International Economics
Part II
G. Di Bartolomeo
Lecture 1
The exchange rate: Basic definitions
The exchange rate
• It is the price of a currency in terms of
another currency (i.e. relative price!!!).
• In the US if the exchange rate with the
Euro is 0.8, it means that you need of 0.8
euro to buy one dollar.
• In Europe the exchange rate will be the
same but because of the definition in the
bank you will find 1/0.8=1.25, i.e. you
need of 1.25 dollars to buy one euro.
The Exchange Rate
• The price of one unit of foreign currency
expressed in terms of domestic currency
• For example, one Euro costs $.50
• 1€ = $.5 ($/€)
• 1$ = (€/$) = 1/.5 = 2 €
Exchange rates notation:
• Direct quotation : U.S dollars per unit of
foreign currency.
R = ($ / €) = $ .5639
• Indirect quotation : Units of foreign currency
per U.S. dollar.
1/R = (€ / $) = € 1.7735
Notice!!! The direct quotation in Europe equals the
indirect in US.
Wall Street Journal
$/£ =1.6961 and £/$ = 0.58959
The Real Exchange Rate
RE =
P(us)$
(€/$)P(it)€
or
($/€)P(us)$
P(it)€
It measures the competitiveness.
Remark 1: R = ($/€) nominal exchange rate (the
relative price of the $, how many € for one $).
Remark 2: RE is independent of the definition of
the nominal exchange rate.
Exchange Rate Floating
Who does Demand or Supply euro?
• Exchange rate is a price!!!
• Thus it is determined by demand and supply.
But who does demand or supply foreign
currencies?
– Tourism
– International trade
– Financial investments
• Summarizing: Payment to or from a foreign
agent
– If I have to pay I will demand euro.
– If I have been paid I will supply euro.
The Foreign Currency Market (US):
Direct Quotation $/€
The dollar price of one euro
Exchange Rate = R
Excess of supply
Supply of euro
1.0
euro depreciation
0.8
euro appreciation
0.6
Demand of euro
Excess of demand
Quantities exchanged
The Foreign Currency Market (US):
Indirect Quotation €/$
The euro-price of one dollar
Exchange Rate
Excess of supply
Supply of dollars
(Demand of euro)
1.0
dollar depreciation
0.8
dollar appreciation
0.6
Demand of dollars
(Supply of euro)
Excess of demand
Quantities exchanged
The Other Side of the Market
The euro-price of one dollar
Exchange Rate
Demand of dollars
(Supply of euro)
Supply of dollars
(Demand of euro)
0.8
dollar depreciation
0.6
Quantities exchanged
euro appreciation
The large demand for Euro increases
its price (appreciation)
Appreciation/Depreciation
• Appreciation: increase in the value of the
currency (increase in the exchange rate,
direct quotation).
• Deprecation: reduction in the value of the
currency (fall of the exchange rate, direct
quotation).
Henceforth
• We consider the direct quotation only.
Thus the exchange rate is the price of one
union of the domestic currency in terms of
the foreign one.
• In Europe R(US$)=1.2 means that you
need of 1.2 $ to but one euro.
• In US R(euro)=0.83 means that you need
0.83€ to buy one dollar.
Instability: The stable case (look at
the slopes)
The dollar price of one euro
Exchange Rate = R
Excess of supply
Supply of euro
1.0
0.8
0.6
Demand of euro
Excess of demand
Quantities exchanged
Instability: The unstable case (look
at the slopes)
The dollar price of one euro
Exchange Rate = R
Excess of demand
Demand of euro
1.0
0.8
0.6
Supply of euro
Excess of supply
Quantities exchanged
Instability (look at the slopes)
Exchange Rate
Demand
1.2
stable
1.0
unstable
0.8
0.6
Supply
Quantities exchanged
Slopes = Demand/Supply Elasticities