Todays Agenda

1. Exchange Rates

2. Exchange Rates in the Long-Run

Exchange Rates, 3. Exchange Rates in the Short-Run
Part 1

25-1 25-2

Exchange Rates: The Nominal Rate

Most countries have their own currencies.

International trade and/or financial transactions

require the exchange of the different currencies.
Exchange Rates
The nominal exchange rate, E, is the price of
one currency in terms of another currency.

It is the number of units of one currency that is

exchanged for one unit of another currency.
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1
Exchange Rates: The Nominal Rate
Nominal exchange rates are determined in the
foreign exchange market.
This is an over-the-counter market of several
hundred dealers (mostly banks) actively buying
and selling bank deposits denominated in foreign
currencies.
25-5
Exchange Rates: A Direct Quote
25-7
Exchange Rates: The Nominal Rate
Nominal exchanges rates are quoted two ways:
1. The amount of foreign currency per unit of
domestic currency, a direct quote.
For example, the number of Japanese yen per dollar.
2. The amount of domestic currency per unit of
foreign currency, an indirect quote.
For example, the number of dollars per U.K. pound.
Direct quotes, which we will always use, are
much easier to analyze.
25-6
Exchange Rates: An Indirect Quote
25-8
2
Exchange Rates: The Nominal Rate
Changes in the nominal foreign exchange rate:
1. When a currency rises in value so that it is worth
more units of another currency, an appreciation
occurs.
Alternatively, the currency is said to have increased or
strengthened.
2. When a currency falls in value so that it is worth
less units of another currency, a depreciation
occurs.
Alternatively, the currency is said to have decreased or
weakened.
25-9
Exchange Rates: The Nominal Rate
Two types of nominal foreign exchanges rates:
1. The spot exchange rate is the exchange rate for
spot transactions, which are immediate exchanges
of bank deposits.
2. The forward exchange rate is the exchange rate
for forward transactions, which are exchanges of
bank deposits at some specified future date.
25-10

Exchange Rates: The Real Rate Exchange Rates: The Real Rate
The real exchange rate, , is the price of goods The real exchange rate is given by:
in one country relative to the price of similar
goods in another country. = E * ( P / Pf )

The real exchange rate is also called the terms of where:

trade.
= the real exchange rate,
E = the nominal exchange rate,
P = the domestic general price level, and
Pf = the foreign general price level.

25-11 25-12

3
Exchange Rates: The Real Rate
Changes in the real foreign exchange rate:
1. When the price of goods in one country increases
relative to the price of similar goods in another
country, a real appreciation occurs.
Domestic goods are becoming more expensive relative
to foreign goods.
2. When the price of goods in one country decreases
relative to the price of similar goods in another
country, a real depreciation occurs.
Domestic goods are becoming less expensive relative to
foreign goods.
25-13
Exchange Rates: The Real Rate
The real exchange rate indicates if a countrys
goods are relatively cheap or expensive
compared to a foreign countrys goods.
1. When the real exchange rate is low (i.e., < 1),
domestic goods are cheap relative to similar
foreign goods; it will be relatively easy to export.
2. When the real exchange rate is high (i.e., > 1),
domestic goods are expensive relative to similar
foreign goods; it will be relatively hard to export.
25-14

Exchange Rates: The Real Rate Exchange Rates: Nominal and Real
Exchange $ Price In the short-run, if prices are sticky, then
$ Price Rate, E *E Yen Price
nominal and real exchange rates should move
$100 10,000
together.
$100 10,000
$100 10,000

When > 1, U.S. goods are relatively expensive.

When < 1, U.S. goods are relatively cheap.

25-15 25-16

4
Exchange Rates: Nominal and Real Exchange Rates: Exports & Imports
When prices are sticky, changes in nominal
exchange rates affect the relative price of
domestic versus foreign goods.

25-17 25-18

Exchange Rates: Exports & Imports Exchange Rates: Exports & Imports
US Price Exchange Rate Yen Price Yen Price Exchange Rate US Price
$100 100:$1 10,000 10,000 100:$1 $100
$100 110:$1 11,000 10,000 110:$1 $91
$100 120:$1 12,000 10,000 120:$1 $83
Dollar appreciation increases the Yen price of Dollar appreciation also decreases the dollar
U.S. exports. price of U.S. imports.
So the Japanese buy fewer U.S. goods and U.S. So Americans buy more Japanese goods and U.S.
exports decline. imports increase.
25-19 25-20

5
Exchange Rates: Exports & Imports
Currency appreciation has the following effects:

1. The countrys exported goods become more

expensive to foreigners who buy fewer of them
and exports decline. Exchange Rates in the Long-Run
2. The countrys imported goods becomes less
expensive to domestic residents who buy more of
them and imports increase.

