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10. Foreign Exchange The basics Long run / PPP Short run / Demand & Supply Gov’t intervention The basics Long run / PPP Short run / Demand & Supply Gov’t.

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Presentation on theme: "10. Foreign Exchange The basics Long run / PPP Short run / Demand & Supply Gov’t intervention The basics Long run / PPP Short run / Demand & Supply Gov’t."— Presentation transcript:

1 10. Foreign Exchange The basics Long run / PPP Short run / Demand & Supply Gov’t intervention The basics Long run / PPP Short run / Demand & Supply Gov’t intervention

2 Exchange rates (XR) Price of one countries currency in terms of another Impacts  Relative prices of imports/exports  Attractiveness of domestic vs. foreign assets Price of one countries currency in terms of another Impacts  Relative prices of imports/exports  Attractiveness of domestic vs. foreign assets

3 Two ways to quote XR Foreign currency per 1 US $ Used to quote  Yen (Japan)  Yuan (China)  Won (S. Korea)  Peso (Mexico)  Rupees (India)  Canadian $ Foreign currency per 1 US $ Used to quote  Yen (Japan)  Yuan (China)  Won (S. Korea)  Peso (Mexico)  Rupees (India)  Canadian $

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7 US $ per 1 unit of foreign currency  Euro  British Pound US $ per 1 unit of foreign currency  Euro  British Pound

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11 XR market Worldwide market $1 trillion in transactions daily 90% involve US $  Size of economy  Store of value  World price of oil in US $ Worldwide market $1 trillion in transactions daily 90% involve US $  Size of economy  Store of value  World price of oil in US $

12 Nominal XR Rate of one country’s currency exchanges for another Amount of foreign currency per US $ China (Yuan) Euro Japan (Yen) Canadian $ Mexico (Peso) British Pound

13 US $ Depreciation US $ buys less of foreign currency  Canada, Euro, UK, China...  Most major trading partners US $ has fallen US $ is weaker US $ buys less of foreign currency  Canada, Euro, UK, China...  Most major trading partners US $ has fallen US $ is weaker

14 US $ appreciation US $ buys more of foreign currency  Mexico US $ has risen US $ is stronger US $ buys more of foreign currency  Mexico US $ has risen US $ is stronger

15 Example: Yen/$ If $ appreciates, the Yen must depreciate XR are a “seesaw” XR changes have winners and losers Example: Yen/$ If $ appreciates, the Yen must depreciate XR are a “seesaw” XR changes have winners and losers

16 Real XR Relative cost of certain goods in two countries Changes in the nominal XR Relative cost of certain goods in two countries Changes in the nominal XR

17 Example: U.S. $ vs. Can $ SUNY tuition, nonresident  Fall 2000: $4150/sem  Fall 2007: $5305/sem  The finest system of public higher ed in the nation: priceless XR  Fall 2000: $1.50 C$ per 1 US $  Fall 2007: $1.10 C$ per 1 US $ SUNY tuition, nonresident  Fall 2000: $4150/sem  Fall 2007: $5305/sem  The finest system of public higher ed in the nation: priceless XR  Fall 2000: $1.50 C$ per 1 US $  Fall 2007: $1.10 C$ per 1 US $

18 How much is tuition to a Canadian student? Convert US $ tuition to Can $ 2000: 4150(1.50) = C$ : 5305(1.10) = C$ Can $ appreciation means an actual fall in tuition for Canadian students Convert US $ tuition to Can $ 2000: 4150(1.50) = C$ : 5305(1.10) = C$ Can $ appreciation means an actual fall in tuition for Canadian students

19 U.S. $ depreciation  Imported goods more expensive  Less purchasing power abroad  Exports less expensive abroad  Foreign visitors have more purchasing power U.S. $ depreciation  Imported goods more expensive  Less purchasing power abroad  Exports less expensive abroad  Foreign visitors have more purchasing power

20 Univ of W. Ontario, nonresident  Fall 2000: C$ 5190/sem  Fall 2007: C$ 7300/sem Tuition costs for a U.S. student  2000: 5190/1.5 = $3460  2007: 7300/1.1 = $6636 Univ of W. Ontario, nonresident  Fall 2000: C$ 5190/sem  Fall 2007: C$ 7300/sem Tuition costs for a U.S. student  2000: 5190/1.5 = $3460  2007: 7300/1.1 = $6636

21 XR in the long run Primarily depends on relative inflation Law of One Price  Identical goods should be about the same price everywhere in the world Primarily depends on relative inflation Law of One Price  Identical goods should be about the same price everywhere in the world

