2 Exchange Rates Exchange Rates 4/1/2017Exchange RatesExchange RatesNominal exchange rate: price of one currency in terms of another currency (bilateral exchange rate)example: 1.30 dollars per euro or euros per dollardetermines price of importsforeign exchange marketdenote as enom , units of the foreign currency per unit of domestic currencyNominal effective exchange rate: average nominal exchange over several other important trade-related currencies
4 Exchange RatesReal Exchange Rate (RER): the price of domestic goods relative to foreign goodssays how much foreign good you could get for domestic goodThe price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency
5 Exchange Rates RER Example Should you buy a Japanese or American computer for your company?Price of U.S. computer = $2,400Price of Japanese computer = 242,000 yenExchange rate = 110 yen/dollarPrice in dollars = price in yen/yen-dollar exchange ratePrice in yen = price in dollars x value of dollar in terms of yenPrice in dollars = 242,000 yen/110 = $2,200Japanese computer is cheaper.Real exchange rate = $2,400/$2,200 = 1.09
6 Exchange Rates Real Exchange Rate (RER) If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other countryNX will tend to be low when the real exchange rate is high.Real exchange rate = “terms of trade” => competitivenessReal exchange rate is an index and is unit-less
8 Purchasing Power Parity Law of One Price and Purchasing PowerParityIdentical goods & services should sell at same price no matter where they are sold…otherwise opportunity for profits (i.e. arbitrage)Law of one price: same price for a commodityCandy bar in Port-of-Spain versus San FernandoPurchasing Power Parity (PPP)The theory that nominal exchange rates are determined as necessary for the law of one price to holdExchange rates should move to equalize prices across countries
9 Purchasing Power Parity PPP implies currencies of countries that experience significant inflation will tend to depreciate
10 Purchasing Power Parity ExampleHow many Indian rupees equal to one Australian dollar?Bushel of grain cost 5 Australian dollars or 150 rupees5 Australian dollars = 150 rupeesOr, a 30 rupee to 1 Aus. Dollar ratioNominal exchange rate should equal 30 rupees/Australian dollarIf not 30:1, what should happen?
11 Purchasing Power Parity How many Indian rupees equal one Australian dollar?Suppose price of grain in India increases from 150 to 300 rupeesPrice of grain in Australia still equals 5 Australian dollarsOriginally: implied exchange rate 5:150 or 1:30Now: implied exchange rate 5:300 or 1:601 Australian dollar = 60 rupeesNominal exchange rate increased from 30 to 60 rupees/Australian dollarIndian currency depreciatedAustralian currency appreciated
12 Purchasing Power Parity Does not hold up well in short runTransportation costsBorder effect – tariffs, technical requirements, regional monopoly powerPricing to marketGoods prices are “sticky”Reduces exchange rate “pass through”Nontradable sectorHigher productivity, higher nontradable wages, higher nontradable inflationWorks better in the long run
13 Price differences between US and Canadian Cities. Figure 19.4
14 Inflation and Currency Depreciation Five Year Window Currency Depreciation (% pa)Inflation Differential
15 Inflation and Currency Depreciation Twenty Year Window Currency Depreciation (% pa)
16 Power Purchasing Parity McParity & the Big Mac IndexThe Economist's Big Mac index is based on the theory of purchasing-power parity (PPP) using the Big MacThe cheapest burger in the chart is in China, at $1.26, compared with an average American price of $3. The PPP implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.
18 Exchange RateRER reflects competitiveness—the higher a country’s RER, the more expensive its goods and services are to foreigners.=> as the RER↑, a country’s NX growth will ↓, leading to a current account deficit (and vice versa)Note: nominal exchange rate can fall but be offset by higher domestic inflation so that RER stays constant