign exchange results in a net outflow
in the financial account through lending abroad, buy-
ing foreign stocks and bonds, buying a shoe plant in
Italy or a vil1a on the French Riviera, and so forth.

When all transactions are considered, accounts
must always balance, though specific accounts usu-
aliy don’t. A deficit in a particular account should
not necessarily be viewed as a source of concern,
nor should a surplus be a source of satisfaction. The
deficit in the U.S. current account in recent years
has been offset by a financial account surplus. As a
result, foreigners are acquiring more ciaims on U.S.
assets.

‘.:lli lil -:

U.S. Balance of Payments lor 20A7 (billions of dollars)

Current Aecounts

i. Merchandise exports

2. Merchandise imports

3. Merchandise trade balance (1 + 2)
4. Service exports

5. Service imports

6. Goods and services balance {3 + 4 + 5}
7. Net investment income from abroad

L Net unilateral transfers

9. Cunent account balance {6 + 7 + B)

Financial Accounts

1 0. Change in U.S.-owned assets abroad

1 1. Change in foreign-owned assets in U.S.

1 2. Financial account balance {1 0 + 1 1 }
1 3. Statistical discrepancy

T0TAI (9 + 12 + 13l

LOz F*:”migre Hxa&:arage
Reg*s and fufarkets
Now that you have some idea about interna-
tional ?lows, we can iite a ilose, iook at tna
forces that determine the underlying value
of the currencies involved. Let’s begin by look-
ing at exchange rates and the market for foreign
exchange.

ForeEgn Exehemge
Foreign exchange, recalI, is foreign money needed to
carry out international transactions. The exchange
rate is the price measured in one country’s curency
of buying one unit of another country’s currency.
Exchange rates are determined by the interaction
of the households, firms, private financial institu-
tions, governments, and central banks that buy
and sell foreign exchange. The exchange rate fluc-
tuates to equate the quantity of foreign exchange
demanded with the quantity supplied. Tirpically, for-
eign exchange is made up of bank deposits denomi-
nated in the foreign currency. When foreign travel is
involved, foreign exchange often consists of foreign
paper money.

The foreign exchange market incorporates ali the
arrangements used to buy and seli foreign exchange.
This market is not so much a physicai place as a
network of telephones and computers connecting
financial centers all over the world. Perhaps you
have seen pictures of foreign exchange traders in
New York, Frankfurt, London, or Tokyo in front of
computer screens amid a tangie of phone lines. The
foreign exchange market is like an ali-night diner-it
never cioses. A trading center is always open some-
where in the world.

We will consider the market for the euro in terms
of the dollar. But first, a little more about the euro. For
decades the nations of Western Europe have tried
to increase their economic cooperation and trade.
These countries believed they wouid be more pro-
ductive and more competitive with the United States
if they acted less like many separate economies and
more like the 5o United States, with a single set of
trade regulations and one currency. Imagine the has-
sle involved if each of the 5o
states had its own currency.

In zooz, euro notes and
coins entered circulation in
the rz European countries
adopting the common cur-
rency. The big advantage of a

exchange raie
the Frice fisasilieci in
{}tie {:*,rilqay’ii ** rtEJriey
cf pilr*h*s,ng ‘1 *nit
*f egr’:thel couilt.y’s
dilrrencv

-t

h
l

+ 1,148.5

– i,967.9

-819.4
+491.7

– 378. 1

– 700.3

+81.7

-112.7

-731.3

* 1,289.9

+2,057.1

+767.8

– 36.5

0.0

S0URCE: “U.S. lnternational Transacti0ns Acc0unts Data,” Bureau of Economic
Analysis, U.S. Department of C0mmerce, Table 1. 15 December 2008, at htto:i/
www.bea.qov/international/xls/table 1.xls,

CHAPTER l9 iitictr;,irora l’l:ii 277

common currency is that Europeans no longer have
to change money every time they cross a border or
trade with another country in the group. Again, the
inspiration for this is the United States, arguably the
most successful economy in world history’

So the euro is the common currency of the euro
areq, or euro zone, as the now r 6-country region is usu-
ally calied. The price, or exchange rate, of the euro in
terms of the dollar is the number of dollars required
to purchase one euro. An increase in the number of
dollars needed to purchase a euro indicates weak-
ening, or depreciation, of the dollar. A decrease in
the number of dollars needed to purchase a euro
indicates strengthening, or appreciation, of the dol-
lar. Put another way, a decrease in the number of
euros needed to purchase a dollar is a depreciation
of the dollar, and an increase in the number of euros
needed to purchase a doliar is an appreciation ofthe
do11ar.

Because the exchange rate
is usually a market price, it is
determined by demand and
supply: The equilibrium price
is the one that equates quan-
tity demanded with quantitY
supplied.To simpiify the anal-
ysis, suppose that the United
States and the euro area
make up the entire world, so
the demand and suPPlY for
euros in international finance
is the demand and supply for
foreign exchange from the
U.S. perspective.

The Demand fon
Forelgn Exchange
Whenever U.S. residents need euros, they must buy
them in the foreign exchange market, which could
include theirlocalbanks, payingfor them with dollars-
Exhibit 4 depicts a market for foreign exchange-in
this case, euros. The horizontal axis shows the quan-
tiqy of foreign exchange, measured here in millions
of euros. The verticai axis shows the price per unit of
foreign exchange, measured here in dollars per euro.
The demand curve D for foreign exchange shows
the inverse relationship between the dollar price of
the euro and the quantity of euros demanded, other ,-
things assumed constant. Assumed constant along !
the demand curye are the incomes and preferences

-i
of U.S. consumers, expected inflation in the United fi
States and in the euro area, the euro price ofgoods in I
the euro area, and interest rates in the United States p
and in the euro area. People have many reasons for H
demanding foreign exchange, but in the aggregate,’
the lower the dollar price of foreign exchange, other
things constant, the greater the quantity of foreign
exchange demanded.

