CHAPTER 2
The Market for Foreign Exchange
CHAPTER OVERVIEW
Chapter 2 begins with a description of the foreign exchange market, and in particular the spot market for foreign
exchange, and then defines the bilateral exchange rate as the relative price of two currencies. When the
exchange rate is defined as the domestic currency required to purchase a unit of the foreign currency, a
domestic currency appreciation is defined as a fall in the domestic to foreign ratio, and a depreciation is defined
as a rise in this ratio. The initial section of this chapter shows how a pair of bilateral rates can be used to
compute the cross rate for a given currency. The section also demonstrates how to compute the bid-ask spread
and the bid-ask margin for a currency, and distinguishes between the nominal and real exchange rates.
The next section defines the concept of an “effective” exchange rate as weighted-average value of a currency
relative to a selected group of currencies. Examples of such weighting include multilateral weights, which
reflect the trade flow of the individual country with all countries included in the index relative to the total trade
volume among all countries included in the index, and bilateral weights, which reflect the trade flow of the
domestic country with respect to each of the countries relative to the total trade of the domestic country with
each of the countries included in the index. A detailed numerical example is provided for a bilateral weighted
effective exchange rate for the U.S. In addition, two examples of composite currencies, specifically the
International Monetary Fund’s Special Drawing Rights currency and the European Currency Unit are discussed
in detail.
The next sections of the chapter present the idea of arbitrage in foreign exchange markets and the role of supply
and demand for foreign currency in determining the equilibrium exchange rate. The supply and demand curves
are described at this stage simply as schedules that relate quantity and price. The distinction between shifts and
movements in the curve is also introduced. The authors point out that the demand for foreign currency is a
derived demand, which depend on the demand for a country’s goods, services, and assets. A more detailed
discussion of the markets for foreign exchange begin in Chapter 9.
The final section of this chapter is devoted to the idea of purchasing power parity, PPP, as a simple theory of the
determination of the exchange rate. Specifically, absolute PPP is equated to the international law of one price,
and is defined as a condition whereby in the absence of transportation costs, tax differentials or trade
restrictions, the price of any two internationally traded and identical goods or services must be the same once
they are adjusted by the value of the exchange rate between the two national currencies. Relative PPP, by
contrast, is defined as the condition whereby changes in the prices of any two internationally traded and
identical goods or services must be the same once they are adjusted by the change in the value of the exchange
rate between the two national currencies. The text discusses problems associated with the measurement of these
PPP concepts as applied to baskets of goods, particularly when price deflators such as the CPI are based on
different baskets for different countries. The chapter concludes by indicating that the empirical evidence tends
12
Chapter Two
to favor the weaker relative PPP condition more than it does the absolute PPP condition, but that both are
relatively poor guides to short-run movements in the exchange rate for most major economies.
OUTLINE
I.
Exchange Rates and the Market for Foreign Exchange
A. Role of the Foreign Exchange Market
1. Spot Market
2. Define the Spot Rate
B. Exchange Rate as Relative Prices
1. Appreciation vs. Depreciation
2. Implied Cross Rates
C. Bid-Ask Spreads
D. Bid-Ask Margins
E. Real Exchange Rates
II. Overall Strength or Weakness of a Currency
A. Effective Exchange Rate
1. Construction
2. Example
3. Intuition
B. Real Effective Exchange Rate
III. Composite Currencies
A. Definition
B. SDR Example
IV. Foreign Exchange Arbitrage
A. Spatial
B. Triangular
V. Supply and Demand of Currencies
A. Demand for
1. Relationship between the price and quantity demanded
2. Sources of Demand
B. Supply
1. Relationship between the price and quantity demanded
2. Sources of Demand
C. Equilibrium
VI. Purchasing Power Parity
A. Absolute
1. Relate to Arbitrage
2. P = S  P*
B. Relative
1. Relative Changes in Prices
2. %S = %P – %P*
VII. Summary
13
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Instructor’s Manual — International Monetary and Financial Economics
FUNDAMENTAL ISSUES
1.
