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Exchange Rates


Nominal exchange rate: price of one currency in terms of another currency ... NX will tend to be low when the real exchange rate is high. ... – PowerPoint PPT presentation

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Title: Exchange Rates

Exchange Rates
Exchange Rates
  • Exchange Rates
  • Nominal exchange rate price of one currency in
    terms of another currency (bilateral exchange
  • example 1.30 dollars per euro or 76.92 euros per
  • determines price of imports
  • foreign exchange market
  • denote as enom , units of the foreign currency
    per unit of domestic currency
  • Nominal effective exchange rate average nominal
    exchange over several other important
    trade-related currencies

Exchange Rates
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 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 Rates
  • Real Exchange Rate (RER)
  • If a countrys 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 gt
  • Real exchange rate is an index and is unit-less

Exchange Rates
Purchasing Power Parity
  • Law of One Price and Purchasing Power
  • Parity
  • Identical goods services should sell at same
    price no matter where they are soldotherwise
    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 Parity
PPP implies currencies of countries that
experience significant inflation will tend to
Purchasing Power Parity
  • Example
  • How many Indian rupees equal to one Australian
  • Bushel of grain cost 5 Australian dollars or 150
  • 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 301, what should happen?

Purchasing Power Parity
  • How many Indian rupees equal one Australian
  • 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 5150 or 130
  • Now implied exchange rate 5300 or 160
  • 1 Australian dollar 60 rupees
  • Nominal exchange rate increased from 30 to 60
    rupees/Australian dollar
  • Indian currency depreciated
  • Australian currency appreciated

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

Price differences between US and Canadian Cities.
Figure 19.4
Inflation and Currency DepreciationFive Year
Currency Depreciation ( pa)
Inflation Differential
Inflation and Currency DepreciationTwenty Year
Currency Depreciation ( pa)
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
  • RER reflects competitivenessthe higher a
    countrys RER, the more expensive its goods and
    services are to foreigners.
  • gt as the RER?, a countrys NX growth will ?,
    leading to a current account deficit (and vice
  • Note nominal exchange rate can fall but be
    offset by higher domestic inflation so that RER
    stays constant