Foreign Exchange Rates
Nominal Exchange Rate
 Real Exchange Rate
 PPP

Nominal Exchange Rate

Nominal Exchange rate: the rate at which one can
exchange the currency of one country for the
currency of another.

The “A” – “B” exchange rate is the price of one unit
of “B” in terms of “A”
–
–
dollar-euro exchange rate is the price of 1 euro in terms of
dollars.
peso-dollar exchange rate is the price of 1 dollar in terms of
pesos.
Nominal Exchange Rates

If the dollar-euro exchange rate is 1.24 and
the peso-dollar exchange rate is 0.05, what
is the peso-euro exchange rate?
1.24 dollars 0.05 pesos

1 euro
1 dollar
0.062 pesos

euro
Nominal Exchange Rate

If the dollar-euro exchange rate is 1.21 and
the dollar-pound exchange rate is 1.76, what
is the pound-euro exchange rate?
pound - dollar : 1/1.76  0.57
0.69 pounds
0.57 pounds 1.21 dollar


euro
1 dollar
1 euro
Nominal Exchange Rate



Assume the pound-euro fx-rate is 0.60.
How could you profit?
Euros look cheap in terms of pounds
–
Buy 100 pounds using dollars

–
Use 100 pound to buy euros

–
Cost = 176 dollars
Get 100/0.60 = 167 euros
Use euros to buy dollars


Euro-dollar rate is 1/1.21 = 0.83
Get 167/0.83 = 201 dollars
Cost of Goods

If a 2007 Hundai costs $10,200 Euros, how much
does it cost in dollars? Assume dollar-euro fx-rate is
1.76.
1.76 dollar  17,952 dollars
10,200 euros 
euro
Real Exchange Rate

Real Exchange rate: Rate at which one can
exchange the goods and services from one
country for the goods and services of another
country.
Real Ex - Rate 
Dollar Price of U.S. Goods
Dollar Price of Foreign Goods
Real Exchange Rate

If a 2007 Hundai costs 11,000 euros, and 28,000
dollars what is the real EU - US fx-rate? Assume dollareuro fx-rate is 1.76.
28,000
28,000

 1.45
1.76 11,000 19,360
Real FX-rate

The real EU-US fx-rate is the cost of real goods
in the US in terms of real goods in the EU.
–
–
A real EU-US fx-rate of 1.45 implies you could trade
1 Hundai in the US for 1.45 Hundais in Europe
You should buy Hundais in Europe and export them
to the U.S.

–
Make 28000-19360=8,640 per transaction
This raises the price of Hundais in Europe and lowers
them in the U.S. until real fx-rate=1
Real Fx-Rate

What prevents the real-fx rate from reaching
unity?
–
Transportation costs, Duties, Tarriffs

–
Example: Suppose it cost $8640 to import cars from
Europe
Some things, such as perishable items, some
services, can’t be traded.
Purchasing Power Parity

Assuming no transaction costs
Real Exchange rate =1
Dollar Price of U.S. Goods

Dollar Price of Foreign Goods
Dollar Price of U.S. Goods
1
Foreign Price of Foreign Goods  (dollar - foreign fx - rate)
Dollar Price of U.S. Goods
 dollar - foreign fx - rate
Foreign Price of Foreign Goods
Purchasing Power Parity
Dollar Price of U.S. Goods
 dollar - foreign fx - rate
Foreign Price of Foreign Goods
Foreign Price of Foreign Goods
 foreign - dollar fx - rate
Dollar Price of U.S. Goods


Not true over the short run
Implications over long run: inflation erodes
value of currency.
Inflation and Exchange Rates
Big Mac Index



Cost of Big Mac in US: 3.15 dollars
Cost of Big Mac in Japan: 250 yen
Implied yen-dollar exchange rate from PPP:
250/3.15 = 79.37



Actual yen-dollar exchange rate = 90
(implied – actual)/actual = 79.37/90 – 1 = -12%
Yen is 12% under-valued relative to dollar
Exchange Rates in the Short Run
Supply and Demand




Home Currency: dollar
Price per dollar: foreign-dollar fx-rate
Who supplies dollars? Primarily U.S. residents.
As price of dollar goes up, U.S. residents are
willing to supply more
–
–

To buy foreign assets
To invest in foreign financial assets
Supply curve for dollars is upward sloping
Supply of Dollars

Who demands dollars? Foreigners

As price of dollar goes up, foreigners demand
less
–
–

To buy American assets
To invest in American financial assets
Demand curve for dollars is downward sloping
Supply and Demand for Dollars
Shifts in the Supply of Dollars

Factors that shift supply curve to right
–
–
–
–
–
–
Increase in U.S. preference for foreign goods
Increase in U.S. real G.D.P.
Increase in real interest rate on foreign bonds
Increase in American wealth
Decrease in relative risk of foreign investments
Expected dollar depreciation (e.g. high U.S. inflation)
Shifts in the Supply of U.S. Dollars
Shifts in the Demand of Dollars

Factors that shift demand curve to right
–
–
–
–
–
–
Increase in foreign preference for U.S. goods
Increase in foreign real G.D.P.
Increase in real interest rate on U.S. bonds (relative
to foreign)
Increase in foreign wealth
Decrease in relative risk of U.S. investments
Expected dollar appreciation (e.g. low U.S. inflation)
Shifts in Demand for U.S. dollars
Current Account

Current account – measures the country’s
trade in currently produced goods and
services.
–
–

Merchandise (soybeans, perfume, cars . . .)
Services (education, tourism, insurance . . .)
Current Account = Exports – Imports
–
–
Imports > Exports : current account deficit
Exports > Imports : current account surplus
Current Account

Current account does not measure trade in
assets already existing.
–

Example: If Japanese investor buys vacation home in
Hawaii, this is not included in current account.
Current Account measures
–
–
Demand of U.S. for current goods abroad (dollar
supply)
Demand of Foreigners for U.S. goods (dollar demand)
Capital Account

Capital account measures trade in all financial assets
and other existing assets.

When U.S. sells asset abroad and receives dollars,
this is counted as a capital inflow to the home country,
and as a credit to the capital account.

Examples:
–
–
I sell euros to buy dollars (credit capital account)
I sell a bond to a Chilean investor for dollars (credit capital
account)
Capital Account

Capital Account measures
–
–
Demand of U.S. for foreign assets (dollar supply)
Demand of Foreigners for U.S. assets (dollar demand)

Capital Account =
capital inflows – capital outflows

Inflows > Outflows capital account surplus
Outflows > Inflows capital account deficit

Capital and Current Account





Capital Account + Current Account = 0
CA=current account
KA=Capital account
You buy a British Sweater for 75 dollars: Debit to CA
The sweater manufacturer can
–
–
–
Use dollars to buy some other U.S. good: Credit CA
Use dollars to buy a U.S. bond: Credit KA
Exchange dollars for pounds at Bank



Bank can sell dollars to someone who wants to buy U.S. good
Bank can buy U.S. financial asset itself
Buy pounds from the Federal Reserve: Credit KA
Current Account Deficit

In U.S. current account deficit is approaching
$one trillion

Import more than we export
What are countries doing with extra dollars?
Buying U.S. bonds and other investments,
leading to capital account surplus.


Capital and Current Accounts
1500.000
Capital Account
1000.000
500.000
0.000
Mar
1960
Sep
1965
Mar
1971
Aug
1976
Feb
1982
Aug
1987
Jan
1993
Jul
1998
Jan
2004
Jul
2009
Dec
2014
-500.000
Current Account
-1000.000
Exchange Rates in the Short Run
September 20th