Tag: The effect of changes in interest rates on exchange rates

Every Day Is a Great Day For Economics. Let’s Solve Two (Exchange Rate) Problems.

Chicago Cubs Hall of Fame shortstop Ernie Banks was known for saying “It’s a great day for baseball. Let’s play two!” (Photo from the Baseball Hall of Fame)

First Solved Problem: Exchange Rates and Tourism

Supports: Macroeconomics, Chapter 18, Sections 18.2 and 18.6; and Economics, Chapter 28, Sections 28.2 and 28.6.

The headline of an article on nbcnews.com is: “The Fed May Soon Cut Interest Rates. That Could Make Your Next Trip Abroad More Expensive.”

  1. Briefly explain the difference between a “strong dollar” and a “weak dollar.”
  2. If you are going to spend two weeks on vacation in France, would you prefer that the dollar be strong or weak during that time? Briefly explain.
  3. Briefly explain the connection between Federal Reserve monetary policy and the exchange rate between the U.S. dollar and other currencies.
  4. Use your answers to parts a., b., and c. to explain what the headline means. 

Solving the Problem

Step 1: Review the chapter material. This problem is about the effect of changes in exchange rates on import and export prices and the effect of changes in interest rates on exchange rates, so you may want to review Chapter 18, Sections 18.2 and 18.6.

Step 2: Answer part a. by explaining the difference between a “strong dollar” and a “weak dollar.” Generally, the U.S. dollar is called strong when it exchanges for more units of foreign currencies and is called weak when it exchanges for fewer units of foreign currencies. (Economists are less likely to use the phrases “strong dollar” and “weak dollar” than are members of the media.)

Step 3: Answer part b. by expalining whether you would like the U.S. dollar to be weak or strong during your vacation in France. France uses the euro as its currency. As a tourist, you will buy goods and services—such as restaurant meals and souvenirs—in euros. You would like the dollar to be strong because then you will be able to use fewer dollars to exhange for the euros you need to buy goods and services during your vacation.

Step 4: Answer part c. by explaining how Federal Reserve monetary policy affects the exchange rate. As we discuss in Section 18.6, when the Fed wants to pursue an expansionary monetary policy, the Federal Open Market Committee (FOMC) reduces its target for the federal funds rate, which typically results in other interest rates also declining. Lower interest rates make U.S. financial asses, such as Treasury bonds, less attractive relative to foreign financial assets, such as bonds issued by the French government. As a result the demand for U.S. dollars falls relative to the demand for foreign currencies, reducing the exchange rate between the dollar and other currencies. In other words, an expansionary monetary policy will result in a weaker dollar.

Step 5: Answer part d. by using your answers to parts a., b., and c. to expalin what the headline means. The headline indicates that the Fed may soon engage in an expansionary monetary policy, which will result in lower interest rates in the United States, leading to a weaker U.S. dollar. The weaker the dollar, the more dollars you will have to exchange to receive the same number of units of a foreign currency, causing you to have to spend more dollars to pay for the same goods and services during your trip. So, the Fed taking action to reduce interest rates will make your trip abroad more expensive.

Second Solved Problem: Solved Problem: Javier Milei and Argentina’s Exchange Rate Policy

Supports: Macroeconomics, Chapter 18, Sections 18.2 and 18.3; and Economics, Chapter 28, Sections 28.2 and 28.3.

Javier Milei was elected president of Argentina in December 2023. During the presidential campaign he proposed using market-based policies to address Argentina’s economic problems, particularly high rates of inflation and low rates of economic growth. One part of his program involves moving the government away from controlling the value of the peso either by allowing it to float or by making the U.S. dollar legal tender in Argentina. Initially, however, although Milei devalued the peso against the dollar, he didn’t allow the peso to float, keeping the peso pegged against the value of the dollar. An article in the Economist states that many economists believe that the peso is overvalued. The article notes that: “A pricey peso scares off tourists, makes exports expensive and deters investors.” The article also notes that allowing the peso to float “would probably push up inflation.”

  1. Briefly explain what it means for a government to allow its currency to float.
  2. What does it mean to say that a county’s currency is overvalued?
  3. What does the article mean by a “pricey peso”? Why would a pricey peso scare off tourists, make exports expensive, and deter investors?
  4. Why would allowing the peso to float probably push up inflation? 

Solving the Problem

Step 1: Review the chapter material. This problem is about exchange rates and exchange rate systems, so you may want to review Chapter 18, Sections 18.2 18.3.

Step 2: Answer part a. by explaining what it means for a government to allow its currency to float. As we discuss in Section 18.3, when a government allows its currency to float it allows the exchange rate between its currency and other currencies to be determined by demand and supply in foreign exchange markets.

Step 3: Answer part b. by expalining what it means for a country’s currency to be overvalued. A currency is overvalued if a government pegs the exchange rate above the market equilibrium exchange rate.

Step 4: Answer part c. by explaining what a “pricey peso” means and why a pricey peso might scare off tourists, make exports expensive, and deter investors. In the context of this article, a pricey peso means an overvalued peso—one that is pegged above the market equilibrium exchange rate, as we noted in the answer to part b. If the peso is overvalued relative to other currencies, then tourists from those countries will find the prices of goods and services in Argentina to be high relative to the prices of those goods and services priced in their domestic currencies. We would expect that fewer foreing tourists would visit Argentina. A pricey peso would make the prices of Argentine exports higher in terms of U.S. dollars, euros, and other currencies. Those high prices will cause a decline in Argentine exports. Finally, a pricey peso will also discourage foreign investors from investing in Argentina because they will receive fewer units of their domestic currency in exchange for the pesos they earn from their investments in Argentina.

