Exchange Rates
20-2
Exchange Rates
Exchange Rates
• Nominal exchange rate: price of one currency in terms of
another currency (bilateral exchange rate)
–
–
–
–
example: 1.30 dollars per euro or 76.92 euros per dollar
determines price of imports
foreign exchange market
denote as enom , units of the foreign currency per unit of domestic
currency
• Nominal effective exchange rate: average nominal
exchange over several other important trade-related
currencies
19
7
19 3-0
74 119 -0 0
1
7
19 5-01-0
7 1 1
19 6-0 -0
1
7
19 7-01-0
1
7
19 8-01-0
1
7
19 9- 1-0
80 01 1
19 -0 -0
1
8
19 1- 1-0
82 01 1
19 -0 -0
1
8
19 3- 1-0
8 0 1
19 4-01-0
1
8
19 5- 1-0
0
1
8
19 6-01-0
1
8
19 7- 1-0
88 01 1
19 - -0
8 0 1
19 9- 1-0
9 01 1
19 0-0 -0
1
9
19 1-01-0
1
9
19 2-01-0
1
9
19 3-01-0
94 1 1
19 -0 -0
1
9
19 5-01-0
96 1 1
19 -0 -0
1
9
19 7- 1-0
0
1
9
19 8-01-0
1
9
20 9- 1-0
0
1
0
20 0- 1-0
01 1
0
20 1- -0
0 0 1
20 2- 1-0
0 0 1
20 3- 1-0
04 01 1
20 - -0
05 01 1
-0 -01
101
Nominal Effect Exchange Rate
160
Nominal and Nominal Effective Exchange Rate
140
120
100
200.00
80
60
150.00
40
100.00
20
50.00
0
0.00
Nominal Effective Exchange Rate
Japanese Yen
Yen Per Dollar
20-3
Exchange Rates
350.00
300.00
250.00
20-4
Exchange Rates
• Real Exchange Rate (RER): the price of domestic
goods relative to foreign goods
– says how much foreign good you could get for domestic
good
• The price of the average domestic good or service
relative to the price of the average foreign good or
service, when the prices are expressed in terms of
a common currency
20-5
Exchange Rates
• RER Example
– Should you buy a Japanese or American computer for your
company?
• Price of U.S. computer = $2,400
• Price of Japanese computer = 242,000 yen
• Exchange rate = 110 yen/dollar
• Price in dollars = price in yen/yen-dollar exchange rate
– Price in yen = price in dollars x value of dollar in terms of yen
– Price in dollars = 242,000 yen/110 = $2,200
– Japanese computer is cheaper.
– Real exchange rate = $2,400/$2,200 = 1.09
20-6
Exchange Rates
Real Exchange Rate (RER)
P

 enom  foreign 
P

domestic
eRER
% eRER  % enom  % P domestic  % P foreign
• If a country’s real exchange rate is rising, its goods are
becoming more expensive relative to the goods of the
other country
– NX will tend to be low when the real exchange rate is high.
• Real exchange rate = “terms of trade” =>
competitiveness
• Real exchange rate is an index and is unit-less
20-7
Exchange Rates
160
U.S. Nominal and Real Exchange Rates
140
120
100
80
60
Nominal Effective Exchange Rate
Real Effective Exchange Rate
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
Jan-73
40
20-8
Purchasing Power Parity
Law of One Price and Purchasing Power
Parity
• Identical goods & services should sell at same price no
matter where they are sold…otherwise opportunity for
profits (i.e. arbitrage)
– Law of one price: same price for a commodity
• Candy bar in Port-of-Spain versus San Fernando
• Purchasing Power Parity (PPP)
– The theory that nominal exchange rates are determined as
necessary for the law of one price to hold
– Exchange rates should move to equalize prices across
countries
20-9
Purchasing Power Parity
P

 enom  foreign   1 
P

domestic
eRER
% eRER  % enom  % P
% enom  % P
enom
domestic
foreign
P

  domestic 
P

foreignc
 % P
 % P
foreign
domestic
PPP implies currencies of countries that
experience significant inflation will tend to
depreciate
0
20-10
Purchasing Power Parity
• Example
– How many Indian rupees equal to one Australian
dollar?
• Bushel of grain cost 5 Australian dollars or 150 rupees
• 5 Australian dollars = 150 rupees
– Or, a 30 rupee to 1 Aus. Dollar ratio
• Nominal exchange rate should equal 30 rupees/Australian
dollar
– If not 30:1, what should happen?
20-11
Purchasing Power Parity
– How many Indian rupees equal one Australian
dollar?
• Suppose price of grain in India increases from 150
to 300 rupees
• Price of grain in Australia still equals 5 Australian
dollars
– Originally: implied exchange rate 5:150 or 1:30
– Now: implied exchange rate 5:300 or 1:60
• 1 Australian dollar = 60 rupees
• Nominal exchange rate increased from 30 to 60
rupees/Australian dollar
• Indian currency depreciated
• Australian currency appreciated
20-12
Purchasing Power Parity
• Does not hold up well in short run
– Transportation costs
– Border effect – tariffs, technical requirements,
regional monopoly power
– Pricing to market
• Goods prices are “sticky”
• Reduces exchange rate “pass through”
– Nontradable sector
• Higher productivity, higher nontradable wages,
higher nontradable inflation
• Works better in the long run
20-13
Price differences between US and Canadian Cities.
Figure 19.4
20-14
Inflation and Currency Depreciation
Five Year Window
Currency Depreciation (% pa)
30
23
17
10
3
-3
-10
-20
-10
0
Inflation Differential
10
20
30
20-15
Inflation and Currency Depreciation
Twenty Year Window
12
Currency Depreciation (% pa)
9
6
3
0
-3
-6
-10
-5
Inflation Differential
0
5
10
15
20-16
Power Purchasing Parity
• McParity & the Big Mac Index
– The Economist's Big Mac index is based on the theory
of purchasing-power parity (PPP) using the Big Mac
– The cheapest burger in the chart is in China, at $1.26,
compared with an average American price of $3. The
PPP implies that the yuan is 58% undervalued relative
to its Big Mac dollar-PPP. On the same basis, the euro
is 25% overvalued, the yen 17% undervalued.
20-17
McParity
20-18
Exchange Rate
• RER reflects competitiveness—the higher a
country’s RER, the more expensive its goods and
services are to foreigners.
• => as the RER↑, a country’s NX growth will ↓,
leading to a current account deficit (and vice
versa)
– Note: nominal exchange rate can fall but be offset by
higher domestic inflation so that RER stays constant