What is the foreign exchange market?
2.
What does it mean when a currency has appreciated or depreciated?
3.
How is the general value of a currency measured?
4.
What is foreign exchange arbitrage?
5.
What determines the value of a currency?
6.
What is purchasing power parity, and is it useful as a guide to movements in exchange rates?
CHAPTER FEATURES
1.
Management Notebook: “How Sensitive Are Manufacturers to Exchange Rate Changes?”
The management notebook examines the channels through which exchange rate changes affect manufacturers.
It notes that when, say, the U.S. dollar appreciates, U.S. exports may fall as their foreign currency denominated
price will have risen; and that U.S. imports may rise, as the dollar price of foreign goods will have fallen.
The notebook discusses two studies that examine how exchange rate changes have affected different industries.
The first constructs a “net external orientation” measure for 20 U.S. manufacturing sectors that is designed to
indicate whether a U.S. dollar appreciation is likely to positively or negatively impact the sector’s international
price competitiveness. The measure is calculated as the share of export revenues out of total revenues minus
the share of imported inputs out of total input expenditures. A positive (negative) value suggests that the sector
is harmed (aided) by the U.S. dollar appreciation. The results indicate that industrial machinery and instruments
had the highest measure of external orientation, and that leather and fabricated metal products had the lowest
external orientation.
The second study examined the impact of the euro’s 1999 decline against the U.S. dollar on European
manufacturers, citing the exaggerated effect of a euro depreciation relative to the U.S. dollar given other nations
that anchor their currency against the dollar. They find that the European industries most affected by exchange
rate changes are computing and office equipment and those least exposed are press and publishing.
For Critical Analysis: The European manufacturers of computing and office equipment were shown to be the
most exposed. An industry like press and publishing may be the least exposed if one considers the fact that
most press and publishing business may be done for the domestic market. For example, the cost of shipping
published works may suggest that local market production, rather than exporting, maybe the cost effective way
to serve a market. In this regard, European exports and imports of press and publishing would be rather
insensitive to exchange rate changes.
2.
Policy Notebook: “The Big Mac Index”
This feature describes the Economist magazine’s popular Big Mac index, a regular annual feature of the
magazine. The index compares the average price of a Big Mac among different countries in dollar prices after
Chapter Two
15
adjusting for the exchange rate. Comparisons of these dollar prices are used to imply over- or undervaluation of
a currency using the underlying PPP theory.
For Critical Analysis: Check to make sure students have correctly applied the absolute and relative PPP
equations to the data they use.
3.
Management Notebook: “Does the Border Between Canada and the United States Matter?”
The notebook applies the idea of purchasing power parity to compare prices of goods in cities similar distances
apart. In one pair of cities, the cities are located in the same country; while another pair of cities will be located
in adjoining countries. A comparison should allow us to see whether, after controlling for distance between the
cities, a border seems to matter for international prices. A study cited indicates that the border between the U.S.
and Canada is equivalent to 1,780 miles. Thus, a border still seems to matter, even after a free trade agreement
like NAFTA.
For Critical Analysis: If prices in the U.S. and Canada showed evidence of price stickiness, we may expect the
spot exchange rate between these countries to remain relatively constant, if PPP holds. If PPP does not hold, we
may expect other factors that influence the spot rate (for example, changes in the demand for, or supple of a
foreign currency) to affect the spot rate.
ANSWERS TO END OF CHAPTER QUESTIONS
1.
Since it cost fewer dollars to purchase a euro after the exchange rate change, the euro depreciated and the
dollar appreciated. The rate of depreciation was [(0.8836 – 0.8828)/0.8828]100 = 0.09 percent.
2.
NUMERATOR
DENOMINATOR
U.S. $
U.S. $
U.K. £
Canadian $
Euro (€)
0.668
1.517
1.082
2.271
1.620
U.K. £
1.497
Canadian $
0.659
0.440
Euro (€)
0.924
0.617
0.713
1.402
3.