A drop in the doliar price of foreign exchange,
in this case the euro, means that fewer doilars are
needed to purchase each euro, so the dollar prices
of euro area products (iike German cars, Italian
shoes, tickets to Euro Disney, and euro area securi-
ties), which list prices in euros, become cheaper. The
cheaper it is to buy euros, the lower the dollar price
of euro area products to U.S. residents, so the greater
the quantity of euros demanded by U.S. residents,
other things constant. For example, a cheap enough
euro might persuade you to tour Rome, climb the
Austrian Alps, wander the museums of Paris, or
crawl the pubs of Dublin.

Exliil:it 4
The Foreign Exchange Market

currel1cv
depreci6tion
with tespect to the
dsllar. an increase in
the number of dallars
needed tc !:urchase 1
unit of icreign exchange
in a flexible rate systerTl

currency.
apprecrattan
with resFect to th*
dollar, a decrease in
the number af dollavs
needed to purchase 1
unit of {ereign exehange
in a flexible rat€ system

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* $1.30
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E 1.25
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“E 1.2oO
X
U

Foreign exchange
{millions of euros)

27A PART + irtientaiional Mactoeconontlc:;

I i” r^ ar’,-hr-.raa a.,rac fnr,4nllryc Fl:r^.y^. yacirlantc

I want doilars to brrv {i.S. soocls ancl ser-vice.q accllit:e
F IT Q rc.ar- .–,-L6’l^Dnc in /-l^11.yo ..?.6h; ,]nllcro rn

$ their U.S. friends and relatives. Euros are supplied
5 in the foreign exchange market to acquire the dol-
! tars peopte vr’ant. An increase in the doilar-per-euro
I exchange rate, other things constant, makes U.S.
F products cheaper for foreigners because foreign resi-L
o< dents need fewer euros to get the same number of p doilars. For example, suppose a Dell computer selis ? for $Ooo. If the exchange rate is $r.zo per euro, that f computer costs 5oo euros; if the exchange rate is $ $t.rS per euro, it costs only 48o euros. The number of { Oett computers demanded in the euro area increases f; as the dollar-per-euro exchange rate increases, other o things constant, so more euros will be supplied on

the foreign exchange market to buy doliars.
The positive relationship between the dollar-per-

euro exchange rate and the quantity of euros sup-
plied on the foreign exchange market is expressed
in Exhibit 4 by the upward-sloping supply curve
for foreign exchange (again, euros in our example).
The supply curve assumes that other things remain
constant, including euro area incomes and tastes,
expectations about inflation in the euro area and in
the United States, and interest rates in the euro area
and in the United States.

Setermining the
Hxe$:ange Rate
Exhibit 4 brings together the demand and supply
for foreign exchange to determine the exchange
rate. At a rate of $r.25 per euro, the quantity of
euros demanded equals the quantity supplied-in
our example, 8oo miilion euros. Once achieved, this
equiiibrium rate will remain constant until a change
occurs in one of the factors that affect supply or
demand. If the exchange rate is allowed to adjust
freely, or to float, in response to market forces, the
market will clear continually, as the quantities of for-
eign exchange demanded and supplied are equated.

What if the initial equilibrium is upset by a
change in one of the underiying forces that affect
demand or supplyi For example, suppose higher U.S.
incomes increase American demand for all normal
goods, including those from the euro area. This shifts
the U.S. demand curve for foreign exchange to the
right, as Americans buy more Itaiian marble, Dutch

$ iffi
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,ffiffii#4r3:. i;i*.i €:i::,:’ il:rii!,,iliF;iiijiaiiiiiir{i:-lt+ir’i*ffiffiE

chocolate, German machines, Parisian vacations, anC
euro area securities.

This increased demand for euros is shown in
Exhibit 5 on the next page by a rightward shift of the
demand curve for foreign exchange. The demari
increase from D to D’ leads to an increase in i:-=
exchange rate per euro from $r.25 to $r.z7.Th’::.
the euro increases in value, or appreciates, whiie -:
doliar falls in value, or depreciates. An increas= -:-
U.S. income should not affect the euro supply c’.il-:ii.
though it does increase the quantity of euros sutr’.’;i
The higher exchange value of the euro prompts -‘-:i.:st
in the euro area to buy more American producls al:
assets, which are now cheaper in terms of the e.:r,:,

To review: Any increase in the demand for icr::=
exchange or any decrease in its supply, other -;-:gs
constant, i.ncreases the number of dollars req’i::3: :l
purchase one unit of foreign exchange, which is a :3::e-
ciation of the doliar. On the other hand, any d<:ease in tJle demand for foreigrr exchange or any ::--clease in its supply, other things constant, reduces th= ::u=- ber of dollars required to purchase one unii c: i:eig'n exchange, which is an appreciation of the doiia;.

Arbltrages;rs ft ffi d Speca*l at*rs
Exchange rates between two currencies are nearly
identical at any given time in markets around the
world. For example, the doliar price of a euro is the
same in New York, Frankfurt, Tokyo, London, Zuich,
Hong Kong, Istanbul, and other financial centers.

CHAFT’EF. :g jr ti:r;:it:rrra; i:lirari:t 279

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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

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28O PART 4 hriernalional lr4;icroccoronricl:

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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