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currency movements.
Under our present system, currency rates change frequently. When other currencies be-
A nation™s currency is said
come more expensive in terms of dollars, we say that they have appreciated relative to the
to appreciate when
exchange rates change so dollar. Alternatively, we can look at this same event as the dollar buying less foreign cur-
that a unit of its currency rency, meaning that the dollar has depreciated relative to another currency.
can buy more units of
What is a depreciation to one country must be an appreciation to the other.
foreign currency.

For example, if the cost of a pound rises from $1.50 to $2, the cost of a U.S. dollar in
A nation™s currency is said
terms of pounds simultaneously falls from 67 pence to 50 pence. The United Kingdom has
to depreciate when
exchange rates change so experienced a currency appreciation while the United States has experienced a currency de-
that a unit of its currency preciation. In fact, the two mean more or less the same thing. As you may have noticed, these
can buy fewer units of
two ways of viewing the exchange rate are reciprocals of one another, that is, 1/1.5 5 0.67
foreign currency.
and 1/2 5 0.50. And of course, when a number goes up, its reciprocal goes down.
When many currencies are changing in value at the same time, the dollar may be ap-
preciating with respect to one currency but depreciating with respect to another. Table 1
offers a selection of exchange rates prevailing in July 1980, February 1985, June 1995, April

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Chapter 18 363
The International Monetary System: Order or Disorder?

TA B L E 1
Exchange Rates with the U.S. Dollar

Cost in Dollars
SOURCE: International Financial Statistics and The Wall Street

Country Currency Symbol July 1980 Feb. 1985 June 1995 April 2002 April 2005 April 2008
Australia dollar $ $1.16 $0.74 $0.72 $0.53 $0.77 $0.93
Canada dollar $ 0.87 0.74 0.73 0.63 $0.82 $0.99
France franc FF 0.25 0.10 0.20 * * *
Germany mark DM 0.57 0.30 0.71 * * *
Italy lira L 0.0012 0.00049 0.0061 * * *
Japan yen ¥ 0.0045 0.0038 0.0118 0.0076 0.0092 0.0096
Mexico new peso $ 44.0† 5.0† 0.16 0.11 0.09 0.09
Sweden krona Kr 0.24 0.11 0.14 0.10 0.14 0.17
Switzerland franc S.Fr. 0.62 0.36 0.86 0.60 0.83 0.98
United Kingdom pound £ 2.37 1.10 1.59 1.44 1.88 1.99

” euro ” ” ” 0.88 1.29 1.58
NOTE: Exchange rates are in U.S. dollars per unit of foreign currency.
*These exchange rates were locked together at the start of the euro in January 1999.
†On January 1, 1993, the peso was redefined so that 1,000 old pesos were equal to 1 new peso. Hence, the numbers 44 and 5 listed for July 1980
and February 1985 were actually 0.044 and 0.005 on the old basis.

2002, April 2005, and April 2008, showing how many dollars or cents it cost at each of
those times to buy each unit of foreign currency. Between February 1985 and April 2002,
the dollar depreciated sharply relative to the Japanese yen and most European currencies.
For example, the British pound rose from $1.10 to $1.44. During that same period, how-
ever, the dollar appreciated dramatically relative to the Mexican peso; it bought about 0.2
pesos in 1985 but more than 9 in 2002.1 Since April 2002, the dollar has depreciated against
most currencies, and sharply against the euro.
Although the terms “appreciation” and “depreciation” are used to describe movements
of exchange rates in free markets, a different set of terms is employed to describe
decreases and increases in currency values that are set by government decree. When an A devaluation is a reduc-
tion in the official value of
officially set exchange rate is altered so that a unit of a nation™s currency can buy fewer
a currency.
units of foreign currency, we say that a devaluation of that currency has occurred. When
the exchange rate is altered so that the currency can buy more units of foreign currency, A revaluation is an
we say that a revaluation has taken place. We will say more about devaluation and reval- increase in the official value
uation shortly, but first let™s look at how the free market determines exchange rates. of a currency.

In 1999, eleven European countries adopted a new common currency, the euro. But why
does a euro now cost about $1.50 and not $1.25 or $1.75? In a world of floating exchange Floating exchange rates
are rates determined in free
rates, with no government interferences, the answer would be straightforward. Exchange
markets by the law of
rates would be determined by the forces of supply and demand, just like the prices of ap-
supply and demand.
ples, computers, and haircuts.
In a leap of abstraction, imagine that the dollar and the euro are the only currencies on
earth, so the market need determine only one exchange rate. Figure 1 on the next page
depicts the determination of this exchange rate at the point (denoted E in the figure)
where demand curve DD crosses supply curve SS. At this price ($1.50 per euro), the num-
ber of euros demanded is equal to the number of euros supplied.
In a free market, exchange rates are determined by supply and demand. At a rate below
the equilibrium level, the number of euros demanded would exceed the number sup-
plied, and the price of a euro would be bid up. At a rate above the equilibrium level,
quantity supplied would exceed quantity demanded, and the price of a euro would fall.
Only at the equilibrium exchange rate is there no tendency for the rate to change.

In fact, the dollar bought about 200 pesos in February 1985, but that is because the old peso was replaced by a

new peso in January 1993, which moved the decimal point three places.

