Exchange Rates and the Open Economy

1. Exchange Rates and the Open Economy Chapter 18 (last chapter!)

2. Chapter 18 Learning Objectives.You should be able to: • Distinguish between fixed and flexible exchange rates. • Indicate the difference between depreciation and devaluation (and appreciation and revaluation). • escribe conditions under which a speculative attack can occur. • List the advantages and disadvantages of fixed exchange rates.

3. Abbreviation: FOREX Over a trillion dollars worth are traded daily. Most trading is to finance the purchase of assets (e.g., bank deposits), not goods and services. Foreign Exchange Market

4. Dollar FinishesMixed on Rivals,Giving Up GainsBy ISABELLE LINDENMAYERDecember 5, 2006; Page C5 The dollar retraced most of its overnight gains, ending the North American session mixed against its major rivals. After starting the day up across the board, the dollar slowly retreated in a data-quiet U.S. session as investors pushed the euro back above the $1.33 mark for much of the session and kept sterling well above the $1.9770 level. Late yesterday in New York, the euro stood at $1.3328, down from $1.3336 late Friday, while the dollar was at 115.33 yen, down from 115.47 yen. The euro was at 153.70 yen from 153.80 yen. The dollar stood at 1.1943 Swiss francs, up from 1.1933 francs, while the pound was unchanged at $1.9797. "The market is waiting for something else to move it," said David Mozina, senior currency strategist at Lehman Brothers in New York. The euro "has rallied big-time, so the market is just catching its breath," he added. With little fresh U.S. data from which to trade, investors instead readied themselves for a slew of data set for release today, as well as a series of central-bank rate decisions throughout the week. The dollar showed little reaction to comments from Chicago Federal Reserve President Michael Moskow early yesterday, who said that weak manufacturing data released last week hasn't changed his view of the economy. "Overall, I still think that the economy is solid," Mr. Moskow said in an interview Webcast on CNBC.com. Mr. Moskow, who isn't currently a voting member of the policy-making Federal Open Market Committee, reiterated that core inflation -- which excludes energy and food costs -- is expected to come down somewhat over the coming year. Nonetheless, he noted that the Fed can't let down its guard on inflation. Similarly, the dollar showed no reaction to news that the National Association of Realtors' index for pending sales in October tumbled again. It fell

5. Flexible Exchange rate determined by supply and demand. Characterized by volatility. Creates uncertainty in conducting international business. Changes in value called appreciation and depreciation. Fixed Central bank buys and sells domestic currency at a fixed price. The gold standard was a fixed exchange rate regime. Bretton Woods was another. Provides more certainty in the short run but the system is susceptible to speculative attacks. Changes in value called revaluation and devaluation. Two types of exchange rate regime

6. 1 oz of gold = $20 = £4 £1 = $5 19th Century Gold Standard

7. Bretton Woods Agreement 1944 Established a system of fixed exchange rates. Breakdown 1971-73.

8. Beginning of the end of fixed exchange rates … Richard Nixon closes the Gold Window in 1971.

10. Speculative Attack • Occurs under a system of fixed exchange rates. • When the official price of the currency is set above the true price. • For example, if the Argentina peso is valued officially at 1 peso for 1 dollar but in reality is worth only 50 cents. • The Argentine central bank must keep buying pesos to keep the price high but it will eventually run out of dollars. • Investors predict a revaluation and sell all their pesos now. • They will also engage in short-selling: borrow pesos, sell for dollars and buy pesos later.