The big picture marcoeconomics 12e parkin chapter 09

W H AT I S E C O N O M I C S ?

75

9

THE EXCHANGE
RATE AND THE
BALANCE OF
PAYMENTS**

The Big Picture
Where we have been:
Chapter 9 is the last of four that examine the long-run trends of the economy.
It uses the quantity theory result from Chapter 8 that in the long run, the price
level is determined by the quantity of money. This result is used to show that
in the long run, the nominal exchange rate is determined by the quantities of
money in the two countries. Chapter 9 also uses the national income
accounting identities introduced in Chapter 4 when explaining the balance of
payments and, quite importantly, the demand and supply model of Chapter 3
when explaining short-run fluctuations in the exchange rate.
Where we are going:
Chapter 9 is the last of the “long-run chapters.” The next section looks at
short-run fluctuations. Chapter 10, with its introduction of the aggregate
supply/aggregate demand model, is key to understanding short run business
cycle fluctuations. The material in this chapter is not prominently featured in
future chapters, though it makes a slight recurrence in Chapter 14 when
monetary policy is covered. Chapter 15, on International Trade, does not use
the material in this chapter directly. However, the global loanable funds
market can be used to motivate the models for the global market in goods and
services.

N e w i n t h e Tw e l f t h E d i t i o n
This chapter has some sections that have been modified, especially the section on
exchange rate expectations. It is mostly a modest reorganization of content, so
there are no new items to call to your attention. However, there is now a section
on the Global Loanable Funds Market that was moved from chapter 7. Data in
tables and graphs have been updated to 2014. The Economics In The News
feature has a 2014 article on the rising value of the dollar. The Worked Problem

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presents a scenario in which the Fed and Bank of Japan announce their interest
rate policies. The students are asked to analyze the announcements using the
foreign exchange market and the supply and demand for U.S. dollars. To include
the new Worked Problem without lengthening the chapter, some problems have
been removed from the Study Plan Problem and Applications. These problems are
in the MyEconLab and are called Extra Problems.

76


Lecture Notes

The Exchange Rate and the Balance of Payments




International trade, borrowing, and lending, make it necessary to exchange
currencies and the foreign exchange value of the dollar is determined in the foreign
exchange market.
The exchange rates for currencies are determined by supply and demand in the
foreign exchange market.
When a nation trades with other nations, the country’s balance of payments records
the transactions.

I. The Foreign Exchange Market
Trading Currencies


International trade, borrowing, and lending, make it necessary to exchange
currencies. Foreign currency is the money of other countries regardless of whether
that money is in the form of notes, coins, or bank deposits. The foreign exchange
market is the market in which the currency of one country is exchanged for the
currency of another. The price at which one currency exchanges for another is called
the exchange rate.

Exchange rates: Exchange rates are always somewhat confusing. The problem is that
there are two ways to express an exchange rate: It can be expressed as the units of foreign
currency per U.S. dollars (84 yen per U.S. dollar) or as U.S. dollars per unit of foreign
currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the
textbook is consistent in using the exchange rate as the units of foreign currency per U.S.
dollars, stick to the “84 yen per dollar” format in your lectures. This also makes it easier for
graphing and for the discussion about appreciation or depreciation. A change from 84 to
94 yen per dollar is dollar appreciation and shown by an increase along the vertical axis.


Over time, the U.S. dollar appreciates and depreciates against other currencies such
as the Japanese yen or European euro. Currency depreciation is the fall in the value
of one currency in terms of another currency. Currency appreciation is the rise in the
value of one currency in terms of another currency.
 A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in
the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money
The exchange rate is determined by demand and supply in the (competitive) foreign
exchange market. When people holding the money of some other country want to exchange
it for U.S. dollars, they supply the other currency and demand dollars. When people holding
U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and
demand the other currency.

Demand in the Foreign Exchange Market
The main factors that influence the dollars that people plan to buy in the foreign exchange
market are the exchange rate, world demand for U.S. exports, interest rates in the United
States and other countries, and the expected future exchange rate.