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Part 4
364 The United States in the World Economy

As usual, supply and demand determine price. But in this
case, we must ask: Where do the supply and demand come
from? Why does anyone demand a euro? The answer comes in
Price of a Euro (in dollars)

three parts:
1. International trade in goods and services. This factor was the
subject of the previous chapter. If, for example, Jane Doe, an
American, wants to buy a new BMW, she will first have to
E buy euros with which to pay the car dealer in Munich.2
Thus, Jane™s demand for a European car leads to a demand
for European currency. In general, demand for a country™s ex-
ports leads to demand for its currency.3
2. Purchases of physical assets such as factories and machinery over-
S D seas. If IBM wants to buy a small French computer manufac-
turer, the owners will no doubt want to receive euros. So IBM
Number of Euros
will first have to acquire European currency. In general, direct
foreign investment leads to demand for a country™s currency.
F I GU R E 1
3. International trade in financial instruments such as stocks and bonds. If American
Determination of
investors want to purchase Italian stocks, they will first have to acquire the euros
Exchange Rates in a
that the sellers will insist on for payment. In this way, demand for European finan-
Free Market
cial assets leads to demand for European currency. Thus, demand for a country™s
financial assets leads to demand for its currency. In fact, nowadays the volume of
international trade in financial assets among the major countries of the world is so
large that it swamps the other two sources of demand.

Now, where does the supply come from? To answer this question, just turn all of these
transactions around. Europeans who want to buy U.S. goods and services, make direct
investments in the United States, or purchase U.S. financial assets will have to offer their
euros for sale in the foreign-exchange market (which is mainly run through banks) to
acquire the needed dollars. To summarize:
The demand for a country™s currency is derived from the demands of foreigners for its
export goods and services and for its assets”including financial assets, such as stocks
and bonds, and real assets, such as factories and machinery. The supply of a country™s
currency arises from its imports, and from foreign investment by its own citizens.
To illustrate the usefulness of even this simple supply-and-demand analysis, think about
how the exchange rate between the dollar and the euro should change if Europeans become
worried about the safety of U.S. assets, as happened during the financial crisis of 2007“2008.
As European investors reduce their desires to buy U.S. assets, they will supply fewer euros
for sale (in order to buy the necessary dollars). In terms of the supply-and-demand diagram
in Figure 2, that decreased sale of euros will shift the supply curve inward from the black
line S1S1 to the brick-colored line S2S2. Equilibrium would shift from point E to point A, and
the exchange rate would rise from $1.30 per euro to $1.50 per euro. Thus, the decreased sup-
ply of euros by European citizens would cause the euro to appreciate relative to the dollar”
which is just what happened.

Exercise Test your understanding of the supply-and-demand analysis of exchange
rates by showing why each of the following events would lead to an appreciation of the
euro (a depreciation of the dollar) in a free market:
1. American investors are attracted by prospects for profit on the German stock market.
2. A recession in Italy cuts Italian purchases of American goods.

Actually, she will not do so because banks generally handle foreign-exchange transactions for consumers. An

American bank probably will buy the euros for her. Even so, the effect is exactly the same as if Jane had done it
See Discussion Question 2 at the end of this chapter.

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Chapter 18 365
The International Monetary System: Order or Disorder?

3. Interest rates on government bonds rise in S2 S1
France but are stable in the United States. (Hint:
Which country™s citizens will be attracted to D
invest by high interest rates in the other country?)
To say that supply and demand determine $1.50
exchange rates in a free market is at once to say

Price of a Euro
(in dollars)
everything and to say nothing. If we are to under- $1.30
stand the reasons why some currencies appreciate E
whereas others depreciate, we must look into the
factors that move the supply and demand curves.
Economists believe that the principal determinants D
of exchange rate movements differ significantly in S1
the short, medium, and long runs. So in the next
three sections, we turn to the analysis of exchange
rate movements over these three “runs,” beginning
Number of Euros
with the short run.
F I GU R E 2
The Effect of Declining
Interest Rates and Exchange Rates: The Short Run Demand for U.S.
Assets on the
Most experts in international finance agree that interest rates and financial flows are the Exchange Rate
major determinants of exchange rates”certainly in the short run, and probably in the
medium run as well. Specifically, one variable that often seems to call the tune in the short
run is interest rate differentials. A multitrillion-dollar pool of so-called hot money”owned
by banks, investment funds, multinational corporations, and wealthy individuals of all
nations”travels rapidly around the globe in search of the highest interest rates.
As an example, suppose British government bonds pay a 5 percent rate of interest
when yields on equally safe American government securities rise to 7 percent. British in-
vestors will be attracted by the higher interest rates in the United States and will offer
pounds for sale in order to buy dollars, planning to use those dollars to buy American se-
curities. At the same time, American investors will find it more attractive to keep their
money at home, so fewer pounds will be demanded by Americans.
When the demand schedule for pounds shifts inward and the supply curve shifts out-
ward, the effect on price is predictable: The pound will depreciate, as Figure 3 shows. In
the figure, the supply curve of pounds shifts outward from S1S1 to S2S2 when British
investors seek to sell pounds in order to purchase more U.S. securities. At the same time,
American investors wish to buy fewer pounds because they no longer desire to invest as F I GU R E 3
much in British securities. Thus, the demand curve shifts inward from D1D1 to D2D2. The The Effect of a Rise
result, in our example, is a depreciation of the pound in U.S. Interest Rates
from $2.10 to $1.80. In general:
Other things equal, countries that offer investors D1 S1
higher rates of return attract more capital than
countries that offer lower rates. Thus, a rise in in- D2 S2
terest rates often will lead to an appreciation of
the currency, and a drop in interest rates often E1
Price of a Pound

will lead to a depreciation. $2.10
(in dollars)

It is useful to think of interest rate differentials as
standing in for the relative returns on all sorts of fi- $1.80
nancial assets in the two countries. In the late 1990s


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