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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

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Exchange Rates

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Exchange Rates

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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

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Exchange Rates

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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

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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

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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

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Exchange Rates

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Purchasing Power Parity

Law of One Price and Purchasing Power


  • 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

  • Purchasing Power Parity (PPP)

    • 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

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Purchasing Power Parity

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

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Purchasing Power Parity

  • 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?

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Purchasing Power Parity

  • 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

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Purchasing Power Parity

  • 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”

    • Nontradable sector

      • Higher productivity, higher nontradable wages, higher nontradable inflation

  • Works better in the long run

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Price differences between US and Canadian Cities.Figure 19.4

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Inflation and Currency DepreciationFive Year Window

Currency Depreciation (% pa)

Inflation Differential

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Inflation and Currency DepreciationTwenty Year Window

Currency Depreciation (% pa)

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Power Purchasing Parity

  • 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.

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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

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