Fundamental Questions

1. How does a change in the exchange rate affect the prices of goods traded between countries?

2. Why don't similar goods sell for the same price all over the world?

3. What is the relationship between inflation and changes in the exchange rate?

4. How do we find the domestic currency return on a foreign bond?

5. What is the relationship between domestic and foreign interest rates and changes in the exchange rate?

6. Why don't similar financial assets yield the same return all over the world?

7. How does fiscal policy affect exchange rates?

8. How does monetary policy affect exchange rates?

9. What can countries gain by coordinating their macroeconomic policies?

Teaching Objectives

The primary purpose of this chapter is to analyze the financial connections between countries.

The unique features of the chapter include (a) the theory of purchasing power parity and the reasons that goods do not sell for the same prices throughout the world; (b) the relationship between relative inflation rates and exchange rates among countries; (c) the theory of interest rate parity and the reasons that the theory may not hold; and (d) the impact of fiscal and monetary policy on the exchange rate. The chapter concludes with an examination of the potential costs and benefits of policy coordination.

An area that requires special attention is the theory of interest rate parity. This, along with the theory of purchasing power parity, tends to be a tricky concept for many students. This chapter introduces concepts that will be used extensively in Chapter 35 on world trade equilibrium and Chapter 37 on exchange rates.

Key Term Review

arbitrage
open economy
interest rate parity (IRP)
purchasing power parity (PPP)
capital controls
risk premium

Lecture Outline and Teaching Strategies

1. Prices and Exchange Rates

The price a foreign buyer must pay for goods is the result of the product price and the exchange rate.

Teaching Strategy: Discuss exchange rates as the price of one currency in terms of another and ask your students to look at exchange rate equalities as the number of one country's currency units that are required to buy one unit of another country's currency. Then, it is easy to see that a currency appreciates when one currency unit buys more foreign currency and depreciates when one currency unit buys less foreign currency.

1.a. Appreciation and depreciation: When the domestic currency depreciates against another currency, fewer units of the foreign currency can be purchased with a unit of the domestic currency. When the domestic currency appreciates, a unit of the currency can purchase more units of the foreign currency.

1.b. Purchasing power parity: If goods were identical, information were free, shipping costs were zero, tariffs were zero, and there were no legal restrictions, goods arbitrage would equalize prices across countries.

Teaching Strategy: Be careful to discuss clearly the theory of purchasing power parity. This concept can sometimes be difficult.

1.c. Inflation and exchange rate changes: When foreign inflation is greater than domestic inflation, the domestic currency appreciates against the foreign currency.

Teaching Strategy: Note the reasons that purchasing power parity doesn't hold. This sometimes makes the concept of purchasing power parity clearer.

2. Interest Rates and Exchange Rates

2.a. The domestic currency return from foreign bonds: The domestic currency return from a foreign bond is the foreign interest rate plus the percent change in the exchange rate.

2.b. Interest rate parity: For bonds with similar risks and maturities, the interest rate differential should equal the expected change in the exchange rate.

Teaching Strategy: Emphasize the concept of arbitrage when you present interest rate parity.

Compare the interest rate on a 90 day money market instrument for the United States, Germany, and Japan (these rates can be found in a publication such as the Economist). Compare the money market rates for these countries from the previous quarter. Ask your class whether interest rate parity is a good predictor of exchange rates.

2.c. Deviations from interest rate parity: Differences in parity can be the result of government controls, political risk, and taxes.

3. Policy Effects

3.a. Government borrowing: Larger budget deficits lead to higher domestic interest rates; as a result, the domestic currency appreciates.

Teaching Strategy: Use the large U.S. budget deficits of the early 1980s as an example of how a currency can become overvalued due to fiscal policy.

Show how recent budget deficits can result in a weakening currency. Ask your class why this can happen.

3.b. Monetary policy: An inflationary monetary policy leads to a higher nominal interest rate and an expected depreciation of the domestic currency. Hence, interest rate parity holds.

3.c. Linking IRP and PPP

Teaching Strategy: This material is tricky. Make sure that you work through some numerical examples.

4. International Policy Coordination

Teaching Strategy: Point out that if countries can coordinate their policies, they gain an additional tool for macroeconomic policymaking.

4.a. Potential gains: Countries can achieve improved outcomes from macroeconomic policy when their policies are coordinated.

4.b. Obstacles: Countries may disagree about the goals of a coordinated policy, the current macroeconomic conditions, or the theory that best describes the behavior of the economy.