Exchange Rates and Purchasing Power Parity Brian Greber Spring, 2017

Exchange rate. The exchange rate is the price at which the currency of one country can be converted to the currency of another. Although some exchange rates are fixed by agreement, most fluctuate or float from day to day Dictionary of Financial Terms. Copyright © 2008 Lightbulb Press, Inc. All Rights Reserved

Depreciation vs Appreciation One unit of your currency buys less of the foreign currency One unit of foreign currency buys more units of your currency. Cost of foreign goods goes up in your currency. Cost of your exports is less in the foreign currency. Appreciation One unit of your currency buys more of the foreign currency One unit of foreign currency buys less units of your currency. Cost of foreign goods goes down in your currency. Cost of your exports is more in the foreign currency.

Currency Impacts Imports Exports Effect Dollar Appreciates (Strengthens) Foreign Imports Less Expensive to US Consumers US Exports More Expensive to Foreign Consumers US Consumption up; US Production Down; Foreign Consumption Down; Foreign Production Up Dollar Depreciates (Weakens) Foreign Imports More Expensive to US Consumers US Exports Less Expensive to Foreign Consumers US Consumption Down; US Production UP Foreign Consumption Up; Foreign Production Down

Purchasing Power Parity equivalent buying power in different currencies: a way of estimating national income by showing the number of currency units required to buy the same amount of goods and services in another country as one currency unit would buy at home Encarta® World English Dictionary[North American Edition] © & (P) 2009 Microsoft Corporation. All rights reserved Currency & Exchange theory linking exchange rate to purchasing power a theory that the exchange rate between two currencies is in equilibrium when the purchasing power of currency is the same in each country. If a basket of goods costs £100 in the United Kingdom and $150 for an equivalent in the United States, for equilibrium to exist, the exchange rate would be expected to be £1 = $1.50. If this were not the case, arbitrage would be expected to take place until equilibrium was restored http://www.qfinance.com/dictionary/purchasing-power-parity

Working with Currencies Go to a currency calculator and “ground” your understanding Review Trends in Exchange Rates Look up PPP Strategize About the Future

Currency Converter https://www.oanda.com/currency/converter/

Review Trends https://fred.stlouisfed.org/series/EXUSEU Confirm Data Reflects the Conversion rate Sought: Note, in this case the data is reported as $’s per Euro. We wanted Euro’s per dollar. https://fred.stlouisfed.org/series/EXUSEU

Review Trends https://fred.stlouisfed.org/series/EXUSEU In this instance, I took 1/($’s/Euro) = Euro’s/dollar https://fred.stlouisfed.org/series/EXUSEU

Look-up PPP http://stats.oecd.org/Index.aspx?DataSetCode=CPL

Strategize About Future In the long-run, it is assumed that the exchange rate should “trend” at the level of PPP. Currently, Is the US dollar over valued or under valued? Meaning “can it buy more foreign goods than it ‘should’, or less than it ‘should’?” By how much? Meaning what % more or less goods can an American buy than they “should” be able to? Should the dollar appreciate or depreciate? Meaning , trend in the future to being able to buy more or less foreign goods? The next assumption a business makes is, “how many years will it take for exchange rate to return to the PPP level?” PPP =0.748 In the above example, the current exchange rate is 0.94Euro/$; the PPP is 0.75Euro/$. So the dollar is overvalued by 0.19 Euros. If you assumed a 5 year return to PPP, the value of the dollar would fall 0.038 Euro/$ per year (0.19/5). A reasonable assumption in 2/1/2020 would be an exchange rate of 0.83Euro/$ = 0.94-3*0.038