22 Pack of gum If $1 = 115 yen  Then gum should cost $1 in U.S. and 115 Y in Japan Pack of gum If $1 = 115 yen  Then gum should cost $1 in U.S. and 115 Y in Japan

23 Now suppose prices double in US, so gum is $2. At the XR of 115Y/$, gum is cheaper in Japan  Gum is 115Y or $1 in Japan  Run on gum in Japan Now suppose prices double in US, so gum is $2. At the XR of 115Y/$, gum is cheaper in Japan  Gum is 115Y or $1 in Japan  Run on gum in Japan

24 To equalize things,  XR moves: $ must depreciate  57.5Y/$ then gum is same price To equalize things,  XR moves: $ must depreciate  57.5Y/$ then gum is same price

25 Purchasing power parity (PPP) XR adjust to relative price changes in two countries, so law of one price holds If US inflation is higher than other countries  $ depreciate  If lower, then $ appreciates XR adjust to relative price changes in two countries, so law of one price holds If US inflation is higher than other countries  $ depreciate  If lower, then $ appreciates

26 Does PPP hold?  In the long run, yes  In the short run, no way Big Mac Index (240-41) Not all goods identical or traded across countries Does PPP hold?  In the long run, yes  In the short run, no way Big Mac Index (240-41) Not all goods identical or traded across countries

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28 Other LR factors Trade barriers—tariffs/quotas  Boost domestic demand  $ appreciates Productivity -- GDP/labor hour  Higher relative productivity in US  $ appreciates Trade barriers—tariffs/quotas  Boost domestic demand  $ appreciates Productivity -- GDP/labor hour  Higher relative productivity in US  $ appreciates

29 XR in the Short Run Supply and Demand, US $ Explains short term volatility Supply and Demand, US $ Explains short term volatility

30 Who supplies $ to XR market? People buying foreign goods People investing in foreign assets As $ appreciates (Price of $ rises)  People buy more foreign goods because they are cheaper  Supply slopes up People buying foreign goods People investing in foreign assets As $ appreciates (Price of $ rises)  People buy more foreign goods because they are cheaper  Supply slopes up

31 Q of $ E/$ S

32 Who demands $ in XR market? People wanting to buy U.S. goods or dollar assets As $ depreciates (Price of $ falls)  People buy more US goods because they are cheaper  Demand slopes down People wanting to buy U.S. goods or dollar assets As $ depreciates (Price of $ falls)  People buy more US goods because they are cheaper  Demand slopes down

33 Q of $ E/$ S D

34 What causes the $ to depreciate? An increase in the supply of $ A decrease in the demand for $ An increase in the supply of $ A decrease in the demand for $

35 What increases $ supply? Increase in preference for foreign goods An increase in US GDP and income  Buy more imports An increase in real interest rate on foreign bonds relative to US OR decrease in relative foreign investment risk  Investors supply more $ to buy them Expectation of $ depreciation  People supply $ now Increase in preference for foreign goods An increase in US GDP and income  Buy more imports An increase in real interest rate on foreign bonds relative to US OR decrease in relative foreign investment risk  Investors supply more $ to buy them Expectation of $ depreciation  People supply $ now

36 What decreases $ demand? Decrease in preference for US goods in foreign countries A decrease in foreign GDP/income A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments An expected depreciation of the $ Decrease in preference for US goods in foreign countries A decrease in foreign GDP/income A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments An expected depreciation of the $

37 Increase in $ supply Q of $ E/$ S D S’’

38 Decrease in $ demand Q of $ E/$ S D D’’

39 So what is causing $ depreciation? Trade deficit  US imports > US exports As $ depreciates, this will narrow the trade deficit Federal deficit  World market believes the US borrows too much? Trade deficit  US imports > US exports As $ depreciates, this will narrow the trade deficit Federal deficit  World market believes the US borrows too much?

40 Consequences?Consequences? The good:  Rising US exports  Tourism in US  Less pressure for trade barriers The good:  Rising US exports  Tourism in US  Less pressure for trade barriers

41 The bad:  Possible inflation (higher import prices)  US tourists abroad  US debt less attractive  Pressure to move oil pricing to Euros The bad:  Possible inflation (higher import prices)  US tourists abroad  US debt less attractive  Pressure to move oil pricing to Euros

42 Government Intervention Can the government affect XR markets?  Yes, but interventions are rare  Only effective if nations cooperate, scale is large  At best interventions are short run solutions Can the government affect XR markets?  Yes, but interventions are rare  Only effective if nations cooperate, scale is large  At best interventions are short run solutions


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