>> [music]. Hi, I'm Richard McKenzie.
In former lectures on international economics, I focused on the trade of real
goods and services. In our case, it was textiles for aircraft.
If international trade was made in terms of goods for goods, or barter, there would
likely be far less international trade. This is because people would have to seek
out what economists call double coincident of once.
Or potential traders would need to search relevant others who want what they have,
and have what they want. You didn't get that?
Let me give you a concrete example of what I, I mean.
If I have wine to sell, and want cheese. And goods trade for goods directly.
Then I would have to seek out someone who has cheese and wants wine.
In my search, I might find any number of people who want my wine.
But have, for example, only turkeys. Or, for that matter.
Hair spray, to sell. The use of currencies in trade can be
productive in itself because people can sell their goods for money and use the
money acquired to buy what they want. In my example, I can sell my wine for cash
or credit to the person who has turkeys to sell.
After he sells his turkeys for cash to someone who wants, wants them and so on.
This means that the search costs of buyers and sellers for workable trades with cash
within the domestic economy and across national borders can be reduced, which can
free up resources for use in the actual production of goods and services, which
can translate into greater incomes. Trades over the domestic economy are
relatively simple, since only one currency, the dollar in the United States,
and the yuan in China is usually involved. International trade usually involves at
least 2 currencies, say, the dollar and the Yuang, which means there must be some
means by which the currencies are traded. Chinese might accept dollars in exchange
for the goods they export to the In the United States.
But only because the dollars can be exchanged and sold for yuans.
The Chinese exporters need the yuans to pay their workers andn suppliers.
If the Chinese demand yuans in exchange for their exports to the United States
then the American importers must be able to exchange their dollars for or buy
Either way, there must be an international currency market in which various national
currencies are bought and sold at a price, or what is called an exchange rate which
says what it means the rate at which two currencies exchange.
I am sure most viewers of this video lecture have participated in the
international currency market, at least at the retail level.
You have done this when you have gone up to one of those currency exchange booths
at airports, and handed over dollars or whatever, for what you want, or whatever.
In making the currency exchanges, you might never have thought about why the
exchange rates are what they are. Or why they can change, even while you
were waiting in line to make your exchange.
The focus of this lecture will be on how international currency exchange rates are
determined. My guess is that by now you've learned a
pat answer to the question of how exchange rates are determined through the forces of
supply and demand, and you would be so right, which is why we will once again use
supply and demand curves to explain exchange rate determination.
After all, we are only trying to establish the price of one currency in terms of
another. But our supply and demand curve analysis
will have major twist. First in markets for real goods, the
demand for the good is a function of the good's intrinsic value or utility.
In the market for a national currency, the demand for the currency, say the yuan, is
not based on its extrinsic value. And it may be none, but rather on what the
yuans that are bought can buy from the Chinese, that is people demand yuans to
buy Chinese goods which have value. In the process the yuon demanders supply
dollars onto the international Market. Similarly, the supply or you, of Yuans
only international money market can come in part from Chinese who demand dollars
they need to buy American goods. Confused?
Just remember these two statements about the international market for Yuans.
The demand for Yuans by Americans mirrors the Americans supply of dollars.
The supply of Yuans from the Chinese mirrors the Chinese demands for dollars.
Didn't get it, rewind and replay what I said.
No rewind and write down my last two statements.
It's important that you understand these statements.
Now to, to the demand for yuans. In trying to understand the supply and
demand curve analysis for the international Money market you must
understand two points. The demands for yuans comes from
Americans. The supply of yuans comes from the
Chinese. Let us consider the demand for yuans.
You might rightfully guess that Americans demand for yuons is Downward sloping like
all other demand curves we have considered, and like the one that's now on
my overhead camera. And, you would be right but for a slightly
different reason than it is the case for the demand curves for raw goods.
As the dollar price of the yuan falls, the price of all Chinese goods and services
fall to Americans. To see this point, consider the American
price of a Chinese good that costs 100 Yuan, in China.
At $5 per Yuan, the price of the good is $500 to Americans.
At $1 per Yuan The price of that same Chinese good falls to $100 to Americans.
More of the specified Chinese goods will be demanded as the price falls.
In terms of my graph, what I have here is a $5 price.
And at that price, we're going to have a quantity of yuans demanded, which I will
specify as y1. And that quantity is going to be demanded
because again, that 100 Yuan Chinese good, is going to cost Americans $500, which is
going to restrict the quantity demanded. But if the price is reduced to say one
dollar, the quantity of yuans demanded is going to increase to y2 and the reason is
that in the case of the 100 yuan good in China, the price of the good falls in the
United States from $500 to 100 dollars and for that matter this drop in the price of
the yuan is going to decrease the price of all other Chinese goods which will magnify
the increase in the quality of yuans demanded.