An arbitrage opportunity does exist. If one were to take the $1,000,000 and purchase U.K. pounds in the
New York market, one could secure 668,002.67 U.K. pounds. To see this, divide the $1,000,000 by the
$1.497/£ U.K. spot rate. Then the individual could purchase euros with the U.K. pounds in the London
market and receive 1,102,204.4 euros. This is obtained by multiplying the 668,002.67 U.K pounds by the
€1.650 /£ U.K. spot rate. Finally, the individual could exchange these euros for U.S. dollars back in New
York to end up with $1,018,436.9. This is obtained by multiplying the 1,102,204.4 euros by the New York
spot rate of $0.924/€. The profit would therefore be $18,436.9 absent any transaction costs.
4.
Because 2000 is the base year, the value of the bilateral effective exchange rate is 100. Using the data in
the table, the weight assigned to the French franc is 0.1152 and the weight assigned to the Canadian dollar
is 0.8848. Using these weights, the effective exchange rate in 2001 is 86.04. This suggests a 13.96 percent
appreciation. If we construct a real bilateral weighted effective exchange rate, the 2001 effective exchange
rate is 88.97; which suggests an 11.03 percent appreciation.
Instructor’s Manual — International Monetary and Financial Economics
16
5.
In nominal terms the euro depreciated, as it cost more euros to purchase the dollar in July of 2000 than in
January of 1999. The rate of depreciation was 20 percent [((1.08 – 0.90)/0.90)100 = 20%]
6.
January 1999 real exchange rate for the euro = 0.90(108.0/105.3) = 0.923
July 2000 real exchange rate for the euro = 1.08(113.3/108.8) = 1.1247
7.
Based on the real exchange rate, the euro depreciated 21.8 percent.
8.
By PPP, the July spot rate should be 108.8/113.3= 0.960. The actual spot rate, however, was 1.08,
suggesting that relative to PPP theory, the actual spot rate was too high. This, relative to PPP, the euro was
undervalued by 12.5 percent.
9.
By relative PPP theory, the euro should have gained 1.59 percent in value; i.e., the euro should have
appreciated 1.59 percent. Thus, we can deduce that the spot rate in July 2000 should have been 0.8857
euros per U.S. dollar.
10. Since, in July 2000, the actual euro to U.S. dollar spot rate was 1.08 (rather than the 0.8857 euro to dollar
spot rate predicted by the relative PPP theory), the euro was undervalued by 21.94 percent.
MULTIPLE CHOICE EXAM QUESTIONS
1.
A market that requires immediate sale or purchase of an asset is known as a(n) ________ market.
A.
B.
C.
D.
exchange
bond
spot
free
Answer: C
2.
The minimum value of a spot currency transaction is generally
A.
B.
C.
D.
$100,000.
$500,000.
$1 million.
$5 million.
Answer: C
3.
If the dollar equivalent exchange rate of the New Zealand dollar is 1.5, what is a New Zealand dollar
worth in terms of U.S. dollars?
A. $0.50
Answer: B
B. $0.67
C. $1.0
D. $1.50
Chapter Two
4.
The dollar equivalent exchange rate of the Argentinean peso is 1. If the peso were to undergo a 50
percent depreciation, the dollar equivalent exchange rate of the Argentinean peso would be
A.
B.
C.
D.
50 pesos.
2 pesos.
1 peso.
0.5 pesos.
Answer: B
5.
For which of the following sets of exchange rates has the cross rate been correctly calculated?
A.
B.
C.
D.
£1 = 15 French francs; $3.00 = £1; $1 = 5 French francs
¥200 = $1.00; 1 ringgit = $0.15; 20 ringgit = ¥1
£1 = 4 DM; 3 Swiss francs = 1 DM; 12 Swiss francs = £1
10 French francs = $1.00; 1 DM = 4 French francs; 1 DM = $0.50
Answer: C
6.
