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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 rates2
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 rates4
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 rates5
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 rates6
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
purchasing power parity
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
purchasing power parity9
Purchasing Power Parity

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

purchasing power parity10
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?
purchasing power parity11
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
purchasing power parity12
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
inflation and currency depreciation five year window
Inflation and Currency DepreciationFive Year Window

Currency Depreciation (% pa)

Inflation Differential

power purchasing parity
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.
exchange rate
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