Here is a definition for you that you simply must learn.
A decrease in the dollar price of the yuan or any other national currency,
constitutes an appreciation of the dollar, and it's an appreciation because the
dollar can now buy more yuan. In, at the $5 exchange rate, then $1 can
buy one-fifth of a yuan. At a $1 exchange rate, then $1 can buy a
whole yuan. The decrease in the dollar price of the
yuan is also a depreciation of the yuan, simply because the yuan cant can then buy
fewer dollars at 5 dollars per yuan, 1 yuan buy 5 dollars, at 1 dollar per yuan,
1 yuan buys only 1 dollar. This means that an appreciation of the
dollar for what ever reason these would be the yuan or any other national currency
will lead to greater imports into the United States, this is because when the
dollar price of the currency falls so do the prices of the goods to Americans, an
increase in the dollar price of the yuan Which amounts to a depreciation of the
dollar. It will simply increase the American
prices of the Chinese goods, which should curb the quantity of yuans demanded by
Americans, because they will be demanding fewer Chinese goods.
All of this means that when we move down the American demand curve for yuans, the
dollar appreciates, spurring greater import.
It also means that when we move up the American's demand curb for yuons the
dollar depreciates spurring a reduction in imports.
To summarize, an appreciate of a national currency leads to greater imports.
A depreciation of the national currency leads to fewer imports.
What usually drives the first time econ-students nuts, is that appreciation
of the dollar mirrors a depreciation of the yuan This means that an appreciation
of the dollar will increase American imports but decrease American exports.
Because dollars have become more expensive to the Chinese.
Which means that the prices of American goods in China have become more expensive.
There. A depreciation of the dollar decreases in
American imports because foreign goods have become more expensive to Americans.
And the depreciation of the dollar increases American export, because
American goods have become less expensive to foreigners.
I know it was tough for you to make sense of what I just said at such a rapid rate.
I have only two points of advice. Rewind and replay what I have just said
about the depreciation and appreciation of the dollar, and the impacts on US imports
and exports. You need to know those relationship, there
are, there really is no need for me to repeat my, myself when you can repeat
myself through the modern magic of the rewind button.
Now lets turn to the supply of yuan. As noted at the start, the supply of yuans
comes from the Chinese which emerges from their demands for American goods.
Here I have a upward sloping supply curve of, of yuan and again the supply of yuans
is coming from the Chinese, and it reflects the Chinese demands for dollars.
They're demanding dollars so they are supply yuans, add a price of $1 per yuan,
then the Chinese will demand y1 yuans. And they'll do that because say the price
of a $100 American good, will cost them 100 yuans because they will need to pay
one yuan for each dollar. But if we raise the price of the yuan to
$5, the quantity of demand of yuans will. I'm sorry, the quantity of yuans supplied
will go up considerably. And the reason is that as we move up this
plank, the yuan appreciates, that is one yuan can buy one dollar here, it can buy
five dollars up here. That means that the price of $100 American
goods goes from $100, I mean 100 yuan at this point And goes to 20 yuans at that
point. So, the quantity of yuans is going to
increase because this appreciation of the yuan, or the depreciation of the dollar,
is going to cause Chinese to see American goods as cheaper, and they're going to buy
a wide variety of additional American goods.
And in order to buy the wide variety of American goods are going to have to have
more dollars and they're going to have to supply more yuans.
Now let's look at the exchange rate. Determination.
The equilibrium exchange rate between the dollar and the yuan or the dollar price of
yuan is established in much the same way that the dollar price of any good in the
US economy is established. Now let me go to the supply and demand
curve for yuans that I have here Again we know that the exchange rate is going to
move to, to p1, or price of the yuan is going to be there and quantity demanded
is, is there. Again, remember that the demand for yuans
is coming from Americans. The supply of yuans is coming from, the
Chinese. Now, let's suppose that the price of a
yuan is P2. The quantity supplied of yuans is going to
be Y1. The quantity demanded of yuans is going to
be Y2. And the reason is that at this low price,
the price of American goods is very expensive to Chinese, but of course, that
means that the Chinese goods have low prices to Americans, and so we have this
gap. Well you can imagine that on a market as
expansive as, as the international money market, which is highly competitive, this
shortage that emerges in the market will quickly be relieved.
And it will be relieved by all of the Americans who want to buy all of the
Chinese goods pushing up the price of the yuan, as the price of the yuan goes up,
the cost of American goods goes up, and Americans are going to pull back on the
quantity of yuans demanded. By the same token, as the price of yuans,
dollar price of yuans goes up, then the price of American goods in China goes
down, and so we have a meeting of the equilibrium there.
