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## Exchange Rates and Purchasing Power Parity

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Presentation Transcript

Introduction

- Exchange rates matter in many different ways to many different constituencies in the world economy
- Much of this section on international finance will be directly or indirectly concerned with exchange rates

The Nominal Exchange Rate

- Relative price of two currencies
- Often expressed as number of units of local or home currency required to buy a unit of foreign currency
- We will usually view Mexico (peso) as our home country and United States (dollar) as our foreign country
- Nominal or currency exchange rate (e) is

- If e increases the value of the peso (home currency) falls
- If e decreases the value of the peso (home currency) rises
- e and the value of the peso are inversely related
- e is often graphed as its inverse which is equal to the value of the peso

The Real Exchange Rate

- Measures the rate at which two countries’ goods trade against each other
- Makes use of the price levels in the two countries under consideration
- PM—overall price level in Mexico (the home country)
- PUS—overall price level in the United States (the foreign country)

The Real Exchange Rate

- Suppose that the price level in the United States rises
- Takes more Mexican goods to purchase US goods
- Represents a fall in the real value of the peso
- Suppose that the price level in Mexico rises
- Takes fewer Mexican goods to purchase US goods
- Represents a rise in the real value of the peso
- Suppose that the nominal exchange rate increases
- Takes more Mexican pesos to buy a US dollar and, therefore, more Mexican goods to buy US goods
- Represents a fall in the real value of the peso
- Real exchange rates affected by both nominal exchange rates and price levels

Exchange Rates and Trade Flows

- is in dollar terms
- Multiplying it by e gives us in peso terms

- Changes in e have an impact on trade flows
- Consider the case of Mexico’s imports and exports
- World prices (PW) are typically in US dollar terms
- Mexican prices (PM) are in peso terms
- Relationship between the peso and world prices of Mexico’s import (Z) goods can be expressed as

Exchange Rates and Trade Flows

- Suppose e were to increase (the value of the peso falls)
- Movement down the scale in Figure 13.1 increases the peso price of the imported good in Mexico
- Import demand consequently decreases
- Suppose e were to decrease (the value of the peso rises)
- Movement up the scale in Figure 13.1 decreases the peso price of the imported good in Mexico
- Import demand consequently increases

Exchange Rates and Trade Flows

- Relationship between the peso and dollar prices of Mexico’s exported (E) goods can be expressed as

- Suppose e were to increase (the value of the peso falls)
- Movement down the scale in Figure 13.1 increases the peso price of the export good in Mexico
- Export supply in Mexico consequently increases
- Mexican firms now have more of an incentive in peso terms to export

Exchange Rates and Trade Flows

- Suppose e were to decrease (the value of the peso rises)
- Movement up the inverse scale in Figure 13.1 decreases the peso price of exports in Mexico
- Export supply consequently decreases
- Can put the relationships of Figures 13.2 and 13.3 together
- Figure 13.4 represents the positive relationship between value of peso and trade deficit, or Z – E

The Purchasing Power Parity Model

- Begins with the hypothesis that the nominal exchange rate will adjust so that the purchasing power of a currency will be the same in every country
- Implications of hypothesis
- Purchasing power of a currency in a given country is inversely related to price level in that country
- For example, purchasing power of the peso in Mexico can be expressed as

- The higher the price level in Mexico the lower the purchasing power of the peso
- Purchasing power of peso in United States is more complicated
- Need rate at which a peso can be exchanged into dollars, or 1/e
- Need purchasing power of a dollar in United States, or 1/PUS
- Purchasing power of a peso in United States is

PPP Equation

- PPP hypothesis is

- Invert the equation

- Divide both sides of the above equation by PUS to obtain PPP equation

Meaning of PPP Equation

- Suppose PM were to increase
- According to the PPP model, e would increase
- Value of the peso would move down the scale in Figure 13.1
- Suppose PUS were to increase
- According to the PPP model e would decrease
- Value of the peso would move up the scale in Figure 13.1
- Nominal value of the peso adjusts to changes in its real purchasing power in the two countries

Meaning of PPP Equation

- Restrictiveness of PPP model can be seen when we re-express it in a third equation
- Multiplying both sides of the PPP equation by

- Obtain modified PPP equation

- Compare this equation with real exchange rate

PPP Model as Special Case

- PPP model is a special case of the real exchange rate
- Implies that real exchange rate is fixed at unity
- No change in real exchange rate
- However real exchange rates do change therefore there must be important elements of the real world that the PPP theory ignores
- PPP assumes all goods entering into the price levels of both countries are internationally traded
- Phenomenon of product differentiation
- Allows for separate markets (and therefore prices) for import and domestic varieties of a good

PPP Model as Special Case

- Real exchange rate equation captures reality at any point in time
- PPP relationship never holds exactly
- PPP equation gives a sense of a long-term tendency towards which nominal exchange rates move absent other changes

Exchange Rate Exposure

- If sales from either exporting or foreign direct investment are not denominated in the currencies of the firms’ home countries
- Exchange rate exposure issues arise
- Suppose that the €/US$ exchange rate is currently at a value of 1.00
- Suppose also that a US firm is expecting euro revenues of €1.0 million
- Current exchange rate (spot rate) suggests US firm might be expecting dollar revenues of US$1.0 million
- Suppose, however, that the spot rate moves to e = 1.25 (a dollar value of the euro of $0.80)
- Now takes more euros to purchase a dollar—dollar revenues shrink to $800,000

Forward Markets

- For some currencies forward rates also exist
- Rates of current contracts for “forward” transactions in currencies
- Usually for one, three, or six months in the future
- If the forward rate of the euro (€/US$) is exactly the same as the spot rate
- Euro is “flat”
- If the forward rate of the euro is above the spot rate
- Euro is at a “forward discount”
- If the forward rate of the euro is below the spot rate
- Euro is at a “forward premium”
- Hedging exchange rate exposure requires that firms have expectations or forecasts of future spot rates that they can compare to forward rates

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