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10. Foreign Exchange. The basics Long run / PPP Short run / Demand & Supply Gov’t intervention. Exchange rates (XR). Price of one countries currency in terms of another Impacts Relative prices of imports/exports Attractiveness of domestic vs. foreign assets. Two ways to quote XR.

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10 foreign exchange
10. Foreign Exchange
  • The basics
  • Long run / PPP
  • Short run / Demand & Supply
  • Gov’t intervention
exchange rates xr
Exchange rates (XR)
  • Price of one countries currency in terms of another
  • Impacts
    • Relative prices of imports/exports
    • Attractiveness of domestic vs. foreign assets
two ways to quote xr
Two ways to quote XR
  • Foreign currency per 1 US $
  • Used to quote
    • Yen (Japan)
    • Yuan (China)
    • Won (S. Korea)
    • Peso (Mexico)
    • Rupees (India)
    • Canadian $
xr market
XR market
  • Worldwide market
  • $1 trillion in transactions daily
  • 90% involve US $
    • Size of economy
    • Store of value
    • World price of oil in US $
nominal xr
Nominal XR
  • Rate of one country’s currency exchanges for another
us depreciation
US $ Depreciation
  • US $ buys less of foreign currency
  • 2000-2008
    • Canada, Euro, UK, China . . .
    • Most major trading partners
  • US $ has fallen
  • US $ is weaker
us appreciation
US $ appreciation
  • US $ buys more of foreign currency
  • 2000-2008
    • Mexico
  • US $ has risen
  • US $ is stronger
slide15
Example: Yen/$
  • If $ appreciates, the Yen must depreciate
  • XR are a “seesaw”
  • XR changes have winners and losers
real xr
Real XR
  • Relative cost of certain goods in two countries
  • Changes in the nominal XR
example u s vs can
Example: U.S. $ vs. Can $
  • SUNY tuition, nonresident
    • Fall 2000: $4150/sem
    • Fall 2007: $5305/sem
    • The finest system of public higher ed in the nation: priceless
  • XR
    • Fall 2000: $1.50 C$ per 1 US $
    • Fall 2007: $1.10 C$ per 1 US $
how much is tuition to a canadian student
How much is tuition to a Canadian student?
  • Convert US $ tuition to Can $
  • 2000: 4150(1.50) = C$ 6225
  • 2007: 5305(1.10) = C$ 5835.50
  • Can $ appreciation means an actual fall in tuition for Canadian students
slide19
U.S. $ depreciation
    • Imported goods more expensive
    • Less purchasing power abroad
    • Exports less expensive abroad
    • Foreign visitors have more purchasing power
slide20
Univ of W. Ontario, nonresident
    • Fall 2000: C$ 5190/sem
    • Fall 2007: C$ 7300/sem
  • Tuition costs for a U.S. student
    • 2000: 5190/1.5 = $3460
    • 2007: 7300/1.1 = $6636
xr in the long run
XR in the long run
  • Primarily depends on relative inflation
  • Law of One Price
    • Identical goods should be about the same price everywhere in the world
slide22
Pack of gum
  • If $1 = 115 yen
    • Then gum should cost $1 in U.S. and 115 Y in Japan
slide23
Now suppose prices double in US, so gum is $2.
  • At the XR of 115Y/$, gum is cheaper in Japan
    • Gum is 115Y or $1 in Japan
    • Run on gum in Japan
slide24
To equalize things,
    • XR moves: $ must depreciate
    • 57.5Y/$ then gum is same price
purchasing power parity ppp
Purchasing power parity (PPP)
  • XR adjust to relative price changes in two countries, so law of one price holds
  • If US inflation is higher than other countries
    • $ depreciate
    • If lower, then $ appreciates
slide26
Does PPP hold?
    • In the long run, yes
    • In the short run, no way
      • Big Mac Index (240-41)
      • Not all goods identical or traded across countries
other lr factors
Other LR factors
  • Trade barriers—tariffs/quotas
    • Boost domestic demand
    • $ appreciates
  • Productivity -- GDP/labor hour
    • Higher relative productivity in US
    • $ appreciates
xr in the short run
XR in the Short Run
  • Supply and Demand, US $
  • Explains short term volatility
who supplies to xr market
Who supplies $ to XR market?
  • People buying foreign goods
  • People investing in foreign assets
  • As $ appreciates (Price of $ rises)
    • People buy more foreign goods because they are cheaper
    • Supply slopes up
slide31

E/$

Q of $

S

who demands in xr market
Who demands $ in XR market?
  • People wanting to buy U.S. goods or dollar assets
  • As $ depreciates (Price of $ falls)
    • People buy more US goods because they are cheaper
    • Demand slopes down
slide33

E/$

Q of $

S

D

what causes the to depreciate
What causes the $ to depreciate?
  • An increase in the supply of $
  • A decrease in the demand for $
what increases supply
What increases $ supply?
  • Increase in preference for foreign goods
  • An increase in US GDP and income
    • Buy more imports
  • An increase in real interest rate on foreign bonds relative to US OR decrease in relative foreign investment risk
    • Investors supply more $ to buy them
  • Expectation of $ depreciation
    • People supply $ now
what decreases demand
What decreases $ demand?
  • Decrease in preference for US goods in foreign countries
  • A decrease in foreign GDP/income
  • A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments
  • An expected depreciation of the $
so what is causing depreciation
So what is causing $ depreciation?
  • Trade deficit
    • US imports > US exports

As $ depreciates, this will narrow the trade deficit

  • Federal deficit
    • World market believes the US borrows too much?
consequences
Consequences?
  • The good:
    • Rising US exports
    • Tourism in US
    • Less pressure for trade barriers
slide41
The bad:
    • Possible inflation (higher import prices)
    • US tourists abroad
    • US debt less attractive
    • Pressure to move oil pricing to Euros
government intervention
Government Intervention
  • Can the government affect XR markets?
    • Yes, but interventions are rare
    • Only effective if nations cooperate, scale is large
    • At best interventions are short run solutions