Determinants of Exchange Rate Video Lecture | Macroeconomics- Learning and Analysis

[Music]
hi everyone for today's video lesson
we're going to be talking about exchange
rates the determinants of exchange rates
and the difference between a floating
exchange rate mechanism and a fixed or
managed exchange rate mechanism this
video has a practice worksheet that goes
along with it that you can find from the
blog on which this video will be posted
so this activity is something I gave my
own IV economics students today in class
we started out with the market for two
currencies one the market for u.s.
dollars in Japan and the other the
market for Japanese yen in the United
States we should notice right away that
these graphs are missing all labels
therefore before we can complete these
graphs we must first go find the actual
exchange rates of these two currencies
to do that we're going to go to the
following website XE comm okay now we
have a table of the value of several
different currencies at today's exchange
rates we can see that the u.s. dollar
right here is currently equal seven
equal to seventy five point nine yen
we'll round that to 76 yen we can also
see that the yen is worth point zero one
three u.s. dollars with that information
in mind we can go back to our graphs and
we can add the current equilibrium
exchange rates to these graphs so first
let's look at the US dollar the current
rate is 76 yen per dollar so the next
thing we need is a label for this
vertical axis which since we're in the
market for US dollars is the number of
yen per dollar and the other graph we
can show the equilibrium exchange rate
as point zero one three dollars per yen
of course we need to label our
equilibrium quantities I'll just call
that QE and we'll call this QE we need
to label our axes in the market for u.s.
dollars we'll call this the quantity of
dollars demanded and supplied in Japan
and in the market for yen will call this
the quantity of yen demanded in supply
in the u.s. of course our demand and
supply curves need labels as well and
the dollar market will call this the
demand for dollars and this the supply
of dollars in the yen market we have the
demand for yen in the United States and
we have the supply of yen in the United
States now we've got to correctly label
graphs we can see that the price of one
US dollar in Japan is 76 Japanese yen
and the price of one yen in the United
States is point zero one three u.s.
dollars the next question has us examine
the impact of an expansionary monetary
policy in Japan meant to stimulate
domestic aggregate demand on the markets
for Japanese yen in the United States
and the market for u.s. dollars in Japan
so here we have our original diagrams
let's talk about what would happen if
the Bank of Japan engages in
expansionary monetary policy an
expansionary monetary policy means that
the Bank of Japan is increasing the
domestic money supply how would that
look on the market for yen of the market
for dollars the answer is it would have
no immediate effect on the market for
yen in dollars however a greater money
supply in Japan will lead to lower
Japanese interest rates now this has an
impact on the market for yen in the
market for dollars as we learned in a
previous video lecture relative interest
rates are a determinant of exchange
rates if Japanese interest rates fall we
can assume that foreign investors who
can save their money in Japan or in the
United States will demand fewer Japanese
yen because the interest or the rate of
return on investments in Japan has
decreased therefore the demand for
Japanese yen will fall American
investors who are looking to earn the
highest possible return on their
financial investments will see that at
lower interest rates in Japan there is
less profit to be earned on investments
in Japan this means that the demand for
Japanese yen has decreased putting
downward pressure on the value of the
yen let's say that the yen now only
costs American investors 0.01
US dollars compared to the previous
exchange rate of 0.01 three US dollars
there is now at the lower exchange rate
a smaller quantity supplied of yen in
the United States due to the lower
demand for yen in the United States how
will this affect the exchange rate for
the US dollar at the same time that the
demand for yen decreases in the graph on
the right the decrease in US investment
in Japan will mean there is less supply
of US dollars in Japan American
investors are now demanding less yen
therefore they're supplying fewer
dollars to the Japanese market the
decrease in the supply of US dollars in
Japan puts upward pressure on the US
dollar exchange rate in Japan and we can
actually calculate very easily the new
value of the US dollar in Japan since
the value of one currency is always the
inverse of the value of the other
currency 1 over 0.01 tells us the value
of the US dollar in Japan which in this
case is now 100 yen instead of 76 yen
the decrease in interest rates on
Japanese assets reduces the demand for
Japanese yen in the United States and
thereby reduces the supply of US dollars
in Japan
this puts upward pressure on the value
of the US dollar and downward pressure
on the value of the Japanese yen the
dollar has appreciated and the yen has
depreciated as a result of the Bank of
Japan's expansionary monetary policy
which lowered interest rates and made
investments in Japan less attractive to
foreign financial investors let's move
on and explain how this will affect
