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The ForeignExchange
Market and
Exchange Rates
Exchange Rates
The nominal exchange rate is the price of one
countrys exchange rate in terms of anothers.
Example: In India, if you want to buy a dollar,
it costs 50 Rupees on the market- so, the
nominal exchange for dollars is 1/50=.02
dollars per rupee in India. In the U.S, the
nominal exchange rate for a rupee is 50
rupees to the dollar.
Real E.R
Formula: EXr=[EX X P]/Pf
Real E.R= (Nominal ER X Domestic Price)/Foreign
Price
= (Rs.50/$1 )*($10)/Rs.250=2 Indian Shirts/1 U.S
Shirt
So shirts are in real terms, twice as expensive in the
U.S as they are in India
Price indices
In reality, we compare not prices of any
particular good, but general prices
(price indices) (basket of goods
containing lots of common items)
So we compare general price levels
Example
EXr/EXr= EX/EX+P/P-Pf/Pf
Let us take our previous example and say that
that shirts cost more in the US- (now they are
$15). The RER is now
(Rs.50/$1 )*($15)/Rs.250=3 Indian Shirts/1
U.S Shirt
The change in EX=0, in P=50% in Pf=0
Change in EXr=50%
Foreign-Exchange Markets
Spot market transactions involve immediate
exchanges of currency or bank deposits.
Example: I exchange one dollar for 45 rupees
today
Forward transactions involve future
exchanges of currencies or bank deposits.
Example: I buy a contract today to exchange
$1 for 45 rupees 3 months from now? Why?
Zero sum game.
Determining Short-run
Exchange Rates
Investors compare the return on a
domestic asset with the return on a
foreign asset evaluated in terms of
domestic currency.
Rules
Nominal interest rate parity: ceteris paribus, the
nominal returns of domestic and foreign assets must
be equal.
International capital mobility results in an exchange
rate market equilibrium reflecting the nominal
interest rate parity condition: When domestic and
foreign assets have identical risk, liquidity, and
information characteristics, their nominal returns
(measured in the same currency) also must be
identical (i = if EXe/EX).
Real interest rate parity: expected real rates of
interest are equal. (1 + r) = (1 + rf)(EXrr/EXre ).
Effect of Changes in
Exchange Rate Expectations
Play ball!
You are a currency speculator. Choose
(as soon as you can) what currency,
Yen or the Dollar, you would under the
following bits of news
Choices
Japanese productivity continues to increase
U.S announces unilateral tariffs on all
Japanese products
U.S products seen to be of better quality
Japanese raise interest rates
Higher expected inflation in the U.S
Moodys downgrades Japanese bonds
U.S trade deficit continues to rise