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

Expectations about changes in the exchange rate in fact play a role in all overseas
investment. Suppose you have saved up some money for a new car, but you
don’t plan to buy it until the summer you graduate from college, eighteen months
away. A savings account, U.S. government bonds, and the stocks of an American
company are among the many options you have for investing the funds until you
need them. You also could choose to invest in European assets. If you do, you will
first need to sell your dollars for euros. But in eighteen months, you will need dollars
for your new car; you will have to sell the European assets you purchased and then
convert the euros you receive back into dollars. Thus, in deciding whether to make
investments in Europe while you wait to buy your new car, you must form expectations
about how much the dollar will be worth in eighteen months when you want to
sell euros for dollars. If you think the euro will rise in value (i.e., the dollar will fall in
value) over the next year and half, investing in Europe will look more attractive,
since you anticipate that each euro will get you more dollars when it is sold. But
if you think the euro will fall in value (the dollar will rise in value) over the next
eighteen months, then investing in Europe will look less attractive because each
euro will get you fewer dollars when you need them.
As this simple example illustrates, expectations that the dollar will fall in value
in the future make investing abroad look more attractive. Conversely, expectations
that the dollar’s value will rise make investing abroad look less attractive. The same
is true from the perspective of a foreign investor: investing in the United States
looks less attractive if the dollar is expected to fall and more attractive if the dollar
is expected to rise in value.
The role played by expectations helps us understand how speculation in foreign
exchange markets can introduce a source of instability. Suppose investors
suddenly decide the Mexican peso is going to fall in value, perhaps because new
reports of corruption have caused worries about Mexico’s political stability. Each
investor will want to sell pesos before they fall in value; but as all investors attempt
to sell, the collapsing demand for pesos pushes its value down immediately. Thus
expectations that the peso would depreciate become self-fulfilling. This process is
key in international currency crises, a topic we will return to later.
Wrap-Up
WHAT DETERMINES THE EXCHANGE RATE?
The U.S. exchange rate is determined by the supply of and demand for dollars.
Foreigners’ demand for U.S. dollars and Americans’ supply of dollars are
determined by
1. Underlying trade factors: the overseas demand for U.S. goods (U.S. exports)
and Americans’ demand for foreign goods (U.S. imports)
2. Underlying investment factors: the returns to investments in the United
States and abroad
3. Speculation based on expectations about future changes in the exchange rate.
DETERMINING THE EXCHANGE RATE ∂ 765