Foreign Exchange Rates Nominal Exchange Rate Real Exchange Rate PPP

Nominal Exchange Rate Nominal Exchange rate: the rate at which one can exchange the currency of one country for the currency of another. The “A” – “B” exchange rate is the price of one unit of “B” in terms of “A” – dollar-euro exchange rate is the price of 1 euro in terms of dollars. – peso-dollar exchange rate is the price of 1 dollar in terms of pesos.

Nominal Exchange Rates If the dollar-euro exchange rate is 1.24 and the peso-dollar exchange rate is 0.05, what is the peso-euro exchange rate?

Nominal Exchange Rate If the dollar-euro exchange rate is 1.21 and the dollar-pound exchange rate is 1.76, what is the pound-euro exchange rate?

Nominal Exchange Rate Assume the pound-euro fx-rate is How could you profit? Euros look cheap in terms of pounds – Buy 100 pounds using dollars Cost = 176 dollars – Use 100 pound to buy euros Get 100/0.60 = 167 euros – Use euros to buy dollars Euro-dollar rate is 1/1.21 = 0.83 Get 167/0.83 = 201 dollars

Cost of Goods If a 2007 Hundai costs $10,200 Euros, how much does it cost in dollars? Assume dollar-euro fx-rate is 1.76.

Real Exchange Rate Real Exchange rate: Rate at which one can exchange the goods and services from one country for the goods and services of another country.

Real Exchange Rate If a 2007 Hundai costs 11,000 euros, and 28,000 dollars what is the real EU - US fx-rate? Assume dollar- euro fx-rate is 1.76.

Real FX-rate The real EU-US fx-rate is the cost of real goods in the US in terms of real goods in the EU. – A real EU-US fx-rate of 1.45 implies you could trade 1 Hundai in the US for 1.45 Hundais in Europe – You should buy Hundais in Europe and export them to the U.S. Make =8,640 per transaction – This raises the price of Hundais in Europe and lowers them in the U.S. until real fx-rate=1

Real Fx-Rate What prevents the real-fx rate from reaching unity? – Transportation costs, Duties, Tarriffs Example: Suppose it cost $8640 to import cars from Europe – Some things, such as perishable items, some services, can’t be traded.

Purchasing Power Parity Assuming no transaction costs Real Exchange rate =1

Purchasing Power Parity Not true over the short run Implications over long run: inflation erodes value of currency.

Inflation and Exchange Rates

Big Mac Index Cost of Big Mac in US: 3.15 dollars Cost of Big Mac in Japan: 250 yen Implied yen-dollar exchange rate from PPP: 250/3.15 = Actual yen-dollar exchange rate = 90 (implied – actual)/actual = 79.37/90 – 1 = -12% Yen is 12% under-valued relative to dollar

Exchange Rates in the Short Run

Supply and Demand Home Currency: dollar Price per dollar: foreign-dollar fx-rate Who supplies dollars? Primarily U.S. residents. As price of dollar goes up, U.S. residents are willing to supply more – To buy foreign assets – To invest in foreign financial assets Supply curve for dollars is upward sloping

Supply of Dollars Who demands dollars? Foreigners As price of dollar goes up, foreigners demand less – To buy American assets – To invest in American financial assets Demand curve for dollars is downward sloping

Supply and Demand for Dollars

Shifts in the Supply of Dollars Factors that shift supply curve to right – Increase in U.S. preference for foreign goods – Increase in U.S. real G.D.P. – Increase in real interest rate on foreign bonds – Increase in American wealth – Decrease in relative risk of foreign investments – Expected dollar depreciation (e.g. high U.S. inflation)

Shifts in the Supply of U.S. Dollars

Shifts in the Demand of Dollars Factors that shift demand curve to right – Increase in foreign preference for U.S. goods – Increase in foreign real G.D.P. – Increase in real interest rate on U.S. bonds (relative to foreign) – Increase in foreign wealth – Decrease in relative risk of U.S. investments – Expected dollar appreciation (e.g. low U.S. inflation)

Shifts in Demand for U.S. dollars

Current Account Current account – measures the country’s trade in currently produced goods and services. – Merchandise (soybeans, perfume, cars...) – Services (education, tourism, insurance...) Current Account = Exports – Imports – Imports > Exports : current account deficit – Exports > Imports : current account surplus

Current Account Current account does not measure trade in assets already existing. – Example: If Japanese investor buys vacation home in Hawaii, this is not included in current account. Current Account measures – Demand of U.S. for current goods abroad (dollar supply) – Demand of Foreigners for U.S. goods (dollar demand)

Capital Account Capital account measures trade in all financial assets and other existing assets. When U.S. sells asset abroad and receives dollars, this is counted as a capital inflow to the home country, and as a credit to the capital account. Examples: – I sell euros to buy dollars (credit capital account) – I sell a bond to a Chilean investor for dollars (credit capital account)

Capital Account Capital Account measures – Demand of U.S. for foreign assets (dollar supply) – Demand of Foreigners for U.S. assets (dollar demand) Capital Account = capital inflows – capital outflows Inflows > Outflows capital account surplus Outflows > Inflows capital account deficit

Capital and Current Account Capital Account + Current Account = 0 CA=current account KA=Capital account You buy a British Sweater for 75 dollars: Debit to CA The sweater manufacturer can – Use dollars to buy some other U.S. good: Credit CA – Use dollars to buy a U.S. bond: Credit KA – Exchange dollars for pounds at Bank Bank can sell dollars to someone who wants to buy U.S. good Bank can buy U.S. financial asset itself Buy pounds from the Federal Reserve: Credit KA

Current Account Deficit In U.S. current account deficit is approaching $one trillion Import more than we export What are countries doing with extra dollars? Buying U.S. bonds and other investments, leading to capital account surplus.

Capital and Current Accounts Capital Account Current Account

Exchange Rates in the Short Run

September 20th