Introduction to Unit 13: The Macroeconomy and Exchange Rates

In the previous section, we looked at the exchange rate for two currencies. The value of one currency in terms of another is determined in foreign exchange markets by the supply and demand for that currency. We also considered how different economic conditions affect the current and capital accounts. The current account refers to the value of exported goods and services from a country and imports into a country. If the value of exports is less that imports during a given time period (month, quarter, year) then the country runs a current account trade deficit during that period. Economic growth rates, inflation rates and interest rates were varied in order to look at the current and capital account consequences.

In this section we link together changes in macroeconomic conditions and the impact on exchange rates. For each scenario go through the following steps:

• Isolate the macroeconomic change, holding everything else constant.
• How does the macroeconomic condition impact the current or capital account?
• Given the change in the current or capital account, how are exchange rates affected?

We will consider the following scenarios:

• Noninflationary economic growth .
• Assume domestic economic growth increases relative to foreign growth rates.
• Increase purchases of imported goods and the supply of dollars to foreign exchange markets.
• Dollar depreciates.

• A rise in the domestic inflation rate.

• As the prices of domestically produced goods rise, consumers may substitute in favor of imports that are now relatively cheaper. Foreign consumers substitute away from exports that are increasing in price.
• Increase supply of dollars (and can reinforce analysis with a drop in demand for dollars) in foreign exchange markets.
• Dollar depreciates.

• The Fed reacts to higher domestic inflation by raising interest rates.

• Higher interest rates makes the return on domestic financial assets (bonds) more favorable in comparison to foreign financial assets.
• Net inflow of money into the economy through the capital account and increase demand for dollars.
• Dollar appreciates.

LINK TO MAIN SECTION OF UNIT 13 - THE MACROECONOMY AND EXCHANGE RATES