Exchange Rates
Exchange Rates
• Exchange Rate: S - # of domestic
currency units purchased for 1 US$.
• An increase in S is a depreciation and a
decrease in S is an appreciation.
International Comparisons Project
• Researchers at U. of Pennsylvania periodically
choose a representative world market basket
and go to different countries to collect prices of
that market basket of good.
• For a country, we calculate PPP = Purchasing
Power Parity as the price of the market basket
relative to price of the market basket in US.
• For any country, the exchange rate, St, is the
number of domestic dollars per US$.
Penn World Tables
Comparing GDP across
Countries
• When you compare income in two different
countries, each country’s GDP per capita is
measured in local currency. You need to
measure both with common yardstick to
compare.
• Typically, the common yardstick will be
US$. GDP can be converted to US$ by
Exchange Rate Method (divide national
GDP by the exchange rate) or PPP Method
(divide national GDP by PPP).
PPP vs. Exchange Rate
Conversion
• Exchange rates are easily available so
exchange rate is a “quick and dirty” comparison.
– Measures how many US dollars someone could buy
with average income.
• However, money goes farther in some countries
as many types of goods are relatively cheap
(especially developing countries).
– PPP conversion measures how much the goods
purchased by the average person would cost in the
US. Better measure of living standards.
Convert sums into another
economy’s currency
• Nj is a number
measured in country
j’s currency & you
want to convert it into
country REF’s
currency.
Exchange Rate Conversion
N
Ref$
t
S Ref
 Nt 
St
PPP Conversion
N
Ref$
t
PPPRef
 Nt 
PPPt
Comparison of China vs. HK
• Goods are cheaper in
China than in HK
Hong Kong
China
Local
Currency
GDP
HK$192,776
￥6,423.00
in RMB
Hong Kong
China
World Bank Conversion Factors
2002
S
PPP
7.8
8.28
S
6.9
1.8
PPP
204,639.14 50,289.39
￥6,423.00
Which exchange rate conversion to
use?
• Depends on where the money will be
spent.
• If you have a value of foreign currency that
you will want to spend at home, convert
using exchange rate because foreign
prices are irrelevant.
• If you want to spend the money in foreign
country, then using PPP conversion may
be more helpful.
Problem
• You are a Chinese multinational that wants
to construct salaries to be paid to
employees in Canada that will provide
same living standard as salary of
RMB20,000.
• Canada PPP in 2002 is 1.2.
Exchange Rate Model
Exchange Rates are Volatile
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
280.00
260.00
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
Jan-84
Yen per Dollar
Yen-Dollar Rate
Why do exchange rates change?
• Relative values of two currency
determined by supply and demand by
traders of the two currencies.
• People trade currencies to engage in
foreign trade and international investment.
• Monetary policy is a prime driver of
exchange rates.
– And vice versa, Some economies structure
monetary policy around exchange rate.
Forex Market: Supply & Demand
Consider the spot foreign exchange market.
• Price of US$: S is the price of US$ in terms of DCU.
• Supply of US$: Foreign people who want to acquire
DCU to buy domestic goods or assets.
– When US$ becomes expensive, domestic goods
or assets get cheap and foreign investors are
attracted to domestic currency.
• Demand for US$: Domestic people who want to
acquire US$ for foreign purchases or overseas
investment.
– When US$ get cheap, US$ goods or assets get
cheap and demand for US$ rises
Equilibrium in Forex Market
Supply Equals Demand
S
Demand
S*
Supply
Increase in Desired Capital Outflows by
Domestic Investors/
Desired Purchases of Foreign Goods
S
S**
2
S*
Domestic
Currency
Depreciates
1
Supply'
Supply
Demand '
Demand
Increase in Desired Capital Inflows by
Foreign Investors/
Desired Purchases of Domestic Goods
S
Supply
Supply'
Domestic
Currency
Appreciates
1
S*
S**
2
Demand
US Monetary Policy Causes
US$ Interest Rates Go Up
Relative Demand for US$ Goes Up
S
2
S**
Domestic
Currency
Depreciates
S*
1
Supply'
Supply
Demand '
Demand
Domestic Monetary Policy Causes
D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
S
Supply
Supply'
1
S*
Domestic
Currency
Appreciates
S**
2
Demand
Demand '
Monetary Policy & Exchange Rates
• The central impact of the foreign currency
intervention is on domestic interest rates.
• Monetary policy that shifts domestic interest
rates will also shift exchange rates
regardless of whether it occurs through
currency intervention, OMO, or some other
change in quantity of bank reserves.
• Monetary policy that does not shift interest
rates will not shift exchange rates.
Foreign Currency Intervention
• Foreign currency purchase:
–
–
–
–
Central bank purchases foreign currency
Credit reserve accounts of counterparty commercial bank
More reserves pushes down interest rates
Increases demand for and reduces supply of US$ in forex
market
• Foreign currency sale
–
–
–
–
Central bank sells foreign currency
Debit reserve accounts of purchasing bank
Less reserves pushes up interest rates
Reduces demand for and increases supply of US$ in
forex market
Excess Demand for Foreign Currency
1. Domestic
Currency Faces
Depreciation
Pressure
S
A
S*
Supply
Demand '
Demand
Forex Sale
Supply
S
A
S*
B
Supply'
1. Central Bank
does Forex
Sale
maintaining
Exchange
Rate Stability
2. Shrinking
money
Demand
supply and
higher
domestic
Demand '
interest rates
Excess Supply of Foreign Currency
1. Domestic
Currency Faces
Appreciation
S
S*
A
Supply
Demand
Forex Purchase
S
B
S*
Supply'
Supply
A
1. Central Bank
does Forex
Purchase
maintaining
Exchange
Rate Stability
2. Growing
money
supply and
Demand ' lower
domestic
interest rates
Demand
Iron Triangle of International
Finance
Open to
International
Capital Flows
Monetary
Policy that
Controls The
Interest Rate
Pick 2 items from this menu
Fixed
Exchange
Rates
Learning Outcomes
• Students should be able to
• Convert series from one currency to another
using the exchange rate or the PPP rate.
• Use the Supply-Demand model of the forex
model to explain:
– the effect of international trade conditions on the
exchange rate.
– the impact of interest rates and other financial market
conditions on exchange rates.
– Government policy efforts to stabilize the exchange
rate.