Macroeconomics - Exchange Rates

Official Reserves

Official reserves refer to the foreign currency assets held by a country's central bank or monetary authority. These reserves can include foreign currencies, gold, special drawing rights (SDRs), and other internationally recognized reserve assets.

Official reserves play an important role in a country's economy, as they can be used to support the country's exchange rate, finance international trade and payments, and provide a cushion against external shocks. Central banks can also use official reserves to intervene in foreign exchange markets to maintain stability in the exchange rate.

For example, let's say that the central bank of a country has accumulated $100 billion in official reserves through trade surpluses, foreign investments, and other means. In case of a sudden outflow of foreign capital, the central bank can use these reserves to intervene in the foreign exchange market and prevent a rapid depreciation of its currency. Alternatively, if the country wants to expand its money supply or finance a large current account deficit, it can use these reserves to buy foreign currencies or other assets.

Flexible Exchange Rates

Flexible exchange rates refer to the exchange rate regime in which the value of a country's currency is determined by the foreign exchange market through the forces of supply and demand without the intervention of the government or central bank. The exchange rate is allowed to fluctuate based on various factors such as the demand for a country's exports, the inflow and outflow of capital, and changes in interest rates.

For example, the US dollar is a flexible exchange rate currency. The exchange rate between the US dollar and other currencies such as the euro, Japanese yen, or British pound is determined by the supply and demand in the foreign exchange market. If the demand for the US dollar increases, its exchange rate will appreciate, and if the demand decreases, its exchange rate will depreciate.

Determinants of Exchange Rate

Exchange rates are determined by the interaction of demand and supply in the foreign exchange market. The determinants of exchange rates include:

• Relative interest rates: Higher interest rates in one country can attract foreign investors, leading to an increase in demand for that country's currency and a higher exchange rate.
• Inflation rates: Countries with high inflation rates are likely to see their currencies depreciate as the purchasing power of their currency declines relative to other currencies.
• Economic growth: Countries with strong economic growth tend to attract foreign investment, which can lead to an increase in demand for their currency and a higher exchange rate.
• Political stability: Political instability can lead to uncertainty and a decrease in demand for a country's currency, leading to a lower exchange rate.
• Current account balance: A country's current account balance (the difference between its exports and imports) can also affect its exchange rate. A country with a current account surplus (i.e., exports exceed imports) may see its currency appreciate as there is greater demand for its currency to pay for its exports.

Factors that can shift the demand and supply of currencies in foreign exchange markets:

• Changes in tastes: If consumers in one country develop a greater preference for goods and services produced in another country, the demand for the currency of the other country will increase.
• Relative income changes: If incomes in one country rise faster than in another, the demand for imports from the other country will increase, leading to an increase in demand for the other country's currency.
• Relative price-level changes: If prices in one country rise faster than in another, the demand for imports from the other country will increase, leading to an increase in demand for the other country's currency.
• Purchasing-power-parity theory: According to this theory, exchange rates should adjust so that the same basket of goods and services costs the same in all countries. If prices in one country rise faster than in another, the exchange rate should adjust to reflect the difference.
• Relative interest rates: If interest rates in one country rise relative to another, investors may shift their funds to take advantage of the higher returns, increasing demand for the currency of the country with higher interest rates.
• Relative expected returns on assets: If investors expect that assets denominated in one currency will appreciate more than those denominated in another currency, they may shift their funds to the currency with the higher expected return, increasing demand for that currency.
• Speculation: If investors believe that a currency is going to appreciate or depreciate, they may buy or sell it in anticipation of the expected change in value.

Note that these factors can affect either the demand for a currency or the supply of a currency, depending on the context. For example, an increase in interest rates in one country could increase demand for that country's currency, but it could also increase the supply of that currency if investors who hold that currency decide to sell it in order to take advantage of higher returns elsewhere.

Example

Under flexible exchange rates, a shift in the demand for pounds, all other things equal, would cause a U.S. balance of payments deficit because it would increase the supply of dollars in the foreign exchange market, leading to a decrease in the value of the dollar and an increase in the quantity of dollars demanded by foreigners.

Assuming the U.S. dollar is the home currency and the British pound is the foreign currency, we can illustrate the effect of a shift in the demand for pounds using the following demand and supply schedule:

Suppose that there is a shift in the demand for pounds from D1 to D2, as shown in the graph below:

This increase in demand for pounds leads to an increase in the equilibrium exchange rate from $1.74 per pound to $1.78 per pound, and a corresponding increase in the quantity of pounds demanded from 75 to 85. This means that Americans are demanding more British goods and services, which increases the U.S. balance of payments deficit.

Therefore, under flexible exchange rates, a shift in the demand for pounds, all other things equal, would cause a U.S. balance of payments deficit.

Purchasing Power Parity

Purchasing Power Parity (PPP) is an economic theory that suggests that exchange rates between two currencies will eventually equalize the prices of a basket of goods and services in both countries. In other words, the exchange rate between two currencies should reflect the relative prices of goods and services in each country.

The PPP equation is as follows:

S = P1/P2

Where:

S is the exchange rate between two currencies

P1 is the price of a basket of goods in country 1

P2 is the price of the same basket of goods in country 2

For example, suppose that the price of a basket of goods in the United States is $100, while the price of the same basket of goods in Japan is ￥10,000. The exchange rate between the U.S. dollar and the Japanese yen would be:

S = ￥10,000/$100 = ￥100/$1

This suggests that the exchange rate between the two currencies should be ￥100/$1 in order to reflect the relative prices of goods and services in the two countries.

PPP can also be used to compare the overall level of prices between two countries. For example, if the price level in the United States is 20% higher than in Canada, the PPP exchange rate would suggest that the Canadian dollar should be 20% higher than the U.S. dollar.