Step 5: Answer part d. by explaining why the Argentine government allowing the peso to float would likely increase inflation. The Argentine peso is overvalued, so allowing it to float will cause the value of the peso to decline relative to other currencies. As a result, the peso price of imports will increase. The prices of imported goods and services are included in the price indexes used to measure inflation, so floating the peso will likely increase the inflation rate in Argentina.

Solved Problem: Will Investors in Japan and Europe Buy the Increased Quantity of U.S. Treasury Bonds?

Supports: Macroeconomics, Chapter 18, Section 18.2;  Economics, Chapter 28, Section 28.2; and Essentials of Economics, Chapter 19, Section 19.6.

As the figure above shows, federal government debt, sometimes called the national debt, has been increasing rapidly in the years since the 2020 Covid pandemic. (The figure show federal government debt held by the public, which excludes debt held by federal government trust funds, such as the Social Security trusts funds.) The debt grows each year the federal government runs a budget deficit—that is, whenever federal government expenditures exceed federal government revenues. The Congressional Budget Office (CBO) forecasts large federal budget deficits over the next 30 years, so unless Congress and the president increase taxes or cut expenditures, the size of the federal debt will continue to increase rapidly. (The CBO’s latest forecast can be found here. We discuss the long-run deficit and debt situation in this earlier blog post.)

When the federal government runs a budget deficit, the U.S. Treasury must sell Treasury bills, notes, and bonds to raise the funds necessary to bridge the gap between revenues and expenditures. (Treasury bills have a maturity—the time until the debt is paid off by the Treasury—of 1 year or less; Treasury notes have a maturity of 2 years to 10 years; and Treasury bonds have a maturity of greater than 10 years. For convenience, we will refer to all of these securities as “bonds.”) A recent article in the Wall Street Journal discussed the concern among some investors about the ability of the bond market to easily absorb the large amounts of bonds that Treasury will have to sell. (The article can be found here. A subscription may be required.)

According to the article, one source of demand is likely to be European and Japanese investors.

“The euro and yen are both sinking relative to the dollar, in part because the Bank of Japan is still holding rates low and investors expect the European Central Bank to slash them soon. That could increase demand for U.S. debt, with Treasury yields remaining elevated relative to global alternatives.”

a. What does the article mean by “the euro and the yen are both sinking relative to the dollar”?

b. Why would the fact that U.S. interest rates are greater than interest rates in Europe and Japan cause the euro and the yen to sink relative to the dollar?

c. If you were a Japanese investor, would you rather be invested in U.S. Treasury bonds when the yen is sinking relative to the dollar or when it is rising? Briefly explain.

Solving the Problem

Step 1:  Review the chapter material. This problem is about the determinants of exchange rates, so you may want to review Macroeconomics, Chapter 18, Section 18.2, “The Foreign Exchange Market and Exchange Rates” (Economics, Chapter 28, Section 28.2; Essentials of Economics, Chapter 19, Section 19.6.)

Step 2: Answer part a. by explaining what it means that the euro and the yen “sinking relative to the dollar.” Sinking relative to the dollar means that the exchange rates between the euro and the dollar and between the yen and the dollar are declining. In other words, a dollar will exchange for more yen and for more euros.

Step 3: Answer part b. by explaining how differences in interest rates between countries can affect the exchange between the countries’ currencies. Holding other factors that can affect the attractiveness of an investment in a country’s bonds constant, the demand foreign investors have for a country’s bonds will depend on the difference in interest rates between the two countries. For example, a Japanese investor will prefer to invest in U.S. Treasury bonds if the interest rate is higher on Treasury bonds than the interest rate on Japanese government bonds. So, if interest rates in Europe decline relative to interest rates in the United States, we would expect that European investors will increase their investments in U.S. Treasury bonds. To invest in U.S. Treasury bonds, European investors will need to exhange euros for dollars, causing the supply curve for euros in exchange for dollars to shift to the right, reducing the value of the euro.

Step 4: Answer part c. by discussing whether if you were a Japanese investor, you would you rather be invested in U.S. Treasury bonds when the yen is sinking relative to the dollar or when it is rising.  In answering this part, you should draw a distinction between the situation of a Japanese investor who already owns U.S. Treasury bonds and one who is considering buying U.S. Treasury bonds. A Japanese investor who already owns U.S. Treasury bonds would definitely prefer to own them when the value of the yen if falling against the dollar. In this situation, the investor will receive more yen for a given amount of dollars the investor earns from the Treasury bonds. A Japanese investor who doesn’t currently own U.S. bonds, but is thinking of buying them, would want the value of the yen to be increasing relative to the dollar because then the investor would have to pay fewer yen to buy a Treasury bond with a price in dollars, all other factors being equal. (The face value of a Treasury bond is $1,000, although at any given time the price in the bond market may not equal the face value of the bond.) If the interest rate difference between U.S. and Japanese bonds is increasing at the same time as the value of the yen is decreasing (as in the situation described in the article) a Japanese investor would have to weigh the gain from the higher interest rate against the higher price in yen the investor would have to pay to buy the Treasury bond.