The law of demand in the foreign exchange market is: Other things remaining the
same, the higher the exchange rate, the smaller is the quantity of dollars demanded
in the foreign exchange market. There are two reasons for the law of demand:
 Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate,
with everything else the same, the cheaper are U.S. exports so the greater the


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

quantity of dollars demanded on the foreign exchange market to pay for the
exports.
 Expected Profit Effect: The lower the exchange rate, with everything else the
same (including the expected future exchange rate), the larger the expected
profit from buying dollars so the greater the quantity of dollars demanded on the
foreign exchange market.
The law of demand means that the demand curve for U.S. dollars is downward
sloping, as illustrated in the figure below.

Supply in the Foreign Exchange Market
The main factors that influence the dollars that people plan to sell in the foreign exchange
market are the exchange rate, U.S. demand for imports, interest rates in the United States
and other countries, and the expected future exchange rate.




The law of supply in the foreign exchange market is: Other things remaining the
same, the higher the exchange rate, the greater is the quantity of dollars supplied in
the foreign exchange market. There are two reasons for the law of supply:
 Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange
rate, with everything else the same, the cheaper are foreign produced imports so
the greater the quantity of dollars supplied on the foreign exchange market to
buy these imports.
 Expected Profit Effect: The higher the exchange rate, with everything else the
same (including the expected future exchange rate), the smaller the expected
profit from holding dollars so the larger the quantity of dollars supplied on the

foreign exchange market.
The law of supply means that the supply curve for U.S. dollars is upward sloping, as
shown in the figure.

Market Equilibrium


Demand and supply in the foreign
exchange market determine the
exchange rate. In the figure, the
equilibrium exchange rate is 100 yen
dollar, where the demand and supply
curves intersect.
 If the exchange rate is higher than
equilibrium exchange rate, a surplus
dollars drives the exchange rate
down.
 If the exchange rate is lower than
equilibrium exchange rate, a
shortage of dollars drives the
exchange rate up.
 The market is pulled to the
equilibrium exchange rate at which there is neither a shortage nor a surplus.

per
the
of
the

Changes in the Demand for U.S. Dollars



A change in any relevant factor other than the exchange rate changes the demand
for dollars and shifts the demand curve for dollars.
 World Demand for U.S. Exports: An increase in the world demand for U.S. exports
increases the demand for U.S. dollars because U.S. producers must be paid in
U.S. dollars. The demand curve for U.S. dollars shifts rightward.
 U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S.
interest rate minus the foreign interest rate. The larger the U.S. interest rate
differential, the greater is the demand for U.S. assets and the greater is the


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

demand for U.S. dollars on the foreign exchange market. An increase in the U.S.
interest rate differential shifts the demand curve for U.S. dollars rightward.
Expected Future Exchange Rate: The higher the expected future exchange rate,
the greater is the expected profit from holding U.S. dollars. As a result, the
demand for U.S. dollars increases and the demand curve shifts rightward.

Changes in the Supply of U.S. Dollars


A change in any relevant factor other than the exchange rate changes the supply of
dollars and shifts the supply curve of dollars.
 U.S. Demand for Imports: An increase in the U.S. demand for imports increases
the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy
the foreign currency necessary to pay foreign producers. The supply curve of U.S.

dollars shifts rightward.
 U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the
greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars
on the foreign exchange market. An increase in the U.S. interest rate differential
shifts the supply curve for U.S. dollars leftward.
 Expected Future Exchange Rate: The higher the expected future exchange rate,
the greater is the expected profit from holding U.S. dollars. As a result, the supply
of U.S. dollars decreases and the supply curve shifts leftward.

Emphasize that the quantity of dollars measured on the horizontal axis are only dollars
that are being offered for foreign exchange, not the entire quantity of money as we learned
in Chapter 8.

Changes in the Exchange Rate
The exchange rate changes when the demand
for and/or the supply of foreign exchange
change.


When the expected future U.S. exchange
rate increases, the demand for U.S.
dollars increases and the supply
decreases. As the figure shows, the
demand curve shifts rightward, from D0
to
D1, and the supply curve shifts leftward,
from S0 to S1. The exchange rate rises, in
the figure from 77 yen per dollar to 102
yen per dollar, and quantity traded does
not change by much, indeed in the figure

it
does not change at all. Such changes
took place between 2012 and 2014 when
traders started to expect that the Federal Reserve would raise the interest rate in the
United States while the Japanese interest rate would not change.

II. Arbitrage, Speculation, and Market Fundamentals
Exchange rate expectations depend on deeper economic forces that influence the value of
money.