aggregate demand in Japan the next
question asks us to explain the impact
that the Bank of Japan's expansionary
monetary policy will have on aggregate
demand output and employment in Japan to
do this we can use some basic
macroeconomic analysis to combine it
with our analysis of what happened in
the foreign exchange markets as we know
that an increase in the money supply in
Japan will lead to lower interest rates
in Japan lower interest rates should
lead to an increase in domestic
consumption and
meh stick investment in Japan since
there is now a lower return for Japanese
households who are considering saving
their money therefore they're also more
likely to increase their consumption
lower interest rates also allow for
higher levels of domestic capital
investment by Japanese firms but at the
same time we have what's called a net
export effect the lower interest rate on
Japanese assets will lead to a decrease
in the demand for Japanese yen which
leads to a decrease in the exchange rate
of the yen a weaker Japanese yen should
lead to an increase in the demand for
Japan's exports abroad and a decrease in
demand for imports within Japan as
exports increase and imports decrease
from Japan we should see net exports
increase so what we see is that
consumption has increased investment has
increased and net exports have all
increased in Japan
all of these are components of aggregate
demand so the increase in aggregate
demand that results from the expansion
and monetary policy will lead to more
employment for Japanese workers a
greater level of national income in
Japan and a higher price level in Japan
the expansionary monetary policy of
lowering interest rates not only
contributed to domestic consumption and
investment but through the net export
effect ultimately leads to an increase
in Japan's net exports further
reinforcing the Bank of Japan's
expansionary monetary policy so we can
see that lower interest rates stimulate
both domestic consumption and investment
but also net exports through the effect
on the Japanese yen the next question in
this activity has is consider the effect
that widespread speculation that the US
dollar will appreciate against other
foreign currencies will have on the
market for both the US dollar and Japan
and the market for the Japanese yen in
the United States first let's define
speculation speculation is simply the
expectation that the value of a certain
asset will either increase
or decrease in the future the asset in
question here is US dollars if if
international investors expect that the
value of the US dollar will rise they
will wish to hold more US dollars now
this includes Japanese investors who may
wish to invest in u.s. dollars or u.s.
dollar denominated assets in the
anticipation of their future
appreciation the expectation of the
speculation of future appreciation of
the US dollar should lead to an increase
in the current demand for u.s. dollars
at the same time since Japanese
investors now wish to hold more US
dollars they're going to supply more
Japanese yen to the US market increasing
the supply of yen and the United States
predictably the increase in demand for
US dollars should cause the u.s. dollar
to appreciate let's assume the new
equilibrium exchange rate for the US
dollar is 100 yen per dollar at the
higher exchange rate American households
are willing to supply a greater quantity
of Japanese yen to Japanese investors
the increase in the supply of Japanese
yen in the United States will cause the
value or the exchange rate of the yen
against the dollar to decrease two point
zero one which is the inverse of 100 the
decrease in the value of the yen will
mean that American households will
demand a greater quantity of yen in
order to buy more Japanese goods and
services as we can see speculation that
the US dollar will increase in value
leads to an increase in the current
demand for dollars in Japan causing the
dollar to appreciate at the same time
the supply of yen in the United States
increases causing the yen to depreciate
we'll move on to the next question now
the next question asks us to consider
the likely impact that the speculation
on the appreciation of the US dollar
will have on the level of aggregate
demand in the United States we can use a
similar rationale or logic as we did
when the Japanese yen depreciated in the
question above we know that if the
exchange rate of the US dollar increases
due to speculation this will make US
exports more expensive abroad leading to
leading to a decrease in the demand for
US exports
at the same time the stronger dollar
will make imports more attractive to US
households therefore imports will
increase the decrease in exports an
increase in imports causes net exports
to fall in the United States which
causes aggregate demand to fall in the
United States of course a decrease in
aggregate demand will lead to lots of
undesirable consequences for the US
including a fall in employment a fall
and national income and possibly even a
fall on the average price level or
deflation so for all of these reasons
the strengthening of the US dollar is
considered undesirable due to
speculation in the United States for an
exchange market let's say that the US
government and the US central bank the
Fed are unhappy about the fluctuations
in the value of the US dollar 100 yen
per dollar is simply too harmful for the
US economy instead the US government
wishes to maintain a stable exchange
