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Chapter 19. The Foreign Exchange Market Exchange rates Long run factors Short run factors Exchange rates Long run factors Short run factors.

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Presentation on theme: "Chapter 19. The Foreign Exchange Market Exchange rates Long run factors Short run factors Exchange rates Long run factors Short run factors."— Presentation transcript:

1 Chapter 19. The Foreign Exchange Market Exchange rates Long run factors Short run factors Exchange rates Long run factors Short run factors

2 I. Exchange rates definitions, data, examples typically exchange rate = definitions, data, examples typically exchange rate = Mexican Peso, Japanese Yen

3 also quoted as British pound, Canadian dollar, euro

4 exchange rate market spot exchange rates  currency exchanges w/in 2 days forward exchange rates  currency exchange at future date, but ratio is set today spot exchange rates  currency exchanges w/in 2 days forward exchange rates  currency exchange at future date, but ratio is set today

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9 why care? determines relative prices  imports in U.S.  our exports abroad determines relative returns  U.S. investments vs. foreign investments  financing U.S. debt determines relative prices  imports in U.S.  our exports abroad determines relative returns  U.S. investments vs. foreign investments  financing U.S. debt

10 exampleexample GM Saturn  $13,500 in U.S. Toyota Corolla  1.8 million yen GM Saturn  $13,500 in U.S. Toyota Corolla  1.8 million yen

11 case 1: 120 yen/$ price of Corolla in U.S.: 1.8 million/120 = $15,000 price of Saturn in Japan: 13,500 x 120 = 1.62 million yen price of Corolla in U.S.: 1.8 million/120 = $15,000 price of Saturn in Japan: 13,500 x 120 = 1.62 million yen

12 case 2: 110 yen/$ $ has depreciated against yen  yen has appreciated against $ $ has fallen  yen has risen $ is weaker  yen is stronger $ has depreciated against yen  yen has appreciated against $ $ has fallen  yen has risen $ is weaker  yen is stronger

13 price of Corolla in U.S. 1.8 million/110 = $16,364 price of Saturn in Japan 13,500 x 110 = 1.485 million yen $ depreciated  Corolla is more expensive here  Saturn is cheaper in Japan price of Corolla in U.S. 1.8 million/110 = $16,364 price of Saturn in Japan 13,500 x 110 = 1.485 million yen $ depreciated  Corolla is more expensive here  Saturn is cheaper in Japan

14 In general, $ appreciates  imports cheaper, exports pricier  U.S. trade deficit rises $ depreciates  imports pricier, exports cheaper  U.S. trade deficit falls $ appreciates  imports cheaper, exports pricier  U.S. trade deficit rises $ depreciates  imports pricier, exports cheaper  U.S. trade deficit falls

15 exchange rate movement  short-run volatility  long-run trends exchange rate movement  short-run volatility  long-run trends

16 II. Exchange rates in LR A. Purchasing power parity (PPP) if countries have different inflation rates,  exchange rate movement law of one price  identical goods should have same value all over world A. Purchasing power parity (PPP) if countries have different inflation rates,  exchange rate movement law of one price  identical goods should have same value all over world

17 exampleexample pack of gum 120 yen/$ gum = $1 in U.S. gum = 120 yen in Japan pack of gum 120 yen/$ gum = $1 in U.S. gum = 120 yen in Japan

18 U.S. prices double  gum = $2 if still 120 yen/$  gum is cheaper in Japan (120 yen)  everyone buys gum in Japan exchange rate moves,  120 yen/$2 or 60 yen/$ U.S. prices double  gum = $2 if still 120 yen/$  gum is cheaper in Japan (120 yen)  everyone buys gum in Japan exchange rate moves,  120 yen/$2 or 60 yen/$

19 PPPPPP if U.S. prices rise faster than world, $ depreciates if U.S. prices rise more slowly, $ appreciates if U.S. prices rise faster than world, $ depreciates if U.S. prices rise more slowly, $ appreciates

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21 PPP works in LR PPP lousy in SR why?  assumes goods transportable cheaply -- gum, yes -- haircuts, no  assumes goods identical PPP works in LR PPP lousy in SR why?  assumes goods transportable cheaply -- gum, yes -- haircuts, no  assumes goods identical

22 B. Other factors anything impacting relative demand for U.S. stuff vs. foreign stuff increase demand U.S. stuff, increase demand for $, $ appreciates anything impacting relative demand for U.S. stuff vs. foreign stuff increase demand U.S. stuff, increase demand for $, $ appreciates

