LECTURE7 FOREIGN EXCHANGE RATES: MONETARY APPROACH
FOREIGN EXCHANGE MARKET • FOREIGN EXCHANGE RATE • CURRENCY APPRECIATION • CURRENCY DEPRECIATION • PRICE PARITY • INTEREST PARITY RATIO • SPOT EXCHANGE RATE • FORWARD EXCHANGE RATE • REAL EXCHANGE RATE • NOMINAL EXCHANGE RATE
The Key to Understanding the Global Trade • A fallacy students make in trying to understand international trade is to assume that a nation trades only goods. In fact, nations also trade financial assets such as stocks, bonds and bank loans. The United States sells its goods and assets in exchange for other nations’ goods and assets. • Exports are the US goods and services sold to foreigners, and imports are the foreigners’ goods and services purchased by US citizens.
The Key to Understanding the Global Trade • Net exports is the net of the goods and services sold by the United States and equals the value of exports minus the value of imports. • Equivalent to exported goods are the United States assets purchased by foreigners. Equivalent to imported goods are the foreign assets purchased by United States citizens. • Net foreign investment is the net of the assets purchased by United States citizens and equals purchases of foreign assets by United States citizens minus the purchase of United States assets by foreigners.
The Key to Understanding the Global Trade • Unless governments intervene, the total amount of goods and assets bought and sold tend to equally each other. So, • Imports plusforeign assets purchased by United States citizensequalExportsplus United States assets purchased by foreigners.
The Key to Understanding the Global Trade • When the nation buys more than its sells, it has a shortage of foreign currency and the exchange rate for that currency (foreign currency) will rise until the market clears. • When a nation sells more than it buys, it has a surplus of foreign currency and the exchange rate for that currency will fall until imports plus foreign assets purchased by domestic citizens equals exports plus domestic assets purchased by foreigners.
WSJ CURRENCY TRADING COLUMN DATE OF QUOTE SPOT RATES FORWARD RATES WHOLESALE QUOTES: TRADING AMONG BANKS NAME OF COUNTRY’S LEGAL TENDER
AT THIS POINT LET’S ADD A FOREIGN ASSET ( BOND ) TO THE PORTFOLIO DECISION FRAMEWORK. PORTFOLIO CASH ($) DOMESTIC BONDS FOREIGN BONDS COMMON STOCK
FOREIGN EXCHANGE MARKET • Look at the purchase of the bond in this simple sequence. $ PORTFOLIO CASH DOMESTIC BONDS FOREIGN BONDS COMMON STOCK FOREIGN EXCHANGE MARKET
FOREIGN EXCHANGE MARKET • AT THIS POINT LET’S ADD A FOREIGN ASSET ( BOND ) TO THE PORTFOLIO DECISION FRAMEWORK FROM CHAPTER 6 . $ YEN PORTFOLIO CASH DOMESTIC BONDS FOREIGN BONDS COMMON STOCK FOREIGN EXCHANGE MARKET FOREIGN BOND MARKET YEN DENOMINATED BONDS
IF YOU HAVE A CHOICE BETWEEN DOMESTIC AND FOREIGN BONDS THEN THIS IMPLIES THAT THEIR RATES OF RETURN ARE INTERRELATEDAND FURTHERMORE , FOREIGN EXCHANGE RATES MUST BE RELATED TO DOMESTIC INTEREST RATES.
THE PRICE OF ONE COUNTRY’S CURRENCY IN TERMS OF ANOTHER COUNTRY’S CURRENCY IS CALLED THE EXCHANGE RATE . • THE EXCHANGE RATE IS DETERMINED IN THE FOREIGN EXCHANGE MARKET. • THERE TWO KINDS OF EXCHANGE RATE TRANSACTIONS. - SPOT TRANSACTIONS - FORWARD TRANSACTIONS
SPOT TRANSACTIONSINVOLVE IMMEDIATE EXCHANGE OF CURRENCIES OR BANK DEPOSITS. • FORWARD TRANSACTIONS INVOLVE THE EXCHANGE OF CURRENCIES OR BANK DEPOSITS AT SOME FUTURE DATE . HOWEVER, THE CONTRACT TAKES PLACE TODAY.
How to Convert Foreign Prices into Dollars • Let the exchange rate be expressed in terms of dollars. • If the exchange rate is 100 yen, then the US dollar will purchase 100 yen. • Yen / Dollar or yen per Dollar • Dollar Price of Foreign Goods = Foreign Price / Exchange rate • Yen / (Yen / Dollar) = Dollar • If a watch cost 1000 yen and the exchange rate is 100 yen to the dollar, the dollar price is • 1000 / (100/1) = 1000 / 100 = $10 • If the exchange rate goes to 110 to the dollar, the new dollar price would be 1000 / 110 = $9.09
How to Convert Dollar Prices into Foreign Prices • Foreign price = dollar price * exchange rate • From our previous example, • Foreign price = $10 * (100/1) = 1000 Yen • Foreign price = $9.09 * (110/1) =1000 Yen
Problem • The exchange rate for the US dollar is 0.90 British pounds per dollar and 260 Yen per dollar. • How many dollars will it take to buy 1 pound? 1 Yen? • What will a $12,000 Chevrolet cost in Britain? In Japan? • What will a suit costing 200 pounds cost in the US? A 20,000 Yen suit?
