THE MARKET FOR FOREIGN CURRENCY EXCHANGE

The second market in our model of the open economy is the market for foreign-currency exchange Participants in this market trade US. dollars in exchange for foreign currencies, To understand the market for foreign-currency exchange, we begum with another identity from the last chanter:

 This identity states that the imbalance between the purchase and sale of capital assets abroad (NeO) equals the imbalance between exports and imports of goods and services (NXj. For example, when, the US. economy is running a trade surplus (NX > 0), foreigners are buying more US. goods and services than Americans are buying foreign goods and services. What are Americans doing with the foreign currency they are getting from this net sale of goods and services abroad? They must be buying foreign assets, sc US. capital is flowing abroad (NeO > 0). Conversely, if the United States is running a trade deficit (N): <: 0), Americans are spending more on foreign goods and services than they are earning from selling abroad. Some of this spending must be financed by selling American assets abroad, so foreign’ capital is flowing into the United States (NeO < 0). Our model of the open economy treats the two sides of this identity as representing the two sides of the market for foreign-currency exchange. Net capital outflow represents the quantity of dollars supplied for ‘the purpose of buying foreign assets, For example, when a US. mutual fund wants to buy a, Japanese government bond, it needs to change dollars into yen, so it supplies ‘dollars in the market for foreign currency exchange, Net exports represent the quantity of dollars demanded for tile purpose of buying l},S net exports of goods and services. For example. when a Japanese airline wants to buy a plane made Boeing, it needs to change its yen into dollars. so it demands dollars m the market for foreign-currency exchange What price’ balances the supply and demand in the market for foreign-currency exchange? The answer 1£ the real exchange rate. As we saw in the preceding chapter.. the real exchange rate is the relative price of domestic and foreign goods and, therefore, is a key determinant of net exports. When the US, real exchange rate appreciates, US. goods become more expensive relative to foreign goods, making U.S. goods less attractive to consumers both at home and abroad. As a result, exports from the United States fall, and imports into the United States rise. For both reasons, net exports fall. Hence, an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange. Figure·2 shows supply and demand in the market for foreign-currency exchange. The demand curve slopes downward for the reason we just discussed: A higher real exchange rate makes U.S. goods more expensive and reduces the quantity of dollars demanded to buy those goods. The supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the real exchange rate (As discussed earlier, net capital outflow depends on the real interest rate. When discussing the market for foreign-currency exchange, we take the real interest rate and net capital outflow as given.) The real exchange rate adjusts to balance the supply and demand for dollars just as the price of and good adjusts to balance supply and demand for that good. If the real exchange rate were below the equilibrium level, the quantity of dollars supplied would be less than the quantity demanded. The resulting shortage of dollars would push the value of the dollar upward. Co we reversely, if the real exchange rate wen’ above the equilibrium level, the quantity of dollars supplied would exceed the quantity demanded. ‘flu, surplus of dollars would drive the value of the dollar downward. At the equilibrium real exchange rate, the demand for dollars by foreigners arising from the Us. net exports of goods and services exactly balances :~e supply of dollars from Americans arising from US. net cambial out low .