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Economics U$A: 21st Century Edition
Exchange Rates (International)
By 1925 Great Britain went off the gold standard, managing to increase exports and lessen imports. The U.S. market was flooded with British goods and U.S. industry suffered. In July, 1944 world economic leaders met in Bretton Woods, NH for a “new world economic order” and soon the dollar became the new standard. In 2002 the Euro became the standard currency for the entire European Union and threatened to compete with the dollar. These stories portray the palpable cycle of effects involving trade, domestic growth, inflation, and flexible exchange rates.
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Unit Overview
Purpose:
To show the effect of exchange rates on trade and domestic growth and inflation, and the effect of domestic economic events on foreign exchange rates.
Objectives:
- If the value of the dollar compared to other currencies increases, goods exported from the U.S. will cost more in terms of foreign currencies than before, and imports will cost less than before. Therefore, net exports will tend to fall, depressing economic growth in the U.S. and stimulating growth overseas.
- A country’s ability to import and export changes over time because of underlying changes in relative wage rates, productivity, technology, etc. When such long-term changes occur, either the exchange rates have to be realigned or the country which has lost its competitive ability will have to endure a long period of slow growth in order to restore the trade balance.
- The following will tend to cause the dollar to fall vis-à-vis foreign currencies:
- a higher real growth rate in the U.S. (because it will cause net exports to fall);
- a higher inflation rate in the U.S. (because people will want to hold currencies that are not depreciating);
- a lower interest rate in the U.S. (because people will convert their dollars to foreign currencies to earn high interest);
- pessimism regarding the relative value of investment opportunities in the U.S. The converse of these effects will cause the dollar to rise.
- While flexible exchange rates are more volatile than fixed exchange rates, they tend to create fewer distortions and macroeconomic challenges.
Meet the Series Experts
Edward M. Bernstein
Principal Economist for the U.S. Treasury, 1940–1946, during which time he also served as Assistant Director of the Monetary Research Division and Assistant to the Secretary of the U.S. Treasury Department. In 1944, he was Chief Technical Advisor and Executive Secretary to the U.S. Delegation to the Bretton Woods Conference. From 1946 to 1958, he was Director of the International Monetary Fund’s Research Department. Later, he founded EMB (Ltd.) Research Economists, an international monetary research firm. He retired as president of EMB in 1981 and in 1982 took up the position of Guest Scholar at the Brookings Institution. He also taught economics at North Carolina State University and the University of North Carolina. Dr. Bernstein received his Ph.B. from the University of Chicago and Ph.D. from Harvard University.
Joan Spero
Under Secretary of State for Foreign and Agricultural Affairs, under President Bill Clinton, and United States Ambassador to the United Nations Economic and Social Council, 1980–1981. She is a Director of the Council on Foreign Relations, a Trustee of Columbia University and the Brookings Institution, and a member of the Trilateral Commission, the Atlantic Institute, and the American Academy of Diplomacy. She served as president of the Duke Farms Foundation and the Doris Duke Foundation for Islamic Art and became an IBM director in 2004. She has authored several books, many articles in professional journals, and is active in professional associations in foreign affairs and economics. She is also a member of the Academy of American Ambassadors, the Academy of Diplomacy, and the American Philosophical Society. Dr. Spero received her B.A. from the University of Wisconsin and M.A. and Ph.D. in International Affairs from Columbia University.
Marina Von Neuman Whitman
Professor of Business Administration and Public Policy at the University of Michigan since 1992, and Senior Staff Economist to the Council of Economic Advisers, 1970–1971. She has also been a Director at the Council of Foreign Relations, Vice-President and Chief Economist at General Motors Corp., and Group Executive for Public Affairs. She lectured in economics at the University of Pittsburgh, where she became the Distinguished Public Service Professor of Economics. Ms. Von Neuman Whitman received her B.A. from Radcliffe College and M.A. from Columbia University.
What's your Economics IQ?
Take the Economics USA: Exchange Rates Quiz.
3. Suppose that a number of French consumers decide to purchase shares of stock on the New York Stock Exchange. In that case, the exchange rate (in terms of dollars to the franc) will:
Answer:
fall because of greater supply.
4. This diagram shows that under fixed exchange rates, Germany has a:
Answer:
balance of payments deficit and its currency is overvalued.
Glossary
- balance-of-payments deficit
The difference between the quantity supplied and the quantity demanded of a currency when the currency is overvalued (that is, priced above its equilibrium price). - balance-of-payments surplus
The difference between the quantity demanded and the quantity supplied of a currency when the currency is undervalued (that is, priced below its equilibrium price). - economic activity
The production, distribution, purchase, and consumption of goods and services. - exchange rate
The number of units of one currency that can purchase a unit of another currency. - fixed exchange rate
System in which the value of a country’s currency, in relation to the value of other currencies, is maintained at a fixed conversion rate through government intervention. - flexible exchange rate
System in which the value of the currency is determined by the free market. - gold standard
A method of exchange-rate determination prevailing until the 1930s, under which currencies were convertible into a certain amount of gold. - government intervention in currency markets
A contentious debate involving the role of government in determining exchange rates. A government that intervenes and keeps its exchange rate below the free-market level effectively provides an export subsidy, or an import tariff, for its domestic industries giving them an advantage over producers in other countries. - inflation
An increase in the general level of prices economy-wide. - interest rate
The annual amount that a borrower must pay for the use of a dollar for a year. - parity
The principle that farmers should be able to exchange a given quantity of farm output for the same quantity of nonfarm goods and services they would have been able to purchase at some point in the past. In effect, the principle that farm prices should increase at the same rate as the prices of the goods and services that farmers buy. - purchasing power
Value of money (currency) measured by the quantity and quality of goods and services it can buy.