Arbitrage is the practice of seeking to profit by buying in one market and selling for
a higher price in another related market. Arbitrage in the foreign exchange market
and international loans markets and goods markets achieves four outcomes:
 The law of one price: If an item is traded in more than one place, the price will be
the same in all locations. An example of this law is that the exchange rate

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





between the U.S. dollar and the U.K. pound is the same in New York as it is in
London.
No round-trip profit: A round trip is using currency A to buy currency B, and then
using B to buy A. A round trip might involve more stages, using B to buy C and
then using C to buy A. Regardless, arbitrage removes the profit made from a
round trip.
Interest rate parity: Borrowers and lenders must choose the currency in which to
denominate their assets and debts. Interest rate parity, which means equal rates
of return across currencies, means that for risk-free transactions, there is no gain
from choosing one currency over another.
Purchasing power parity: Purchasing power parity, which means equal value
of money, is the idea that, at a given exchange rate, goods and services should
cost the same amount in different countries. Purchasing power parity is an
important force affecting prices and exchange rates in the long run and
influences exchange rate expectations.

Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are
many horror stories of people losing their shirts by misunderstanding interest rate parity.
One story concerns the once wealthy Catholic Church of Australia that decided to borrow in
Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher
interest rates. When the Australian dollar nosedived against the Japanese yen, the church
struggled to repay its loans. Interest rate parity always holds. Interest rates might look
unequal, but the market expectation of the change in the exchange rate equals the gap
between interest rates. It is a foolish person (or organization) that acts as if it can beat the
market.

If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is
attained when one U.S. dollar buys the same quantity goods and services in the United
States as 1.33 Canadian dollars buys in Canada.
 If one U.S. dollar buys more goods and services in the United States than 1.33

Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually
appreciate.
 Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33
Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually
depreciate.
The Economics in Action detail discusses the “Big Mac Index.” The Economist reports a Big
Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to
make predictions about exchange rate movements. The index is somewhat tongue-incheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on
a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs
into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac
prices over time. The Economist claims some success in its exchange rate predictions.

Speculation
Speculation is trading on the expectation of making a profit. Speculation contrasts with
arbitrage, which is trading on the certainty of making a profit. Most foreign exchange
transactions are based on speculation, which explains why the expected future exchange
rate plays such a central role in the foreign exchange market. Changes in the expected
future exchange rate instantly change the current exchange rate.


T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S

Market Fundamentals
The fundamentals underlying the exchange rate are the demand for U.S. dollars, which
depends on world demand for U.S. exports, and the supply of U.S. dollars, which depends
on U.S. demand for imports. Both demand and supply depend on the U.S. interest rate
differential.

The Real Exchange Rate


The nominal exchange rate is the value of the U.S. dollar expressed in units of
foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S.
dollar buys. The real exchange rate is the relative price of U.S-produced goods
and services to foreign-produced goods and services. It tells how many units of
foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E  P)/P*



where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign
price level.
Price Levels and Money: Nominal and real exchange rates are linked by the equation
RER = E  (P/P*). This relationship can be used in the short run and long run:
 Short Run: In the short run, this equation determines the real exchange rate. The
nominal exchange rate is determined in the foreign exchange market by the
supply and demand for dollars. Price levels do not change rapidly and so any
change in the nominal exchange rate translates into a change in the real
exchange rate.
 Long Run: In the long run, rewrite the equation as E = RER  (P*/P). In the long
run, the real exchange rate is determined by the supply and demand for imports
and exports and the price level in each nation is determined by the quantity of
money in that nation. So in the long run, a change in the quantity of money
changes the price level and thereby changes the nominal exchange rate. This
result means that in the long run, the nominal exchange rate is a monetary
phenomenon. Chapter 8 showed that in the long run, the quantity of money
determines a nation’s price level, so the nominal exchange rate is determined by
the quantities of money in the two countries.

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III. Exchange Rate Policy
Because the exchange rate is the price of a country’s money, governments and central
banks must have a policy toward the exchange rate. Three possible exchange rates policies
are.