Now, suppose that the exchange rate is something above the equilibrium.
That is, the quantity demanded is going to now be q one.
The quantity supplied is now going to be. Y3 it just conincidentally hit here on
both p1, I mean p2 and p3. Now the price of, of the yuan at p3, the
dollar price of the yuan means that Chinese goods are very expenseive so the
quantity of yuans demanded is going to be low.
But at that high dollar price of the yuan, the price of American goods to the Chinese
is going to be low so that you're going to have a much greater quan-, quantity of
yuans being made available. We have here a surplus, and of course that
its going to set up co, co, competition. The yu, the Chinese are going to want to
try to get rid of their yuans in order to get the dollars they want.
Get this high price for the yuan and they're, they're, going to bid the price
of dollars, of yuans down. As the price of dollars, as the price of
yuans goes up, the price of American goods in China goes down, so the quantity, of
yuan supplied contracts. As the price of the yuan goes down the
dollar price of the yuan goes down then the prices of Chinese goods go down to
Americans, and they're going to want to buy more American goods.
So if we're at a price above the equilibrium, or a price below, then
there's going to be this imbalance - shortage in one case, surplus in the
other, and they're going to be competitive forces, pushing the price toward this,
this equilibrium. As you might imagine, international
exchange rates can move in response to a multitude of forces in countries around
the world. To keep this lecture to a reasonable
length, I will consider just a few changes in domestic forces that will effect the
exchange rate between the dollar and the yuan.
Now, let's consider, an increase in the demand, the American demand for Chinese
goods. Now, if Americans want more Chinese,
Chinese goods their, their demand for Chinese goods is going to go up.
But in order to get the Chinese goods, the greater quantity of Chinese goods their
going to have to demand more, more yuans, and so the demand curve for yuans can, can
increase. It can go from D1 to D2 And as a result we
know that the equilibrium price of the yuan is going to go from the center
section to this one appear. That is the price of the yuan is going to
go to p two. The quantity is going to go to y one.
Now why does it go up, well if we had the old exchange rate p one.
The quantity of yuans being supplied is Q1, but the quantity demanded is much
greater. And the reason is, Americans want, want
more yuans to buy Chinese goods, for whatever reason that happens to be.
Well that means we have a shortage in the market, and with the shortage in the
market you going to have upward pressure on, on the price on the yuan, dollar price
on the yuan's going to escalate from P1 to P, P2.
Now let's take a case of an increase in, in the real income of, of Chinese.
Well the Chinese, with their increase in real income, are going to want to buy more
imports and specifically American goods. If they want to buy more American goods,
they've got to demand dollars to do so and in the process they've got to supply
yuans. So we have an increase in supply of yuans
that moves in this direction ffrom s1 to s2.
And we know that the, the increase of supply yuans, yuans is going to create a
surplus in the market which is going to be force for pushing the price down.
As the price comes down, then Chinese goods to Americans goes down and as a
result they're going to be demanding more yuans.
As the price of the yuan, dollar price of the yuan declines, that means that the
price of American goods to the Chinese is going to increase, which means that we end
up with an exchange rate of p 2, and a quantity, equilibrium quantity of y 1.
What has happened here is that the, the increase in demand of American goods due
to Chinese prosperity can appreciate the dollar.
By the same token this appreciation of the dollar is, translates to a depreciation, a
depreciation of the yuan. Now let's, let's consider a recession.
In the United States, that China, escapes. If that is the case, then the United
States' economy is going to be in a tailspin.
Which means real income is going to go down, as unemployment goes up.
You can imagine that the, Americans, are going to have to pull in their spending.
Spending on domestically produced goods and also spending on imported goods.
That means that the demand for the yuon is going to go down and as it goes down from
D1 To D2, we know that initially there's going to be a surplus of yuon in the
market, and that's going to be pressure to push the price of the yuon down.
And as price, the dollar price of the yuan goes down, the price of American goods to
Chinese goes up. The price decrease can, of the yuan can
cause the price of Chinese goods to Americans to go down.
As a result, what we're going to end up with is a appreciation of the dollar and a
depreciation of the yuan and we going to have a new equilibrium quantity equal to
y1. Finally, let's consider an increase in, in
the inflation rate in the United States relative to the inflation rate in China.
There may be inflation in both countries but let's assume that all of a sudden.
The inflation rate in the United States jumps ahead of the Chinese inflation rate.
What this means is that with our prices rising faster than the Chinese, Americans
are going to find Chinese goods relatively cheaper.
And as they see them going, becoming relatively cheaper as the prices domestic
Americans going up, then they're going to want, greater demand, they're going to
have a greater demand of, for the Chinese yuan.
