Foreign Exchange

Foreign exchange: is foreign money, including paper currency and bank deposits like chequing accounts that are denominated in foreign currency.

Foreign exchange market: refers to the global market in which people trade one currency for another.

Foreign Exchange Rate

The exchange rate between two countries is the price at which residents of those countries trade with each other.

Types

Nominal: is the relative price of the currency of the two countries.

E.g. if the exchange rate of USD and INR is Rs.50 per USD, then you can exchange 1 USD for Rs. 50 in the world market for foreign currency.

Real

It is the relative price of the goods of the two countries.

It seeks to measure the value of a country’s goods against those of another country, a group of countries, or the rest of the world, at the prevailing nominal exchange rate.

It tells us the rate at which we can trade the goods of one country for the goods of another.

Also called the terms of trade.

Purchasing Power Parity Law of one price – identical

goods cannot sell for different prices in different locations at the same time.

PPP theory is also extended to the pricing of currencies.

Method

If a good (or a basket of goods) sells for, say Rs. 500 in india and $10 in USA

The exchange rate would beRs. 500 = $ 10Rs. 50 / USDor e = $ 0.02 / Rewhere e = units of foreign currency per unit of domestic currency.

Real exchange rate is obtained by adjusting the nominal exchange rate to changes in relative inflation rates in the two countries.

e = e x (P/P*)where P = inflation rate in IndiaP* = inflation rate in USA

Changes in Exchange rates A relatively higher inflation

rate causes the real exchange rate to go up (appreciate) and vice versa.

E.g. if inflation rate in India = 10%

And in USA = 2%Given e = $0.02/ReReal exchange rate would bee = 0.02 (1.1/1.02) = 0.02157

Therefore, the real exchange rate appreciates by 8%.

Nominal rate has to be adjusted.e = 0.02 = e (1.1/1.02)e = 0.01855i.e. a depreciation of nominal exchange rate of INR by about 8% (from 0.02 to 0.01855 or from Rs.50/USD to Rs.53.9/USD)

Limitation

All the goods are homogeneous and tradable

There are no restrictions to trade across countries

There is no transaction cost.

Big Mac Index

The Big Mac Index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics.

Burgernomics is based on the theory of purchasing-power parity (PPP).  This argues that the exchange rate between two currencies should in the long run move towards the rate that equalises the prices of identical bundles of traded goods and services in each country.  In other words, a dollar should buy the same amount everywhere.

Our "bundle" is a McDonald's Big Mac, which is produced to more or less the same recipe in about 120 countries.  The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in each country. 

The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies.

The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency).

This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.

Calculating RER

E.g. Big Mac - if the real exchange rate is 1 the burger would cost the same in the United States as in, say, Germany, when the price is expressed in a common currency.

That would be the case if the Big Mac costs $1.36 in the United States and 1 euro in Germany, i.e. NER e=1.36

In this one-product world (in which the prices equal the exchange rates), the PPP of the dollar and the euro is the same and the RER is 1.

If the German price is 2.5 euros and the U.S. price is $3.40, then (1.36) x (2.5) ÷ 3.40 yields an RER of 1.

But if the German price were 3 euros and the U.S. price $3.40, then the RER would be 1.36 x 3 ÷ 3.40 = 1.2.

How does it work?

Suppose the burger sells for 1.2 euros in Germany.

That would mean it costs 20 percent more in the euro area, suggesting that the euro is 20 percent overvalued relative to the dollar.

If the real exchange rate is out of sync, as it is when the cost is 1.2, there will be pressure on the nominal exchange rate to adjust, because the same good can be purchased more cheaply in one country than in the other.

It would make economic sense to buy dollars, use them to buy Big Macs in the United States at the equivalent of 1 euro, and sell them in Germany for 1.2 euros.

Arbitrage

Taking advantage of such price differentials is called arbitrage.

As arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars will rise, as will its nominal exchange rate, until the price in Germany and the United States is the same—the RER returns to 1.

Limitations

The burger methodology has limitations in its estimates of the PPP.

In many countries, eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant.

Moreover, the demand for Big Macs is not as large in countries like India as in the United States.

Social status of eating at fast food restaurants like McDonald's, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole.

In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs being different from market exchange rates over time. Nevertheless, economists widely cite the Big Mac Index as a real world measurement of purchasing power parity.

Other rates

Spot rate – the rate of exchange at which the seller at the spot makes the delivery of foreign exchange to the buyer

Forward rate – that rate at which the seller contracts to deliver to the buyer foreign exchange at some future date at a rate settled in the present.

Exchange rate systems

Two types:

Fixed exchange rate system Floating (or flexible) exchange

rate systemThree important cases: Gold standard Floating exchange rate system Managed floating exchange

rate system

Fixed exchange rate system A regime in which the value of a

currency is expressed in terms of another single currency, or to a basket of other currencies, or to another measure of value, such as gold.

Also called the pegged exchange rate.

to maintain a fixed exchange rate, a government has to either buy or sell its own currency on the open market.

Gold standard

Govt produced monies made of precious metals like gold

Paper currency introduced – convertible into gold

Changes in supply of gold will result in changes in price of goods and services.

Floating exchange rates / Free / pure float Inconvertible paper currency

standard Equilibrium in forex market

occurs at the point where the foreign exchange demand and supply curves intersect.

Exchange rate fluctuates from day to day on the basis of demand and supply.

Managed (dirty) floating exchange rate systemIt is a mixture of Gold standard stable

exchange rate system Floating exchange rate system

i.e. exchange rate between A’s and B’s currency is officially fixed but this peg can be altered from time to time by the monetary authorities.

Instability in exchange ratesCauses

Change in demand and supply of forex

Trade conditions => if exports > imports

supply of forex increases appreciation of the domestic currency

If imports > exportsdemand for forex increasesdepreciation of domestic currency

Stock exchange influence If residents of a country buy

stocks, shares and securities in foreign countries => demand for foreign currency increases => depreciation

If residents take loans from foreigners, demand for foreign currency will rise => depreciation

Banking influences

Bank rate – if central bank raises the interest rates, foreign capital will flow into the country - appreciate

Issuing of credit instruments – issue of banker’s drafts or other credit instruments – foreign currency demand increases - depreication

Arbitrage operations – when securities or foreign exchange are bought and sold in different stock exchanges / markets of the world for speculative gains.

Currency conditions

Inflation – repatriation of foreign capital from the county due to decline in purchasing power of domestic currency => depreciation of domestic currency

Deflation – inflow of foreign capital due to appreciation in the value of currency => appreciation of currency