23 tariffs and quotas U.S. tariffs increase domestic demand $ appreciates (but other nations could retaliate) U.S. tariffs increase domestic demand $ appreciates (but other nations could retaliate)

24 preferencespreferences U.S. consumers prefer foreign SUVs increase import demand, decrease $ demand, $ depreciates U.S. consumers prefer foreign SUVs increase import demand, decrease $ demand, $ depreciates

25 productivityproductivity U.S. more productive, make goods at lower cost, U.S. goods more desirable, $ demand increases, $ appreciates U.S. more productive, make goods at lower cost, U.S. goods more desirable, $ demand increases, $ appreciates

26 III. Exchange rates in SR driven by investor behavior capital mobility  investors chose assets globally driven by investor behavior capital mobility  investors chose assets globally

27 example: Japanese investor U.S. CD ($) or Japanese CD (yen) i$ = 7%, iyen = 5% currently 105 yen/$ expect 90 yen/$ in 1 year U.S. CD ($) or Japanese CD (yen) i$ = 7%, iyen = 5% currently 105 yen/$ expect 90 yen/$ in 1 year

28 Japanese CD deposits 105,000 yen in one year 105,000 (1+.05) = 110,250 yen deposits 105,000 yen in one year 105,000 (1+.05) = 110,250 yen

29 U.S. CD convert yen to $ (105 yen/$): 105,000/105 = $1000 deposit $1000 in CD in one year: $1000(1+.07) = $1070 convert back to yen (90 yen/$): $1070 x 90 = 96,300 yen convert yen to $ (105 yen/$): 105,000/105 = $1000 deposit $1000 in CD in one year: $1000(1+.07) = $1070 convert back to yen (90 yen/$): $1070 x 90 = 96,300 yen

30 U.S. interest rate is higher BUT given expected depreciation of $, investor better off w/ Japanese CD U.S. interest rate is higher BUT given expected depreciation of $, investor better off w/ Japanese CD

31 U.S. investor U.S. CD: $1070 Japanese CD: $1000 x 105 = 105,000 yen 105,000(1.05) = 110,250 yen 110,250/90 = $1225 U.S. investor better off holding Japanese CD U.S. CD: $1070 Japanese CD: $1000 x 105 = 105,000 yen 105,000(1.05) = 110,250 yen 110,250/90 = $1225 U.S. investor better off holding Japanese CD

32 in this example,  no one would hold a U.S. CD so it must be the case that  expected returns equalize across countries  interest rate parity in this example,  no one would hold a U.S. CD so it must be the case that  expected returns equalize across countries  interest rate parity

33 Interest Rate Parity exp. returns equalize across countries  based on interest rate, exchange rates so a change in interest rate will cause exchange rate to change exp. returns equalize across countries  based on interest rate, exchange rates so a change in interest rate will cause exchange rate to change

34 Interest rates & exchange rates nominal interest rate = real interest rate + exp. inflation rate if nominal interest rate rises, either real interest rate increased or exp. inflation rate increased nominal interest rate = real interest rate + exp. inflation rate if nominal interest rate rises, either real interest rate increased or exp. inflation rate increased

35 U.S. real interest rate rises  increase demand for $  $ appreciates foreign real interest rate rises  decrease demand for $  $ depreciates U.S. real interest rate rises  increase demand for $  $ appreciates foreign real interest rate rises  decrease demand for $  $ depreciates

36 U.S. expected inflation rises  under PPP, $ depreciates U.S. money supply rises  increase exp. inflation  decrease nominal interest rate  $ depreciates U.S. expected inflation rises  under PPP, $ depreciates U.S. money supply rises  increase exp. inflation  decrease nominal interest rate  $ depreciates

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38 Why has the U.S. dollar fallen since 2002? decline in private foreign investment  EU becoming more attractive? twin deficits  U.S. trade deficit  U.S. federal budget deficits  large amount of borrowing makes our currency less attractive decline in private foreign investment  EU becoming more attractive? twin deficits  U.S. trade deficit  U.S. federal budget deficits  large amount of borrowing makes our currency less attractive

39 Why do we care? U.S. $ as world reserve currency  allows us to borrow cheaply  falling $ place this status as risk Currency instability  huge disruptions to trade, financial markets U.S. $ as world reserve currency  allows us to borrow cheaply  falling $ place this status as risk Currency instability  huge disruptions to trade, financial markets

40 The future? some predict continued decline of $  compare to British pound 60 years ago… however, $ has been lower…  mid 1990s dollar much lower against yen, deutschmark some predict continued decline of $  compare to British pound 60 years ago… however, $ has been lower…  mid 1990s dollar much lower against yen, deutschmark


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