rate at a range between 80 yen and 70
yen in other words US government wishes
to place a price ceiling on the value of
the dollar at 80 yen and a price floor
on the value of the dollar at 70 yen
this is called a managed exchange rate
system next we're going to see what
would happen if the market equilibrium
exchange rate of the US dollar were to
increase above 80 yen per dollar or fall
below 80 yen per dollar and we'll
examine ways that the US central bank
can maintain its managed exchange rate
in the range between 70 yen per dollar
and 80 yen per dollar for this next
question let's assume that market forces
put upward pressure on the demand for
dollars in Japan and push the
equilibrium exchange rate up to 90 yen
per dollar this could be shown as an
increase in the demand for US dollars in
Japan to a level greater than the
desired equilibrium interest rate of 80
yen per dollar if demand for dollars
increases to a level that under free
market conditions would cause the
exchange rate to rise to 90 then the US
government or central bank must now
intervene in the foreign exchange market
to devalue its currency back to an
equilibrium level of at the most 80 yen
per dollar in order to keep the exchange
rate within the desired range
the US central bank has a few options
one thing it can do is reduce interest
rates in the United States a decrease in
interest rates should bring demand back
down to a level that meets the desired
objective of an exchange rate of only 80
yen per dollar another option would be
for the US central bank to buy large
quantities of Japanese yen this would
increase the demand for yen and increase
the supply of dollars which again would
push the value of the currency back to a
desired level so an intervention
involving an increase in the supply of
US dollars on foreign exchange markets
could also bring the exchange rate back
down to the desired level thirdly the US
government could impose exchange
controls an exchange control refers to a
policy that reduces the total amount of
foreign investment in the United States
and thereby reduces the demand for US
dollars in foreign exchange markets such
a control might limit the quantity of US
government bonds that a Japanese
investor can buy it might otherwise
limit the amount of savings among
Japanese investors in the United States
any of these limitations which would
bring down demand and reduce the
exchange rate back to a desirable level
within the range if market forces put
upward pressure on the value of the US
currency
the central bank of the United States or
the government can impose any of the the
three policies outlined here reduce
interest rates would which would reduce
demand for US dollars on the foreign
exchange market by large quantities of
Japanese yen which would increase the
supply of dollars and put downward
pressure on the exchange rate or
implement implement exchange controls
which would reduce the demand for US
dollars in the United States and thereby
bring down the exchange rate finally
let's assume that market forces instead
of putting upward pressure on the value
of the dollar put downward pressure on
the value of the dollar and push the
equilibrium exchange rate to 60 yen per
dollar which is below the desired
minimum value of the dollar of 70 yen as
we can see here a decrease in the demand
for dollars in Japan could cause a
depreciation of the dollar to an
undesirably low exchange rate
now what could the US government
essential Bank do to restore an
equilibrium exchange rate within the
desired range of 70 yen per dollar to 80
yen per dollar quite the opposite of
what we saw when the dollar appreciated
above the desired range the opposite
policy could be implemented in the
United States now an increase in US
interest rates could could be
implemented by the central bank which
would cause a demand for dollars to
increase and restore an equilibrium
exchange rate within the range desired
in addition a large sale of Japanese yen
by the US central bank could push down
the value of the Japanese yen and the
u.s. could buy up some of its own
currency increasing the demand for
dollars on foreign exchange markets and
moving us back to an equilibrium
exchange rate between 70 and 80 finally
the US government could implement
exchange controls in the opposite
direction limiting the demand among US
investors for Japanese assets this
thereby would reduce the outflow of US
dollars from the United States and
reduce the supply of US dollars in Japan
causing the u.s. dollar to appreciate
back to a level within the range desired
so let's briefly review what we've gone
over today we've seen how a change in
relative interest rates due to a central
bank policy can lead to an appreciation
or a depreciation of a nation's currency
we've also gone over speculation and
decided how speculation of an increase
in the value of a currency can lead to a
current appreciation of the currency due
to increased demand for that currency
finally we've talked about how foreign
exchange controls manipulation of
interest rates and purchases of foreign
currencies by a nation central bank can
lead to a revaluation or a devaluation
of a nation's currency to keep it within
a range of desired exchange rates in
order to maintain several macroeconomic
objectives including stable net exports
thanks for watching today's video
lecture be sure to download the PDF from
the blog on which you can practice the
different exercises we've gone over
today