[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

States than moving it to Europe or Japan. And this preference becomes
even stronger when they contemplate investing in countries threatened
by political or economic instability. Many countries have defaulted on their
debts; recent examples include Russia, which in 1998 defaulted on some
of the debt it owed and called a moratorium on interest payments to
foreign creditors, and Argentina, which in 2002 defaulted on payments
it owed. The more stable the political and economic environment of the
world, the more mobile capital becomes across countries.
When foreign borrowing and lending occurs, it affects the equilibrium
exchange rate, which thus is no longer just a matter of balancing
imports and exports. The international flows of financial capital will
influence demand and supply in the foreign exchange market, as illustrated
in Figure 34.4. Consider the case of foreign investors who want
to take advantage of the rates of return available in the United States on
U.S. stocks, bonds, real estate, or other American assets. To buy U.S.
assets, they need dollars, and therefore the demand for dollars increases.
On the other hand, Americans who wish to invest in European assets such
as shares of a German company or bonds issued by the Japanese government
will need to sell dollars to buy foreign currencies, thereby
increasing the supply of dollars in the foreign exchange market. How
these new motives for supply and demand affect the equilibrium exchange
rate depends on the relative amounts that foreigners want to invest in
the United States and Americans want to invest abroad.
Because of international borrowing and lending, interest rates in
different countries significantly influence exchange rates. If interest
rates in Japan rise relative to interest rates available in the United
States, investors will want to put their money into Japanese investments.
To do so, the investor will first need to buy yen; thus an increase in Japanese
interest rates will increase the demand for yen and boost the currency’s value.
Similarly, if interest rates in the U.S. rise relative to rates in other countries, the
demand for dollars will rise and the equilibrium exchange rate will rise to reflect a
higher value of the dollar. If U.S. interest rates fall relative to those available in other
countries, the demand for dollars will also fall and the dollar will depreciate. An
important implication of this discussion is that changes in interest rates in different
countries will affect equilibrium exchange rates and the foreign exchange market.
Speculation The third important factor in determining the exchange rate is
speculation. The demand for any asset depends on beliefs about what that asset
could be sold for in the future; that is, it depends on expectations. If Americans
believe that the Japanese yen is going to increase in value relative to the dollar,
they may want to buy yen. For instance, consider what happens if the current
exchange rate is 200 yen to the dollar and investors believe that the yen is going
to appreciate to a value of 100 to the dollar by the end of the month. They believe,
in other words, that if they took $1,000 and bought 200,000 yen (each dollar
exchanged for 200 yen), at the end of the month they could exchange the yen back
into dollars and receive $2,000 (100 yen buying each dollar). By holding yen for a
month, they would earn a phenomenal 100 percent return. American investors
EXCHANGE RATE (e)
e 1
e 0
Figure 34.4
U.S. DOLLARS
INCREASED ATTRACTIVENESS OF
INVESTING IN THE UNITED STATES
Higher demand
for investment
in the U.S.—lower
demand for investment
abroad—
S' by Americans
S
D'
Higher
D
demand for
investment
in the U.S. by
foreigners
As some Americans decide not to invest abroad, the
supply curve of dollars shifts to the left. As more foreigners
wish to invest in the United States, the demand
curve shifts to the right. Both shifts serve to increase the
equilibrium exchange rate.
DETERMINING THE EXCHANGE RATE ∂ 763