Answer • How many dollars will it take to buy 1 pound? 1 Yen? • Pounds / Dollar = 0.90 so Dollar / Pound = 1 / 0.90 = 1.11 • Yen / Dollar = 260 so Dollar / Yen = 1 / 260 = 0.00385 • What will a $12,000 Chevrolet cost in Britain? In Japan? • $12,000 * • $12,000 *
Answer • What will a suit costing 200 pounds cost in the US? A 20,000 Yen suit?
The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. • For example, if you go to your bank, you might see a posted exchange rate of 100 yen per dollar. The posted exchange rate is the nominal rate. • An exchange rate can always be expressed in two ways. • If the exchange rate is 100 yen per dollar, it is also 1/100 (.01) dollar per yen. • If a U.S. dollar will purchase 100 yen, a yen will purchase 1/100 of a U.S. dollar.
The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another country. • For example, suppose you go shopping and find a block of Dutch cheese is twice as expensive as a block of American cheese. • We would say that the real exchange rate is ½ block of Dutch cheese per block of American cheese. • It takes ½ a block of Dutch cheese to purchase a block of U.S. cheese
Like the nominal exchange rate, the real exchange rate is expressed in units of the foreign item per unit of the domestic item but in this case the item is a good rather than a currency. • Take another example. Suppose a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between the American and Japanese rice. • If the nominal exchange rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equivalent to 8,000 yen per bushel.
American rice is half as expensive as Japanese rice. The real exchange rate is ½ bushels of Japanese rice per bushel of American rice. • The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the domestic currencies.
The real exchange rate is a key determinant to a country’s balance of trade. • For example, if a domestic company is trying to decide where to purchase rice in our previous example , the real exchange rate is important. • The real exchange rate indicates where it is cheapest to purchase rice.
APPRECIATION :WHEN A CURRENCY INCREASES IN VALUE RELATIVE TO OTHER CURRENCIES IT IS SAID TO HAVE APPRECIATED. • DEPRECIATION : WHEN A CURRENCY’S VALUE FALLS RELATIVE TO OTHER CURRENCIES IT IS SAID TO HAVE DEPRECIATED.
EXPORTS TO AMERICANS • ASSUME THAT THERE ARE TWO COUNTRIES : AMERICA AND FRANCE. • AND TWO CURRENCIES : DOLLARS AND EUROS. • FRENCH PERSONS MAY WANT TO HOLD (DEMAND) DOLLARS FOR THREE REASONS • TO BUY AMERICAN GOODS • TO BUY AMERICAN BONDS • TO SPECULATE
AMERICANS MAY WANT TO HOLD EUROS ( SUPPLY DOLLARS) FOR THREE REASONS: • TO BUY FRENCH GOODS • TO BUY FRENCH BONDS • TO SPECULATE • THE EXCHANGE RATE IS THE RELATIVE PRICE OF DOLLARS AND EUROS IN TERMS OF EACH OTHER. • EXCHANGE RATES ARE DETERMINED BY SUPPLY AND DEMAND IN COMPETITIVE MARKETS. IMPORTS TO AMERICANS
WHY DO THE SUPPLY AND DEMAND CURVES FOR FOREIGN EXCHANGE HAVE THE SHAPES THAT THEY DO ? • WHAT CAUSES THE SUPPLY AND DEMAND TO SHIFT ? • ASSUME NO BORROWING BETWEEN COUNTRIES IN THIS FIRST EXAMPLE. (ASSUME A LACK OF TRUST AMONG THE INHABITANTS OF THE COUNTIES.)
WHEN U.S. PRODUCERS SELL GOODS IN FRANCE THEY RECEIVE EUROS AND THEY WANT TO CONVERT THOSE EUROS INTO DOLLARS. • IF THEY DO NOT CONVERT THEM THEY WILL HAVE TO DEPOSIT THEM OR INVEST ( BUY BONDS) THEM IN FRANCE-- i.e., LEND THEM TO FRENCH PERSONS. • WHEN FRENCH PRODUCERS SELL IN THE U.S. THEY RECEIVE U.S. DOLLARS AND WANT TO CONVERT THEM TO EUROS. • THUS THERE IS AN EXCHANGE SITUATION.
EUROS/ DOLLARS (E) DDOLLARS US Goods Expensive More Euros per dollar E2 E0 US Goods Cheap Fewer Euros per dollar E1 EXPORTS U.S. DOLLARS $1 $2 $3
HOW WOULD YOU EXPLAIN THE UPWARD SLOPING SUPPLY FUNCTION ? EUROS/ DOLLARS (E) SDOLLARS IMPORTS More Euros per dollar E2 Foreign Goods Cheap E0 Fewer Euros per dollar E1 Foreign Goods Expensive U.S. DOLLARS $1 $2 $3
SDOLLARS EUROS/ DOLLARS ( E ) DDOLLARS IMPORT E2 Exports = Imports Balance of Payments Equilibrium With no borrowing and lending E0 E1 EXPORT U.S. DOLLARS $*