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Chapter 19. The Foreign Exchange Market

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forward exchange rates. currency exchange at future date, but ratio is set today. why care? ... of borrowing makes our currency less attractive. Why do we ... – PowerPoint PPT presentation

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Title: Chapter 19. The Foreign Exchange Market


1
Chapter 19. The Foreign Exchange Market
  • Exchange rates
  • Long run factors
  • Short run factors

2
I. Exchange rates
  • definitions, data, examples
  • typically exchange rate

Mexican Peso, Japanese Yen
3
  • also quoted as

British pound, Canadian dollar, euro
4
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

5
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6
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8
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9
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

10
example
  • GM Saturn
  • 13,500 in U.S.
  • Toyota Corolla
  • 1.8 million yen

11
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

12
case 2 110 yen/
  • has depreciated against yen
  • yen has appreciated against
  • has fallen
  • yen has risen
  • is weaker
  • yen is stronger

13
  • 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

14
In general,
  • appreciates
  • imports cheaper, exports pricier
  • U.S. trade deficit rises
  • depreciates
  • imports pricier, exports cheaper
  • U.S. trade deficit falls

15
  • exchange rate movement
  • short-run volatility
  • long-run trends

16
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

17
example
  • pack of gum
  • 120 yen/
  • gum 1 in U.S.
  • gum 120 yen in Japan

18
  • 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/

19
PPP
  • if U.S. prices rise faster than world,
  • depreciates
  • if U.S. prices rise more slowly,
  • appreciates

20
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21
  • PPP works in LR
  • PPP lousy in SR
  • why?
  • assumes goods transportable cheaply
  • -- gum, yes
  • -- haircuts, no
  • assumes goods identical

22
B. Other factors
  • anything impacting relative demand for U.S. stuff
    vs. foreign stuff
  • increase demand U.S. stuff,
  • increase demand for ,
  • appreciates

23
tariffs and quotas
  • U.S. tariffs
  • increase domestic demand
  • appreciates
  • (but other nations could retaliate)

24
preferences
  • U.S. consumers prefer foreign SUVs
  • increase import demand,
  • decrease demand,
  • depreciates

25
productivity
  • U.S. more productive,
  • make goods at lower cost,
  • U.S. goods more desirable,
  • demand increases,
  • appreciates

26
III. Exchange rates in SR
  • driven by investor behavior
  • capital mobility
  • investors chose assets globally

27
example Japanese investor
  • U.S. CD () or
  • Japanese CD (yen)
  • i 7, iyen 5
  • currently 105 yen/
  • expect 90 yen/ in 1 year

28
Japanese CD
  • deposits 105,000 yen
  • in one year
  • 105,000 (1.05)
  • 110,250 yen

29
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

30
  • U.S. interest rate is higher BUT
  • given expected depreciation of ,
  • investor better off w/ Japanese CD

31
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

32
  • 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

33
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

34
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

35
  • U.S. real interest rate rises
  • increase demand for
  • appreciates
  • foreign real interest rate rises
  • decrease demand for
  • depreciates

36
  • U.S. expected inflation rises
  • under PPP, depreciates
  • U.S. money supply rises
  • increase exp. inflation
  • decrease nominal interest rate
  • depreciates

37
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38
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

39
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

40
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
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