3. The countrys net exports decline.

25-21 25-22

Exchange Rates in the Long-Run Exchange Rates in the Long-Run

In the long-run, the real exchange rate equals 1. The law of one price says that if:

This is called Purchasing Power Parity, PPP. 1. Two countries produce an identical good and

PPP says that the nominal exchange rate adjusts to make 2. Transportation costs and trade barriers are low,
the price of goods in different countries equal. then

This is an application of the law of one price. 3. The price of the good will be the same in both
countries.

The nominal exchange rate adjusts to make

the price of the good equal in both countries.
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6
Exchange Rates in the Long-Run Exchange Rates in the Long-Run
The real exchange rate is given by: When:
P = Pf / E
= E * (P / Pf)
then similar goods have the same price in terms of
When purchasing power parity holds: the same currency.

=1 Alternatively, the purchasing power of the domestic

currency is the same as the purchasing power of the
Combining and re-arranging terms: foreign currency.

P = Pf / E
25-25 25-26

Exchange Rates in the Long-Run Exchange Rates in the Long-Run

Now, the real exchange rate is given by: Solving for the change in the nominal exchange
rate yields:
= E * (P / Pf)
%E % + f -
In percentage change terms this is:
A nominal appreciation is due to either:
% %E + %P - %Pf
1. A real appreciation, and/or
or
2. Higher relative foreign inflation (or lower relative
% %E + - f domestic inflation).
25-27 25-28

7
Exchange Rates in the Long-Run Exchange Rates in the Long-Run
When purchasing power parity holds, or when The Big Mac index:
the real exchange rate does not change, then:
If PPP held exactly, the real exchange rate would be
%E f 1 and all the prices in terms of dollars would be
identical.

Nominal exchange rate movements only reflect But the data show that this is not the case.
differences in relative inflation.
The data also indicate which currencies are:
This is called relative purchasing power parity. 1. Overvalued ( > 1) or
2. Undervalued ( < 1).
25-29 25-30

Exchange Rates in the Long-Run Exchange Rates in the Long-Run

PPP seems to hold in the long-run but does not
hold in the short-run because:

1. Countries actually produce different goods,

2. Many goods are not traded internationally,

3. There are transportation costs, and

4. There are legal barriers to trade.

25-31 25-32

8
 Exchange Rates in the Short-Run
Nominal exchange rates are determined:

1. In a flexible (or floating) exchange rate system

where the demand for domestic currency-
Exchange Rates in the Short-Run denominated assets equals the supply for domestic
currency-denominated assets.

2. In a fixed exchange rate system by the

government which must intervene in the foreign
exchange market to maintain the fixed exchange
rate.
25-33 25-34

Exchange Rates in the Short-Run Exchange Rates in the Short-Run

In a flexible or floating exchange rate system, The supply of domestic currency-denominated
the nominal exchange rate will appreciate or assets is assumed to be fixed and independent
depreciate whenever there is a change in either: of both the nominal and real exchange rate.

1. The demand for domestic currency-denominated Therefore, the supply curve for domestic currency-
assets, and/or denominated assets is vertical with respect to the
nominal exchange rate.
2. The supply of domestic currency-denominated
assets.

25-35 25-36

9
Exchange Rates in the Short-Run Exchange Rates in the Short-Run
E (Yen:$) The demand for domestic currency-
denominated assets is determined by the
expected return on domestic assets relative to
foreign assets.

Assuming perfect capital mobility, this includes:

1. The interest earned, and

2. Any expected change in the value of the assets which

includes the expected future exchange rate, Eet+1.
Q$ Assets
25-37 25-38

Exchange Rates in the Short-Run Exchange Rates in the Short-Run

Suppose that:
Year 0 Year 1
1. We have $1,000,000 to invest for one year.
U.S.: $1,000,000 5% $1,050,000
2. The U.S. or domestic interest rate is 5%.