Flexible Exchange Rate


A flexible exchange rate policy permits the exchange rate to be determined by
demand and supply with no direct intervention by the central bank. Even so, the
exchange rate is influenced by the central bank’s actions. For instance, if the Fed
raises the U.S. interest rate, the U.S. interest rate differential increases, which
appreciates the U.S. exchange rate. Most countries, including the United States,
have flexible exchange rates.

Fixed Exchange Rate


A fixed exchange rate policy pegs the exchange rate at a value determined by the
government or the central bank and blocks the unregulated forces of supply and
demand by direct intervention in the foreign exchange market. A fixed exchange
rate requires direct and frequent intervention by the central bank.
 If the demand for dollars decreases or the supply of dollars increases, to fix the

exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the
demand for dollars and raises the exchange rate. But the Fed cannot pursue this
policy forever because it eventually will run out of the foreign reserves it is using
to purchase the dollars.
 In the figure the demand for dollars
has decreased from D0 to D1. To keep
the exchange rate fixed at 100 yen per
dollar, the Fed needs to buy 2 billion
dollars per day, the difference
between the quantity of dollars
supplied at the fixed exchange rate (7
billion dollars per day) and the [new]
quantity of dollars demanded (5 billion
dollars per day). To purchase these
dollars the Fed must use its foreign
reserves. Ultimately the Fed will run
out of foreign reserves and when that
takes place the Fed can no longer peg
the exchange rate at 100 yen per
dollar.
 If the demand for dollars increases or the supply of dollars decreases, with no
intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S.
dollars so that it increases the supply of dollars and lowers the exchange rate.
But the Fed will accumulate large stocks of the foreign reserves it is accepting in
payment for the dollars. The People’s Bank of China pursued such a policy to
hold down the value of the yuan and while so doing accumulated billions of
dollars of U.S. dollars.

Crawling Peg


A crawling peg policy selects a target path for the exchange rate with intervention
in the foreign exchange market to achieve that path. A crawling peg works like a
fixed exchange rate only the target value changes. The target changes whenever the
central bank changes. China is now currently using a crawling peg exchange rate
policy for the yuan.


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The People’s Bank of China in the Foreign Exchange Market (Economics In Action
Detail)





From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by
selling yuan and buying dollars to offset the effects of increases in the demand for
yuan. China accumulated foreign currency reserves of almost $1 trillion by mid2006, and by the end of 2007 was fast approaching $2 trillion.
Since 2005, the People’s Bank has allowed the yuan to crawl upward. Even so the
yuan has not risen to its equilibrium level, hence the People’s Bank must buy U.S.
dollars to hold the yuan/dollar exchange rate down.
China most likely fixed its exchange rate to anchor its inflation rate so that it does
not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from
the U.S. inflation rate by an amount determined by the speed of the crawl.

IV. Financing International Trade
Balance of Payments Accounts




A country’s balance of payments accounts records its international trading,
borrowing, and lending. There are three balance of payments accounts:
 The current account records payments for imports of goods and services from
abroad, receipts for exports of goods and services sold abroad, net interest
income paid abroad, and net transfers (such as foreign aid payment). The
current account balance equals exports plus net interest income plus net
transfers minus imports.
 The capital account records foreign investment in the United States minus U.S.
investment abroad. Any statistical discrepancy is included in this account.
 The official settlements account records the change in U.S. official
reserves, which are the government’s holdings of foreign currency. An increase
in foreign reserves corresponds to a negative official settlements account
balance. This occurs because holding foreign currency is like (but not the same
as) investing abroad, which is a negative entry in the capital account.
The sum of the balances always equals zero:

current account + capital account + official settlements account = 0.


In 2013, the U.S. current account balance was negative and almost entirely offset by
a positive capital account balance. Over time, the current account balance tends to
mirror the capital account balance because the official settlements account balance
is small.

Borrowers and Lenders
Because of current account deficits and surpluses, countries, like individuals, can be
borrowers or lenders.



A country that is borrowing more from the rest of the world than it is lending to it is a
net borrower. A net lender is a country that is lending more to the rest of the
world than it is borrowing from the rest of the world. The United States currently is
net borrower. Being a net borrower is not a problem provided the borrowed funds are
used to finance capital accumulation that increases income. Being a net borrower is
a problem if the borrowed funds are used to finance consumption.

The Global Loanable Funds Market
Demand and Supply in Global and National Markets


Demand and supply in the world global loanable funds market determines the world
equilibrium real interest rate.