A Korean trader wishes to make a purchase of Czech crystal worth 3 million korunas.
Unfortunately, there is no published value of the Korean won to Czech koruna exchange rate. In order
to calculate the current price of the crystal in won, the trader will need to calculate
A.
B.
C.
D.
the real exchange rate.
a cross rate.
the purchasing power parity rate.
South Korea’s effective exchange rate.
Answer: B
7.
Suppose the dollar equivalent rate for the Canadian dollar is 1.37, while the dollar equivalent exchange
rate for the British pound is 0.66. What is the cross rate of British pounds per Canadian dollar?
A. 2.08
B. 1.37
C. 0.66
D. 0.48
Answer: D
8.
An American tourist is planning to visit Mexico. The exchange rate at which the tourist can buy pesos
in a retail bank is the
A.
B.
C.
D.
bid price.
ask price.
spot rate.
cross rate.
Answer: B
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Instructor’s Manual — International Monetary and Financial Economics
18
9.
Suppose the bid price of British pounds is $1.49 U.S., and the ask price is $1.51 U.S. What is the bid
ask margin?
A.
B.
C.
D.
0.02%
0.99%
1.01%
1.3%
Answer: D
10. The spot exchange rates published in financial newspapers are ________ exchange rate.
A.
B.
C.
D.
nominal
real
effective
forward
Answer: A
11. Which of the following exchange rates is adjusted for price changes?
A.
B.
C.
D.
nominal
real
effective
forward
Answer: B
12. The table below reports the movements of prices and exchange rates for the U.S. and Indonesia
over a year’s time.
July 1, 1997
July 1, 1998
—————— ——————
Indonesian rupiah/$U.S.
2,435
14,500
Indonesian price level (CPI)
100
152
U.S. price level (CPI)
100
102
In this time, the Indonesian rupiah experienced a nominal
A.
B.
C.
D.
depreciation and a real appreciation.
depreciation and a real depreciation.
appreciation and a real appreciation.
appreciation and a real depreciation.
Answer: B
Chapter Two
19
13. Calculate the percentage change in the nominal value of the dollar as measured in rupiah based on the
table of values below.
July 1, 1997
July 1, 1998
—————— ——————
Indonesian rupiah/$U.S.
2,435
14,500
Indonesian price level (CPI)
100
152
U.S. price level (CPI)
100
102
A.
B.
C.
D.
–16.8%
–495.5%
+ 16.8%
+495.5%
Answer: D
14. The effective exchange rate is
A.
B.
C.
D.
the exchange rate facing large banks and other high-volume traders.
the exchange rate facing retail customers.
the nominal exchange rate adjusted for inflation.
a measure of the weighted-average value of a currency relative to a selected group of countries.
Answer: D
15. An exchange rate that is weighted by the share of each partner in a nation’s trade is an example of a
A.
B.
C.
D.
spot exchange rate.
effective exchange rate.
nominal exchange rate.
real exchange rate.
Answer: B
16. The Special Drawing Right (SDR) is a
A.
B.
C.
D.
means by which banks offer their best clients preferential loan rates.
preliminary form of the proposed common currency in Europe.
composite currency created by the International Monetary Fund.
type of bank account used by currency traders.
Answer: C
17. A currency trader engaging in spatial arbitrage would be doing what?
A.
B.
C.
D.
Purchasing real estate in major financial centers.
Purchasing an asset in one market and simultaneously selling it at a different price in another market.
Choosing an investment portfolio that contained assets from many different countries.
Selling borrowed currency in the hopes that there will be a large appreciation.
Answer: B
Instructor’s Manual — International Monetary and Financial Economics
20
18. The demand for currency is an example of
A.
B.
C.
D.
an aggregate demand.
a derived demand.
spatial arbitrage.
a perfectly elastic demand.
Answer: B
19. A depreciation in the Japanese yen relative to the U.S. dollar is modeled as a
A.
