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Chapter 19. The Foreign Exchange Market. Exchange rates Long run factors Short run factors. I. Exchange rates. definitions, data, examples typically exchange rate =. Mexican Peso, Japanese Yen. also quoted as. British pound, Canadian dollar, euro. exchange rate market.

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chapter 19 the foreign exchange market
Chapter 19.The Foreign Exchange Market
  • Exchange rates
  • Long run factors
  • Short run factors
i exchange rates
I. Exchange rates
  • definitions, data, examples
  • typically exchange rate =

Mexican Peso, Japanese Yen

slide3
also quoted as

British pound, Canadian dollar, euro

exchange rate market
exchange rate market
  • spot exchange rates
    • currency exchanges w/in 2 days
  • forward exchange rates
    • currency exchange at future date,

but ratio is set today

why care
why care?
  • determines relative prices
    • imports in U.S.
    • our exports abroad
  • determines relative returns
    • U.S. investments vs. foreign investments
    • financing U.S. debt
example
example
  • GM Saturn
    • $13,500 in U.S.
  • Toyota Corolla
    • 1.8 million yen
case 1 120 yen
case 1: 120 yen/$
  • price of Corolla in U.S.:

1.8 million/120 = $15,000

  • price of Saturn in Japan:

13,500 x 120 = 1.62 million yen

case 2 110 yen
case 2: 110 yen/$
  • $ has depreciated against yen
    • yen has appreciated against $
  • $ has fallen
    • yen has risen
  • $ is weaker
    • yen is stronger
slide13
price of Corolla in U.S.

1.8 million/110 = $16,364

  • price of Saturn in Japan

13,500 x 110 = 1.485 million yen

  • $ depreciated
    • Corolla is more expensive here
    • Saturn is cheaper in Japan
in general
In general,
  • $ appreciates
    • imports cheaper, exports pricier
    • U.S. trade deficit rises
  • $ depreciates
    • imports pricier, exports cheaper
    • U.S. trade deficit falls
slide15
exchange rate movement
    • short-run volatility
    • long-run trends
ii exchange rates in lr
II. Exchange rates in LR

A. Purchasing power parity (PPP)

  • if countries have different inflation rates,
    • exchange rate movement
  • law of one price
    • identical goods should have same value all over world
example1
example
  • pack of gum
  • 120 yen/$
  • gum = $1 in U.S.
  • gum = 120 yen in Japan
slide18
U.S. prices double
    • gum = $2
  • if still 120 yen/$
    • gum is cheaper in Japan (120 yen)
    • everyone buys gum in Japan
  • exchange rate moves,
    • 120 yen/$2 or 60 yen/$
slide19
PPP
  • if U.S. prices rise faster than world,

$ depreciates

  • if U.S. prices rise more slowly,

$ appreciates

slide21
PPP works in LR
  • PPP lousy in SR
  • why?
    • assumes goods transportable cheaply

-- gum, yes

-- haircuts, no

    • assumes goods identical
b other factors
B. Other factors
  • anything impacting relative demand for U.S. stuff vs. foreign stuff
  • increase demand U.S. stuff,

increase demand for $,

$ appreciates

tariffs and quotas
tariffs and quotas
  • U.S. tariffs
  • increase domestic demand
  • $ appreciates
  • (but other nations could retaliate)
preferences
preferences
  • U.S. consumers prefer foreign SUVs
  • increase import demand,

decrease $ demand,

$ depreciates

productivity
productivity
  • U.S. more productive,

make goods at lower cost,

U.S. goods more desirable,

$ demand increases,

$ appreciates

iii exchange rates in sr
III. Exchange rates in SR
  • driven by investor behavior
  • capital mobility
    • investors chose assets globally
example japanese investor
example: Japanese investor
  • U.S. CD ($) or
  • Japanese CD (yen)
  • i$ = 7%, iyen = 5%
  • currently 105 yen/$
  • expect 90 yen/$ in 1 year
japanese cd
Japanese CD
  • deposits 105,000 yen
  • in one year

105,000 (1+.05)

= 110,250 yen

u s cd
U.S. CD
  • convert yen to $ (105 yen/$):

105,000/105 = $1000

  • deposit $1000 in CD
  • in one year:

$1000(1+.07) = $1070

  • convert back to yen (90 yen/$):

$1070 x 90 = 96,300 yen

slide30
U.S. interest rate is higher BUT
  • given expected depreciation of $,
  • investor better off w/ Japanese CD
u s investor
U.S. investor
  • U.S. CD: $1070
  • Japanese CD:

$1000 x 105 = 105,000 yen

105,000(1.05) = 110,250 yen

110,250/90 = $1225

  • U.S. investor better off holding Japanese CD
slide32
in this example,
    • no one would hold a U.S. CD
  • so it must be the case that
    • expected returns equalize across countries
    • interest rate parity
interest rate parity
Interest Rate Parity
  • exp. returns equalize across countries
    • based on interest rate, exchange rates
  • so a change in interest rate

will cause exchange rate to change

interest rates exchange rates
Interest rates & exchange rates
  • nominal interest rate =

real interest rate + exp. inflation rate

  • if nominal interest rate rises, either

real interest rate increased

or

exp. inflation rate increased

slide35
U.S. real interest rate rises
    • increase demand for $
    • $ appreciates
  • foreign real interest rate rises
    • decrease demand for $
    • $ depreciates
slide36
U.S. expected inflation rises
    • under PPP, $ depreciates
  • U.S. money supply rises
    • increase exp. inflation
    • decrease nominal interest rate
    • $ depreciates
why has the u s dollar fallen since 2002
Why has the U.S. dollar fallen since 2002?
  • decline in private foreign investment
    • EU becoming more attractive?
  • twin deficits
    • U.S. trade deficit
    • U.S. federal budget deficits
    • large amount of borrowing makes our currency less attractive
why do we care
Why do we care?
  • U.S. $ as world reserve currency
    • allows us to borrow cheaply
    • falling $ place this status as risk
  • Currency instability
    • huge disruptions to trade, financial markets
the future
The future?
  • some predict continued decline of $
    • compare to British pound 60 years ago…
  • however, $ has been lower…
    • mid 1990s dollar much lower against yen, deutschmark