1. (c) R.D. Weaver 2004 In the real world, do currencies matter? Adding some reality

2. (c) R.D. Weaver 2004 Exchange rate as a price? Exchange rates are the price of a currency e us,Euro = $/€ e us,yen = $/¥ e us,pound =$/£

3. (c) R.D. Weaver 2004 Exchange rate markets Google “ FX” markets or FOREX markets Today, foreign exchange markets are the representative of state-of-the-art information and trading technology, they operate 24/7

4. (c) R.D. Weaver 2004 Let’s review – exchange rates and international product prices Sources for exchange rates?  Federal Reserve Bank is best source of historical series annual, monthly, weekly, daily are available.  Yahoo Finance and other sites also provide data series  Hundreds of on-line sites provide current rates

5. (c) R.D. Weaver 2004 Spatial arbitrage with differing currencies Buy product in country j in ¥ Sell product in country i in $ In the real world, you open a foreign exchange account, convert $ to ¥ on a continuous basis. Why? Averaging effect In some cases, Pepsi is former Soviet Union, you may not trust the value of the currency, it may not be convertible! So, choose a product (vodka) and ship it back home! Same story with plastic toys and McDonald’s in China In other cases, buy property in the importing country (RCA Building and Rockafellar Center, NYC !)

6. (c) R.D. Weaver 2004 Different currencies trade of same product REVIEW Define exchange rate with US as i Japan as j E ji = units ith cur/ units jth cur ¥/$ Suppose we consider profits in = E ji P e i Y ij - P j Y ij – C ij (Y ij ) > 0 = (¥/$) * ($/box)*boxes - (¥/box)*boxes -¥cost Arbitrage equilibrium if E ji P e i - P j -C(Y)/Y = 0 E ij P e i = P j + AC(Y i,j )  exch rates play a role

7. (c) R.D. Weaver 2004 Implications Exchange Rates and Prices are bound together! Suppose we simplify a bit…… E jit P it = P jt + AC(Y i,j ) and suppose AC(Y i,j ) ~ 0 then E jit P it = P jt  E jit = P jt / P it = ¥/$ In spatial equilibrium, the prices across locations should reflect the exchange rate….

8. (c) R.D. Weaver 2004 In fact, the exchange rate reflects relative purchasing power of the two currencies So what does this mean? E jit = ¥/$= P jt / P it The financial world uses this approach to estimate the true value of currencies…its called the real exchange rate, e jit Official market E jit = ¥/$= P jt / P it = e jit real exchg rate

9. (c) R.D. Weaver 2004 In fact, the exchange rate reflects relative purchasing power of the two currencies If E jit = ¥/$= P jt / P it = e jit If this holds, e jit the real exchange rate is a “barter price” = [¥/bu soy in Tokyo]/ [$/bu soy in U.S.] If soy is soy……..bushels cancel out and we have.. = ¥/$

10. (c) R.D. Weaver 2004 In fact, the exchange rate reflects relative purchasing power of the two currencies We call this rule E jit = ¥/$= P jt / P it = e jit The purchasing power parity rule, and the real exchange rate as the purchasing power parity value of the exchange rate…PPP for short

11. (c) R.D. Weaver 2004 Definitions real vs official exchange rates Define the official exchange rate in the market as: E jit = ¥/$ Define the real exchange rate e jit = ¥/$= P jt / P it Why might these two exchange rates differ?

12. (c) R.D. Weaver 2004 In fact,………. In the 70’s you could take jeans to Poland and sell them for 300 times their value in the U.S. You can still take advantage on many distortions of the purchasing power parity rule! Google your favorite product in 5 countries, compute the PPP or “real” exchange rate and compare vs. official exchange rate! Why does this happen?

13. (c) R.D. Weaver 2004 If exchanges rates are regulated, what is the true value of a currency? Use PPP to compute the “real exchange rate” E Compare vs. the actual official exchange rate e Economist BigMac index Define a currency (e.g. ¥) as “overvalued” vs $ if E = ¥/$ > e “undervalued” vs $ if E < e why??

14. (c) R.D. Weaver 2004 Purchasing Power Parity http://www.economist.com/markets/currency/

15. (c) R.D. Weaver 2004 So, PPP column 3 tells you the true exchange rate Column 4 is official As we can see, many exchange rates are distorted. Why????? Can you circle the currencies that are undervalued vs. the dollar?

16. (c) R.D. Weaver 2004 Exchange rate distortion Define e as the PPP or real exchange rate, E as official……..then For China, we see e yuan/$ = 3.23 <<< E yuan/$ =7.60  $ is undervalued vs yuan = yuan is overvalued vs $

17. (c) R.D. Weaver 2004 Why do governments distort their exchange rates? Suppose E jit P it = P jt + AC(Y i,j ) then, trade flow is optimal at say Y ij * Suppose you would like to increase exports from j you could advertise, you give tax credits for exporters or, you could reduce the value of your currency, making your products cheaper for foreign buyers

18. (c) R.D. Weaver 2004 Why distort your exchange rate? Suppose the real exchange rate is e jit then if the official rate E o jit =e jit arbitrage would force e jit P it = P it + AC(Y i,j ) then, trade flow is optimal at say Y ij * Suppose the government reduces the value of the yen, (undervalues it) making it cheaper so E jit > E o jit = e jit more ¥/$! So,…… E jit P it > e jit P it = P jt + AC(Y i,j ) (yen/$) $ = yen + yen cost This means an exporter would earn more ¥ profits/unit shipped to the U.S. So……exports would increase! Undervalued currency  exports will increase (So why did the Bush Admin allow the dollar to lose value in 2007-2009? )

19. (c) R.D. Weaver 2004 Why distort your exchange rate? Suppose Japan faced inflation, not enough supply relative to demand……….they would like to increase imports, shut off exports…. They could increase the value of their currency, making it more expensive (overvalued) E jit < e jit less ¥/$! So,…… E jit P it < e jit P it = P it + AC(Y i,j ) This would mean Japanese exporters would bring fewer yen home per export sale Overvalued currency  exports will decrease, and imports are encouraged

20. (c) R.D. Weaver 2004 Cutting to the chase………. If you undervalue your currency, you are putting your economy on sale! (can you explain?) If you overvalue your currency, you are making your economy’s products more expensive and will reduce exports and increase imports! Suppose you would like to see an increase in employment in the U.S., a young senator rails for a strong $. Would you recommend he take some economics?

21. (c) R.D. Weaver 2004 Lets take another look at the BigMac PPPs What countries have their currencies undervalued? Are they known as major exporters? Why did the Bush admin allow the $ to substantially weaken in value over the past two years of that admin?

22. (c) R.D. Weaver 2004 Under valued  exports encouraged Imports discouraged Overvalued  exports discouraged, imports encouraged

23. (c) R.D. Weaver 2004 A minor complication! While exchange rates affect product trade they can have an inverse effect on financial flows! A strong currency (perhaps overvalued) means interest earned in that country can buy more in other countries……..so, money flows into countries with overvalued exchange rates! This can offset the effects on product flows!@