Exchange Rates

Exchange Rates Exchange Rate: S - # of domestic currency units purchased for 1 US$. An increase in S is a depreciation and a decrease in S is an appreciation.

International Comparisons Project Researchers at U. of Pennsylvania periodically choose a representative world market basket and go to different countries to collect prices of that market basket of good. For a country, we calculate PPP = Purchasing Power Parity as the price of the market basket relative to price of the market basket in US. For any country, the exchange rate, St, is the number of domestic dollars per US$. Penn World Tables

Comparing GDP across Countries When you compare income in two different countries, each country’s GDP per capita is measured in local currency. You need to measure both with common yardstick to compare. Typically, the common yardstick will be US$. GDP can be converted to US$ by Exchange Rate Method (divide national GDP by the exchange rate) or PPP Method (divide national GDP by PPP).

PPP vs. Exchange Rate Conversion Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. Measures how many US dollars someone could buy with average income. However, money goes farther in some countries as many types of goods are relatively cheap (especially developing countries). PPP conversion measures how much the goods purchased by the average person would cost in the US. Better measure of living standards.

Convert sums into another economy’s currency Nj is a number measured in country j’s currency & you want to convert it into country REF’s currency. Exchange Rate Conversion PPP Conversion

Comparison of China vs. HK World Bank Conversion Factors Goods are cheaper in China than in HK

Which exchange rate conversion to use? Depends on where the money will be spent. If you have a value of foreign currency that you will want to spend at home, convert using exchange rate because foreign prices are irrelevant. If you want to spend the money in foreign country, then using PPP conversion may be more helpful.

Problem You are a Chinese multinational that wants to construct salaries to be paid to employees in Canada that will provide same living standard as salary of RMB20,000. Canada PPP in 2002 is 1.2.

Exchange Rate Model

Exchange Rates are Volatile

Why do exchange rates change? Relative values of two currency determined by supply and demand by traders of the two currencies. People trade currencies to engage in foreign trade and international investment. Monetary policy is a prime driver of exchange rates. And vice versa, Some economies structure monetary policy around exchange rate.

Forex Market: Supply & Demand Consider the spot foreign exchange market. Price of US$: S is the price of US$ in terms of DCU. Supply of US$: Foreign people who want to acquire DCU to buy domestic goods or assets. When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency. Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

Equilibrium in Forex Market Supply Equals Demand

Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods 2 Domestic Currency Depreciates S* 1 Supply' Demand ' Supply Demand

Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand

US Monetary Policy Causes US$ Interest Rates Go Up Relative Demand for US$ Goes Up 2 S** Domestic Currency Depreciates S* 1 Supply' Demand ' Supply Demand

Domestic Monetary Policy Causes D. C Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down S Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand Demand '

Monetary Policy & Exchange Rates The central impact of the foreign currency intervention is on domestic interest rates. Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves. Monetary policy that does not shift interest rates will not shift exchange rates.

Foreign Currency Intervention Foreign currency purchase: Central bank purchases foreign currency Credit reserve accounts of counterparty commercial bank More reserves pushes down interest rates Increases demand for and reduces supply of US$ in forex market Foreign currency sale Central bank sells foreign currency Debit reserve accounts of purchasing bank Less reserves pushes up interest rates Reduces demand for and increases supply of US$ in forex market

Excess Demand for Foreign Currency 1. Domestic Currency Faces Depreciation Pressure A S* Supply Demand ' Demand

Forex Sale Supply Central Bank does Forex Sale maintaining Exchange Rate Stability Shrinking money supply and higher domestic interest rates S A S* B Demand Supply' Demand '

Excess Supply of Foreign Currency 1. Domestic Currency Faces Appreciation S* A Supply Demand

Forex Purchase Central Bank does Forex Purchase maintaining Exchange Rate Stability Growing money supply and lower domestic interest rates S B S* Supply' A Demand ' Supply Demand

Iron Triangle of International Finance Monetary Policy that Controls The Interest Rate Open to International Capital Flows Fixed Exchange Rates Pick 2 items from this menu

Learning Outcomes Students should be able to Convert series from one currency to another using the exchange rate or the PPP rate. Use the Supply-Demand model of the forex model to explain: the effect of international trade conditions on the exchange rate. the impact of interest rates and other financial market conditions on exchange rates. Government policy efforts to stabilize the exchange rate.