3. The Japanese or foreign interest rate is 10%. Spot: 100 : $1

4. The yen-dollar spot exchange rate is 100:$1.

Japan: 100,000,000 10% 110,000,000
Should we invest in the U.S. or in Japan?
25-39 25-40

10
Exchange Rates in the Short-Run
With a forward exchange rate of 104.76 this
transaction represents a risk-free arbitrage.
This is called covered interest parity.
Replace the forward exchange rate with the
expected future exchange rate, Eet+1.
This is called uncovered interest parity.
25-41
Exchange Rates in the Short-Run
Suppose the future exchange rate was expected
to be less than the forward exchange rate, i.e.,
suppose Eet+1 < 104.76.
If Eet+1 < 104.76, investors would want to:
1. Invest in the Japan,
2. Which increases the demand for Japanese yen,
3. Leading to an appreciation of the yen, and
4. A depreciation of the dollar.
25-43
Exchange Rates in the Short-Run
Suppose the future exchange rate was expected
to be more than the forward exchange rate, i.e.,
suppose Eet+1 > 104.76.
If Eet+1 > 104.76, investors would want to:
1. Invest in the U.S.,
2. Which increases the demand for U.S. dollars,
3. Leading to an appreciation of the dollar, and
4. A depreciation of the yen.
25-42
Exchange Rates in the Short-Run
For a given expected future exchange rate, Eet+1,
the lower the current exchange rate is, the more
likely it is that the dollar will appreciate.
This increases the expected return on dollar assets
and, therefore, increases the demand for dollars.
Thus, the quantity of dollar assets demanded
will be inversely related to the exchange rate.
The demand curve is downward sloping.
25-44
11
Exchange Rates in the Short-Run Exchange Rates in the Short-Run
E (Yen:$) The foreign exchange market is in equilibrium
when the quantity of dollar denominated assets
demanded exactly equals the quantity of dollar
denominated assets supplied.

Q$ Assets
25-45 25-46

Exchange Rates in the Short-Run Exchange Rates in the Short-Run

E (Yen:$) S$ An exchange rate higher than the equilibrium
exchange rate implies that the quantity of dollar
assets supplied is greater than the quantity of
dollar assets demanded (excess supply).
E0
An exchange rate lower than the equilibrium
exchange rate implies that the quantity of dollar
D$ assets demanded is greater than the quantity of
dollar assets supplied (excess demand).
Q$ Assets
25-47 25-48

12
Exchange Rates in the Short-Run
Assuming that the supply curve does not shift,
then all changes in the exchange rate are caused
by changes in the demand for dollar
denominated assets.
25-49
Exchange Rates in the Short-Run
Thus, the demand curve for domestic currency-
denominated assets shifts if there are changes
in:
1. The domestic real interest rate, rD,
2. The foreign real interest rate, rF, and/or
3. The expected future exchange rate, Eet+1.
25-51
Exchange Rates in the Short-Run
The demand for dollar assets is derived from the
uncovered interest parity condition:
Et = 1 + iD * Eet+1
1 + iF
In the short-run when prices are sticky, changes
in the nominal interest rates causes similar
changes in the real interest rate.
25-50
Exchange Rates in the Short-Run
1. The domestic real interest rate, rD.
An increase in the domestic real interest rate, rD,
shifts the demand curve for domestic assets, D$, to
the right, causing the domestic currency to
appreciate, E.
25-52
13
Exchange Rates in the Short-Run Exchange Rates in the Short-Run
E (Yen:$) S$ 2. The foreign real interest rate, rF.

An increase in the foreign real interest rate, rF, shifts

the demand curve for domestic currency assets, D$,
to the left, causing the domestic currency to
E0 depreciate, E.

D$

Q$ Assets
25-53 25-54

Exchange Rates in the Short-Run Exchange Rates in the Short-Run

E (Yen:$) S$ 3. The expected future exchange rate, Eet+1.

An increase in the expected future exchange rate,

e
E t+1, shifts the demand curve for domestic currency
assets, D$, to the right, causing the domestic
E0 currency to appreciate, E.

D$

Q$ Assets
25-55 25-56

14
Exchange Rates in the Short-Run
E (Yen:$) S$

The End
E0

D$

Q$ Assets
25-57 25-58

15