And so the demand curve for, for the yuan can go from D1 to D2.
As, and the re, reason again is that we, Americans are trying to buy cheap, buy
cheaper goods and they can get them from the Chinese.
And since they can, they are now demanding a Y1 quantity of yuans but the only at
this exchange rate, the, quantity of yuan supplied is going to be, q1.
We have in the market, a shortage. And again, the impact of this is to cause,
the dollar price of the yuan to rise. As the dollar price of the yuan rises,
then the price of American goods to the Chinese declines, and they are then going
to supply more yuans to get the greater number of dollars to buy the cheaper
American goods. As the exchange rate goes up, then
Americans are going to find that Chinese goods are becoming more expensive, and the
result is that they will pull in their horns.
But notice that because of this inflation rate, this higher inflation rate in the
United States, we have the exchange rate going to P2, as the quantity, the
equilibrium quantity going to Q2. So what we have here is a greater rate of
inflation in the United States relative to the inflation rate in China is going to
lead to a depreciation of the dollar. And it's also going to lead to an
appreciation of the yuan. Now let's suppose that the Chinese decide
that they want to hold the price of the dollar price of the yuan at a level that
is below the equilibrium price. Let's supposed they pick out a price or
exchange rate equal to P two, a dollar price of D one.
They do it because at P two exchange rate, lots of Americans want to buy lots of
Chinese goods. The quantity of yuans demanded is going to
be y1. But at this low exchange rate the price of
American goods in China is going to be high which, this is going to cause the
quantity of yuan supply to be equal to q2 and were going to have this shortage here.
Well, how can the Chinese government hold the exchange rate down well the only way
the can do is they have to come in and, and print the yuans to fill this gap.
Of course, when they print more yuans to fill this gap to keep these, these exports
to the United States growing they're going to add to the money stock in, in their
domestic economy, which can lead to inflation.
Now the United States may get the bright idea of trying to have an exchange rate
equal to p2 as it has in the past. If that's the case then in order for the
exchange rate to be held to p2, then the United States is going to have to get
yuans. Equal to the distance between y2, and y1.
They've got to fill that gap, or else there's going to be competitive pressure
for the, for the dollar price of the yuan, to rise.
So, the United States can fill this gap in one of three ways.
One is, they can sell. They can sell the yuans that they have on
the international money market. Filling this gap, feeling this short,
making sure that there really is no shortage.
But, but they're sort of feeling it. The other thing is the United States can
use its supply of other foreign currencies to buy yuans and then sell them into the
market to keep the price from going above P2.
Or finally the United States as it has done in many years past, it can use its
gold reserves. Which it can then sell for yuans that it
can then, put in to this international money market.
But, you can imagine that there are limits to the holding the exchange rates at some
artificial level like p2. Are there going to be limits in China?
They, they can inflate themselves to kingdom come or there are going to be
limits in the United States that do the same thing Because the limit on reserves
that the United States might have. In this lecture, I had barely scratched
the surface of international finance, and more specifically exchange rate
determination. I've covered only the basics, and we have
not taken up a number of truly profound issues, one of which is the effect of a
change in the confidence of people around the world in the American dollar.
Many people around the world now hold dollars or dollar denominated assets, like
US government bonds, because they have confidence in the vitality of the American
economy, and the confidence that the dollar will hold its value, as well as
confidence that the American government will be able to make good on its
indebtedness. Suppose that people around the world lose
confidence in the dollar's value. Thinking that its future value will fall,
this could be the case, because of massive US government deficit spending, that
everyone begins to expect to extend will into the future, which can undermine the
county's stellar credit rating. For example people might begin to expect
that the dollar price of the 1, of the yuan will fall from 5 dollars to 1 dollar.
What can be expected, well we can expect to several consequences, first people can
be expected to dump their dollars before their values falls through 5 dollars to 1
dollar also the dumping of the dollars will cause the dollar's value to actually
fall, given the greater supply of dollars that will then be on the market.
A fall in the value of the dollar can make foreigners' goods more expensive to
Americans, undermining American real income.
People hold, holding dollar denominated assets, US government bonds for example,
can dump those assets on the financial markets, causing their prices to fall.
That can in turn cause a rise in domestic interest rates which in turn could have,
cause investment in the American economy to decrease which can give rise to a
dampening of growth in the American economy and more concern that the dollar
will not hold its value. And, of course, the dollar not holding its
value can give rise to concern over the American government being able to make
good on its indebtedness. And, the ripple effects can go on and on.
I will leave it to you to work your way through additional ripple effects, which
you should be able to do. For now I am pleased you have been with
me. [music]