B.
C.
D.
rightward movement along the demand curve for Japanese yen.
leftward movement along the demand curve for Japanese yen.
shift rightward in the demand for Japanese yen.
shift leftward in the demand for Japanese yen.
Answer: A
20. An increase in the demand for French goods and services will
A.
B.
C.
D.
induce a rightward shift in the demand for French francs.
induce a leftward shift in the demand for French francs.
result in a leftward movement along the demand curve for French francs.
result in a leftward movement along the demand curve for French francs.
Answer: A
21. The demand for the U.S. dollar in terms of Swedish krone
A.
B.
C.
D.
is perfectly inelastic.
shifts leftward in response to an increase in Swedish demand for U.S. goods.
is upward sloping.
may also be represented as the supply of Swedish krone in terms of U.S. dollars.
Answer: D
22. An increase in U.S. demand for foreign assets will result in a
A.
B.
C.
D.
rightward shift in the supply of U.S. dollars.
rightward movement along the supply schedule for U.S. dollars.
a leftward shift in the supply of U.S. dollars.
a leftward movement along the supply schedule for U.S. dollars.
Answer: A
Chapter Two
21
23. If U.S. demand for German products increases at the same time as German demand for U.S. products rises,
what is the effect on the U.S. dollar to German mark exchange rate?
A.
B.
C.
D.
The U.S. dollar will appreciate
The U.S. dollar will depreciate.
The U.S. dollar will not change relative to the German mark.
The U.S. dollar may appreciate, depreciate, or remain unchanged.
Answer: D
24. An increase in the demand for the Canadian dollar will lead to a(n) ________ of the Canadian dollar and a
________ quantity of Canadian dollars traded.
A.
B.
C.
D.
appreciation; higher
depreciation; higher
appreciation; lower
depreciation; lower
Answer: A
25. An increase in the supply of the Mexican peso will lead to a(n) ________ of the peso and a ________
quantity of pesos traded.
A.
B.
C.
D.
appreciation; higher
depreciation; higher
appreciation; lower
depreciation; lower
Answer: B
26. Purchasing Power Parity is also known as
A.
B.
C.
D.
uncovered interest parity.
covered interest parity.
the Consumer Price index.
the law of one price.
Answer: D
27. Which basket of goods would be most likely to exhibit absolute purchasing power parity?
A.
B.
C.
D.
the goods in the Consumer Price index
specialized luxury goods, which are subject to different tax rates across countries
locally produced goods, such as transportation services, which are not easily traded
highly tradable commodities, such as wheat
Answer: D
Instructor’s Manual — International Monetary and Financial Economics
22
28. The difference between relative and absolute purchasing power parity (PPP) is
A. relative PPP includes a measure of the aggregate price level in each country, while PPP does not.
B. empirical studies show that relative PPP holds in both the short and long run, while absolute PPP
holds only in the short run.
C. relative PPP relates interest rate differentials, while absolute PPP relates goods prices.
D. relative PPP implies that exchange rate movements will offset changes in relative prices over time,
while absolute PPP implies that exchange-rate adjusted prices will always be equal.
Answer: D
29. If the price of a pair of shoes in the U.S. is $80, the price of the same pair of shoes in Germany is 120
DM, and the exchange rate is 1.5 DM/$, the Deutsche mark
A.
B.
C.
D.
is correctly valued according to PPP.
is overvalued relative to PPP.
is undervalued relative to PPP.
would be correctly valued at an exchange rate of 0.67 DM/$ according to PPP.
Answer: A
30. Assume that relative PPP holds in the long run. If the price of a tradable good is $20 in the U.S.
and 100 pesos in Mexico and the exchange rate is 7 pesos/$, which of the following changes
might we expect in the future?
A.
B
C.
D.
an increase in the price of the good in the U.S.
a decrease in the price of the good in Mexico
an appreciation of the peso in nominal terms
a depreciation of the peso in nominal terms
Answer: C