ECON 20 Lecture Notes - Lecture 24: Japanese Currency, U.S. Bancorp, Thai Baht
1 views3 pages
Effect of different inflation rates across countries on exchange rates
● Recap of PPP: exchange rates will adjust so that the law of one price holds.
● Countries with high inflation rates will experience currency depreciate relative to those
countries with low inflation. If the prices in a country increase, goods are more
expensive in that country (in terms of its own currency). To maintain PPP, currency has
to depreciate, which reduces the cost of the country’s goods in foreign currencies.
● Currency markets are sensitive to news that may lead to higher expected inflation. And
if, for example, higher inflation is expected in Mexico, the peso will depreciate.
● High inflation can explain why the Japanese currency (the yen) had such a low unit value.
Japan in the past has experienced high inflation. This caused their currency to depreciate
to the point where a single yen was worth just about a penny.
5. Relative strength of economies and exchange rates
● A country doing well economically will have fast income growth, fast consumption
growth, and therefore fast import growth. If imports in the U.S. are increasing, the U.S.
needs more foreign currency. If the U.S. trading partners are growing more slowly, U.S.
exports will grow relatively slowly and the demand for dollars will be relatively weak.
Therefore, the U.S. demand for foreign currency goes up fast while the demand for
dollars does not grow quickly, which causes the dollar to depreciate.
● In general, a country with a trade deficit will see its currency depreciate. A country with
a trade surplus will see its currency appreciate.
● Implications for the strength of the dollar in late 2003? Since the United States has been
growing faster than its trading partners, we would expect the dollar to depreciate based
on this theory alone. There was some evidence of a weaker dollar at that time. We need
to look, however, at other factors that affect exchange rates.
6. Interest rates and exchange rates
a) Relative interest rates and across countries and the foreign demand for domestic assets
● We have been talking about exchange rates and how they are affected by the international
trade of goods (and some services). However, many international financial flows are for
● The theory predicts that as U.S. interest rates rise, so will the strength of the dollar.
Higher interest rates make interest-bearing assets in the U.S. more attractive to investors
around the world. To put their money in the U.S., however, foreigners need to buy
dollars. (For example, to purchase a high-interest certificate of deposit from a U.S. bank,