Ch. 29: Open Economy:Foreign Exchange

• The Prices for International Transactions: Real and Nominal Exchange Rates

• Nominal Exchange Rates: • Rate you can trade one currency for

another • 80 yen per dollar or 1/80 = .0125 dollar

per yen

• “appreciation” or stronger: dollar buys……more foreign currency• “depreciation” or weaker: dollar buys…..less foreign currency

• When exchange rate changes from 80 yen per dollar to 90 yen per dollar: the dollar has……

appreciated because …..the dollar can now buy more yen • When exchange rate changes from 90 yen per

dollar to 80 yen per dollar: the dollar has…..depreciated because ……the dollar can now buy less yen

FOREX: Who, What, Where, When, Why

• Exchange rates are determined in the foreign exchange market

• open to a wide range of different types of buyers and sellers

• currency trading is continuous: 24 hours a day except weekends.

• The spot exchange rate refers to the current exchange rate.

• The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

(*not responsible for this info*)

• People may need to exchange currencies in a number of situations.

• Example: travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller's cheques or a travel-card.

• From a local money changer they can only buy foreign cash

(*not responsible for this info*)

• At the destination, the traveler can buy local currency at the airport, either from a dealer or through an ATM.

• They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch.

• When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate.

• If they have traveler's cheques or a travel card in the local currency, no currency exchange is necessary.

(*not responsible for this info*)

• If a traveler has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer.

• The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next.

(*not responsible for this info*)

• A currency pair is the …..• quotation of the relative value of a currency

unit against the unit of another currency in the foreign exchange market. (= e = nominal exchange rate)

• The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars.

USD GBP CAD EUR AUD

$1 US will buy: 0.64478 1.01455 0.76359 0.96702

• An exchange rate index - • way of measuring the performance of a

currency against a basket of other currencies.• US Dollar Index• For example, the US dollar index measures the

US dollar against 6 main currencies.

Real Exchange Rate

• Rate you can trade goods/services of one country for that of another

• Ex: for every case of American beer you can buy, you would get 2/3 case of German beer

Real and Nominal Exchange Rates working together Ex: American rice = $100/bushel Japanese rice = 16,000 yen/bushel• What is the real exchange rate? = nominal x domestic P / foreign P• e x P / P*• use to convert prices into a common currency

• e x P / P* (80 yen/$) x ($100/bushel US rice) (16,000yen/bushel Japanese rice) =

8,000 yen / per bushel US rice 16,000 yen/per bushel Japanese rice = ½ bushel Japanese rice per bushel of American rice

• Real Exchange Rate = key determinant of how much a country imports or exports

• Use the Price of basket of goods for both US price (P) and foreign price (P*) and the nominal exchange rates (e)

• Measures the price of a basket of goods domestically relative to the price of foreign goods

• Finding the nominal exchange rate:e = P* / P (-assuming there is purchasing power parity)

• Convert foreign price of good to US $: P*/ e

Purchasing Power Parity

• Purchasing power of the dollar is = to that of other currencies

• According to the theory: The ( e ) between two countries must reflect the different price levels in those countries

• ( e ) change when PL changes **When increase MS, PL increases = value

decreases = depreciate vs. other currencies

If Britain pursues tighter MS and less inflation than the US, then the value of the Pound will appreciate vs. the US $

If the US pursues easy MS and allows more inflation than Britain, then the value of the US$ will depreciate vs. the Pound

• Purchasing Power Parity does not always hold true

• Many goods are not easily traded • Not always perfect substitutes

Case Study: Increasing Openness of the US Economy

• Transportation (ships/jets) • Telecommunications • Technology – change in kinds of goods (easily

transported) • Govt. policies – more free trade : NAFTA,

GATT

Case Study: Are US Trade Deficits a National Problem?

Trade deficit a problem? Maybe a symptom of the problem …= reduce

national savings …. = not providing for future

FOREX Market • Demand curve = Demand for US $ …comes from • Foreign Demand for : • US exports • US financial investments (savings) • Speculation • Ex : if D for US goods increases, shift D for US $ to

right = appreciate• Ex: if Int. Rates in US increase, shift D for US $ to

right = appreciate …..why? ..• Higher int rates = incentive for foreigners to buy US

$ to save (bonds) ….= higher return on their financial investments

• Supply curve = Supply of US $...comes from: • Americans buy imports• US buy foreign financial investments (savings) • Speculation

• If US imports (M) increase = increase Supply of US $ = Supply shifts right = depreciate

• If Foreign int. rates increase = increase Supply of US $ = Supply shifts right = depreciate..why…

• If foreign int rates increase = incentive for Americans to supply $ to buy foreign bonds (savings