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# Lecture 5 - PowerPoint PPT Presentation

Lecture 5. UNDERSTANDING EXCHANGE RATES (1). What is an “exchange rate”?. The price of one currency in terms of another (say dollars per euro) is called the exchange rate. Foreign exchange (forex) transactions are effected on specific markets for: spot transactions; forward transactions;

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UNDERSTANDING

EXCHANGE RATES (1)

• The price of one currency in terms of another (say dollars per euro) is called the exchange rate.

• Foreign exchange (forex) transactions are effected on specific markets for:

• spot transactions;

• forward transactions;

• futures transactions;

• options

w=€/\$

Appreciation

Depreciation

Appreciation and depreciation

• If you pay more € for forex, your currency € is said to “depreciate”; if you pay less, your currency “appreciates”

• They affect the relative price of domestic and foreign goods.

• When a country’s currency appreciates, the country’s goods become more expensive abroad, and foreign goods become cheaper.

• Will the exchange rate equate foreign and domestic prices?

• Under market conditions, arbitrage will indeed equate prices in the different regions of the domestic economy.

• If there are no barriers to trade, this also applies to international trade.

• If the price level in country A is higher than in country B, the exchange rate should correct for this difference.

• Identical goods should sell for the same price in two separate markets when there are no transportation costs and no differential taxes applied in the two markets.

• Consider the following information about movie video tapes sold in the US and Mexican markets:

• Price of videos in US market (Pv) = \$20

• Price of videos in Mexican market (Pv) = p150

• Spot exchange rate (p/\$) = 10 p/\$

• The dollar price of videos sold in Mexico can be calculated by dividing the video price in pesos by the spot exchange rate.

• If the law of one price held, then the dollar price would have to be p150/10p/\$ = \$15 in Mexico to match the price in the US.

• Since the dollar price of the video is less than the dollar price in the US, the law of one price does not hold in this circumstance.

• If the law holds, we speak of “purchasing-power parity” (PPP).

PPP and short-term exchange rate

PPP, et

Short-term exchange rate (e)

Time t

• The PPP theory makes sense only in the long run.

• In the short run there are significant deviations from PPP due to short-term movements of capital.

• Factors that affect the exchange rates are (w = depreciation, w = appreciation):

• Relative price levels: if P/P*, then w

• Tariffs and quota: if import duty , then w

• A shift in preferences for domestic versus foreign goods:

• if export demand , then w

• if import demand , then w

• Productivity: If productivity , then w

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