This presentation is the property of its rightful owner.
1 / 18

# Exchange Rates PowerPoint PPT Presentation

Exchange Rates. 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

## Related searches for Exchange Rates

Exchange Rates

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

## Exchange Rates

### 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 domesticcurrency

• Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies

### 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

### 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

### Exchange Rates

Real Exchange Rate (RER)

• 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

### Exchange Rates

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

• 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

PPP impliescurrencies of countries that experience significant inflation will tend to depreciate

• 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?

• 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

• 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”

• Works better in the long run

### Inflation and Currency DepreciationFive Year Window

Currency Depreciation (% pa)

Inflation Differential

### Inflation and Currency DepreciationTwenty Year Window

Currency Depreciation (% pa)

• 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.

### 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