Ch. 29: Open Economy:
Foreign Exchange
• The Prices for International Transactions:
Real and Nominal Exchange Rates
• Nominal Exchange Rates:
• Rate you can trade one currency for
another
• 80 yen per dollar or 1/80 = .0125 dollar
per yen
• “appreciation” or stronger: dollar buys……
more foreign currency
• “depreciation” or weaker: dollar buys…..
less foreign currency
• When exchange rate changes from 80 yen per
dollar to 90 yen per dollar: the dollar has……
appreciated because …..
the dollar can now buy more yen
• When exchange rate changes from 90 yen per
dollar to 80 yen per dollar: the dollar has…..
depreciated because ……
the dollar can now buy less yen
FOREX: Who, What, Where, When,
Why
• Exchange rates are determined in the foreign
exchange market
• open to a wide range of different types of buyers
and sellers
• currency trading is continuous: 24 hours a day
except weekends.
• The spot exchange rate refers to the current
exchange rate.
• The forward exchange rate refers to an exchange
rate that is quoted and traded today but for
delivery and payment on a specific future date.
(*not responsible for this info*)
• People may need to exchange currencies in a
number of situations.
• Example: travel to another country may buy
foreign currency
, where they may buy foreign currency
cash, traveller's cheques or a travel-card.
they can only
buy foreign cash
(*not responsible for this info*)
• At the destination, the traveler can buy local
currency at the airport, either from a dealer or
through an ATM.
• They can also buy local currency at their hotel, a
local money changer, through an ATM, or at a
bank branch.
• When they purchase goods in a store and they
do not have local currency, they can use a credit
card, which will convert to the purchaser's home
currency at its prevailing exchange rate.
• If they have traveler's cheques or a travel card in
the local currency, no currency exchange is
necessary.
(*not responsible for this info*)
• If a traveler has any foreign currency left over on
their return home, may want to sell it, which
they may do at their local bank or money
changer.
• The exchange rate as well as fees and charges
can vary significantly on each of these
transactions, and the exchange rate can vary
from one day to the next.
(*not responsible for this info*)
• A currency pair is the …..
• quotation of the relative value of a currency
unit against the unit of another currency in
the foreign exchange market. (= e = nominal
exchange rate)
• The quotation EUR/USD 1.2500 means that 1
Euro is exchanged for 1.2500 US dollars.
USD
GBP
CAD
EUR
AUD
$1 US will buy:
0.64478
1.01455
0.76359
0.96702
• An exchange rate index • way of measuring the performance of a
currency against a basket of other currencies.
• US Dollar Index
• For example, the US dollar index measures the
US dollar against 6 main currencies.
Real Exchange Rate
• Rate you can trade goods/services of one country
for that of another
• Ex: for every case of American beer you can buy,
you would get 2/3 case of German beer
Real and Nominal Exchange Rates working together
Ex: American rice = $100/bushel Japanese rice = 16,000 yen/bushel
• What is the real exchange rate? = nominal x domestic P / foreign P
• e x P / P*
• use to convert prices into a common currency
• e x P / P*
(80 yen/$) x ($100/bushel US rice)
(16,000yen/bushel Japanese rice)
=
8,000 yen / per bushel US rice
16,000 yen/per bushel Japanese rice
= ½ bushel Japanese rice per bushel of American rice
• Real Exchange Rate = key determinant of how
much a country imports or exports
• Use the Price of basket of goods for both US
price (P) and foreign price (P*) and the
nominal exchange rates (e)
• Measures the price of a basket of goods
domestically relative to the price of foreign
goods
• Finding the nominal exchange rate:
e = P* / P (-assuming there is purchasing power parity)
• Convert foreign price of good to US $:
P*/ e
Purchasing Power Parity
• Purchasing power of the dollar is = to that of
other currencies
• According to the theory: The ( e ) between
two countries must reflect the different price
levels in those countries
• ( e ) change when PL changes
**When increase MS, PL increases = value
decreases = depreciate vs. other currencies
If Britain pursues tighter MS and less inflation
than the US, then the value of the Pound will
appreciate vs. the US $
If the US pursues easy MS and allows more
inflation than Britain, then the value of the
US$ will depreciate vs. the Pound
• Purchasing Power Parity does not always hold
true
• Many goods are not easily traded
• Not always perfect substitutes
Case Study: Increasing Openness of
the US Economy
• Transportation (ships/jets)
• Telecommunications
• Technology – change in kinds of goods (easily
transported)
• Govt. policies – more free trade : NAFTA,
GATT
Case Study: Are US Trade Deficits a
National Problem?
Trade deficit a problem?
Maybe a symptom of the problem …= reduce
national savings …. = not providing for future
FOREX Market
•
•
•
•
•
•
Demand curve = Demand for US $ …comes from
Foreign Demand for :
US exports
US financial investments (savings)
Speculation
Ex : if D for US goods increases, shift D for US $ to
right = appreciate
• Ex: if Int. Rates in US increase, shift D for US $ to
right = appreciate …..why? ..
• Higher int rates = incentive for foreigners to buy
US $ to save (bonds) ….= higher return on their
financial investments
•
•
•
•
Supply curve = Supply of US $...comes from:
Americans buy imports
US buy foreign financial investments (savings)
Speculation
• If US imports (M) increase = increase Supply of
US $ = Supply shifts right = depreciate
• If Foreign int. rates increase = increase Supply of
US $ = Supply shifts right = depreciate..why…
• If foreign int rates increase = incentive for
Americans to supply $ to buy foreign bonds
(savings