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

A country is a net foreign borrower if the
world equilibrium real interest rate is less
than what would be the no-trade interest
rate in the country. The figure shows this
situation.

 In the figure, when the country is
isolated from international trade the
equilibrium real interest rate would be
6 percent and the equilibrium quantity
of loanable funds would be $1.6
trillion.
 With international trade, the real
interest rate in the country becomes
the world real interest rate, 5 percent.
At this lower real interest rate, the
quantity of loanable funds supplied
decreases to $1.4 trillion and the quantity of loanable funds demanded increases
to $1.8 trillion. The difference, $0.4 trillion, is borrowed from abroad. The country
has negative net exports, with X < M.



A country is a net foreign lender if the world equilibrium real interest rate exceeds
what would be the no-trade interest rate in
the country. The figure shows this
situation.
 In the figure, when the country is
isolated from international trade the
equilibrium real interest rate would be
4 percent and the equilibrium quantity
of loanable funds would be $1.6
trillion.
 With international trade, the real
interest rate in the country becomes
the world real interest rate, 5 percent.

At this higher real interest rate, the
quantity of loanable funds supplied
increases to $1.8 trillion and the
quantity of loanable funds demanded
decreases to $1.4 trillion. The difference, $0.4 trillion, is loaned abroad. The
country has positive net exports, with X > M.
In a small country, changes in the national demand and supply of loanable funds
change the country’s international loaning or borrowing and will change the
country’s net exports.



Debtors and Creditors


A debtor nation is a country that during its entire history has borrowed more from
the rest of the world than it has lent to it. A creditor nation is a country that during
its entire history has invested more in the rest of the world than other countries have
invested in it. The United States currently is debtor nation.
 The net borrower/net lender difference refers to the current flow of borrowing or
lending over a period of time. The debtor nation/creditor nation refers to the
stock of debt or foreign assets that exists at a moment in time.

The analogy of a country being like an individual in terms of being a borrower or lender is
revealing. However, you may want to point out a big difference in lifespan. Long periods of


T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S

deficit seem bad for an individual, but are short when you are expected to live forever.

Much economic activity and development would be impossible without borrowing and
lending. This is true at the individual level and for countries. The key is what the debt is
being spent on. The United States financed its industrialization and railroads in the
nineteenth century by being a debtor nation.

Current Account Balance and Net Exports


The current account balance (CAB) is:



The main item in the current account balance is net exports (X − M). The other two
items are much smaller and don’t fluctuate much.
The national accounts show that Y = C + I + G + X  M and also that Y = C + S + T.
These two relationships can be equated and rearranged to give (X  M) = (S  I) + (T
 G). In this formula,
 (X  M) is net exports, exports of goods and services minus imports of goods
and services.
 (S  I) is the private sector balance, saving minus investment.
 (T  G ) is the government sector balance, net taxes minus government
expenditures on goods and services.
The formula shows that net exports equal the sum of the private sector balance and
the government sector balance. There is a strong tendency for the private sector
balance and the government sector balance to move in opposite directions, which
means that the relationship between net exports and the other two sectors taken
individually is not a strong one.

CAB = X − M + Net interest income + Net transfers




Where Is the Exchange Rate?
In the short run, a change in the nominal exchange rate changes the real exchange rate
and affects the U.S. current account balance. In the long run, a change in the nominal
exchange rate leaves the real exchange rate unaffected and so in the long the nominal
exchange rate plays no role in determining the current account balance.

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Additional Problems
1.

The Dollar’s Short-Lived Comeback
The dollar fell to record lows against the euro in April. Over the next month
the exchange rate rose because traders began to expect that the Federal
Reserve was not going to cut U.S. interest rates any further.
CNN, May 16, 2008
Explain how expectations that the Federal Reserve will not cut the interest
rate can make the dollar appreciate.

2.

3.

Suppose that traders in the foreign exchange market come to believe that the
U.S. exchange rate will rise over the next few months. How does this belief
affect the demand for U.S. dollars and the supply of U.S. dollars? What is the
impact of this belief on the current exchange rate? Draw a graph of the
foreign exchange market to illustrate your answer.
A country has a lower inflation rate than all other countries. It has more rapid
economic growth. The central bank does not intervene in the foreign
exchange market. What can you say (and why) about:
a. The exchange rate?
b. The current account balance?
c. The expected exchange rate?
d. The interest rate differential?
e. Interest rate parity?
f. Purchasing power parity?

Solutions to Additional Problems
1.

If traders come to believe that the Federal Reserve will not cut interest rates, the
interest rate in the future will be higher than previously expected. With the higher
future U.S. interest rate, the future U.S. interest rate differential will also be higher. In
turn, the higher future U.S. interest rate differential will raise the future U.S. exchange
rate. Finally, the expected higher future U.S. exchange rate increases the current
demand for U.S. dollars and decreases the current supply, thereby raising the current
exchange rate and appreciating the dollar.


T H E E X C H A N G E R AT E A N D T H E B A L A N C E O F PAY M E N T S

2.

The rise in the expected future exchange
rate increases the expected profit from
holding dollars. The increase in expected
profit increases the current demand for U.S.
dollars and decreases the current supply of
U.S. dollars. The current exchange rate
rises. Figure 9.1 shows the effect on the
foreign exchange market of the change in
traders’ beliefs. The demand increases so
the demand curve for dollars shifts
rightward from D0 to D1. The supply curve of
dollars shifts leftward from S0 to S1. The
dollar immediately appreciates, rising in the
figure from 110 yen per dollar to 120 yen
per dollar.

3. a. The exchange rate most likely rises—the currency appreciates. The reason is that to
preserve purchasing power parity, the lower inflation rate means that the currency
must appreciate.
b. The current account balance depends on domestic investment relative to national
saving. The balance could be positive or negative. Possibly with more rapid growth,
investment in the country is high and so the current account might be in deficit.
c. The exchange rate will be expected to appreciate so the expected future exchange
rate is higher than the current exchange rate.
d. The interest rate differential is negative. The interest rates in other countries exceed
the domestic interest rate by an amount equal to the expected exchange rate
appreciation.
e. Interest rate parity holds every day. If it did not, large above-average profits would

be available. Such profit opportunities do not go unexploited.
f. Purchasing power parity probably doesn’t hold every day, but does hold on the
average in the long run.

Additional Discussion Questions

1. In 20072008, the nominal exchange rate of U.S. dollars declined
relative to both the Japanese yen and the European euro. What would
you need to know about the U.S. economy to determine whether this
would be a benefit or a problem for the U.S. economy? Point out that
the United States was just starting to enter a recession in 2008, as potentially
was Japan and most of Europe. The Federal Reserve was ahead of other central
banks in responding to the recession by lowering the interest rate before the
other central banks took action. By lowering the U.S. interest rate, the U.S.
interest rate differential decreased, which decreased the demand for U.S.
dollars, increased the supply of U.S. dollars, and forced the exchange rate
lower. By lowering the U.S. exchange rate, U.S. exports increased, which

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helped keep the U.S. economy stronger than otherwise would have been the
case.
2. When the Federal Reserve Chairman Ben Bernanke repeatedly
decreased the interest rate during late 2008, he was attempting to
stimulate the U.S. economy by lowering the interest rates in the U.S.

financial markets and lowering the cost of employing productive
capital. What impact did this policy have on the exchange rates in the
foreign exchange markets, all else equal? The fall in U.S. interest rates
means that the U.S. interest rate differential falls. The fall in the interest rate
differential increases the supply of dollars to the foreign currency exchange
market, shifting the supply curve of dollars rightward. It also decreases the
demand for dollars, shifting the demand curve for dollars leftward. With no
other changes, the equilibrium exchange rate for dollars falls. As it happened,
however, other factors were not equal. In late 2008 other central banks also
lowered their interest rates. And apparently investors believed that the United
States had less default risk than other countries. So on net the demand for
dollars actually increased and the supply decreased so that the U.S. exchange
rate rose. But the increase would have been significantly greater had it not
been for the actions of the Federal Reserve.
3. In part due to the recession of 2008, the U.S. government budget
changed from a smaller deficits to larger deficits. What impact would
this have on the net exports and private sector balances, all else
equal? The three balances are related: Net exports equal the sum of
government and private sector balances. If the private sector balance does not
change, the net export deficit will increase. However if the public sector
surplus were to increase substantially, the net export deficit might decrease.