After studying this chapter, you should be able to: LEARNING OBJECTIVES After studying this chapter, you should be able to: 8.1 Explain the difference between nominal and real exchange rates. 8.2 Explain how markets for foreign exchange operate. 8.3 Explain how exchange rates are determined in the long run. 8.4 Use a demand and supply model to explain how exchange rates are determined in the short run.

Is Ben Bernanke Responsible for Japanese Firms Moving to the United States? The increase in the value of the Japanese yen following the financial crisis made it more expensive for Japanese firms to export products to the United States. Some Japanese firms like Toyota shifted production to the U.S. so that both revenue and costs would be in dollars, thus insulating them from the effects of changes in exchange rates. What led to the rising value of the yen? This was due in part to U.S. monetary policy, which pushed interest rates to record low levels, and therefore declines in the value of the dollar against other currencies.

Key Issue and Question Issue: Volatility in exchange rates during recent years has led some Japanese firms to relocate production to the United States and other countries. Question: Why has the value of the dollar declined against other major currencies during the past 10 years?

8.1 Learning Objective Explain the difference between nominal and real exchange rates.

Exchange Rates and Trade When individuals or firms in the United States import or export goods or invest in other countries, they need to convert dollars into foreign currencies. A nominal exchange rate is the price of one currency in terms of another currency. Changes in the exchange rate between the dollar and foreign currencies affect the prices that U.S. consumers pay for foreign imports. Appreciation is an increase in the value of a currency in exchange for another currency. Depreciation is a decrease in the value of a currency in exchange for another currency. Exchange Rates and Trade

What’s the Most Important Factor in Determining Sony’s Profits? Making the Connection What’s the Most Important Factor in Determining Sony’s Profits? In the long run, Sony’s profits depend on its ability to innovate, to produce at a low cost, and to market its products to consumers. In the short run, Sony’s profits depend on the prices it charges relative to its competitors. Since Sony sells most of its goods outside of Japan, changes in exchange rates will affect its foreign currency prices. An increase in the value of the yen from ¥105 to ¥100 per euro (€) would reduce Sony’s profits by about ¥30 billion. So, top managers of Sony and other Japanese firms continue to find ways to cushion the impacts of the changing value of the yen. Teaching Tips: Have students discuss the different ways that other multinational corporations can be affected by fluctuations in exchange rates. Exchange Rates and Trade

Is It Dollars per Yen or Yen per Dollar? Direct quotations are exchange rates quoted as units of domestic currency per unit of foreign currency. Indirect quotations are exchange rates as units of foreign currency per unit of domestic currency. In financial news, the conventions in reporting exchange rates are a mixture of direct and indirect quotations. Figure 8.1 Exchange Rates and Trade

Foreign-Exchange Cross Rates Figure 8.1 Foreign-Exchange Cross Rates Notes: Foreign-exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as units of foreign currency per U.S. dollar. But the exchange rate between the U.S. dollar and the Japanese yen is always reported as yen per dollar, and the exchange rate between the euro and the dollar is reported as dollars per euro. The second entry in the U.S. row shows that the exchange rate on this day was $1.3034 per euro (€). The last entry in the U.S. Dollar column shows that the exchange rate can be expressed as €0.7672 per dollar. Exchange Rates and Trade

Page 228 Figure 8.2 The panels show the exchange rates between the United States dollar and the yen, the Canadian dollar, and the euro. An increase in the exchange rate represents a depreciation of the dollar. Exchange Rates and Trade 10

Nominal Exchange Rates versus Real Exchange Rates The real exchange rate is the rate at which goods and services in one country can be exchanged for goods and services in another country. Example: The real exchange rate between the dollar and the pound in terms of Big Macs = Using the price indexes of both countries, the real exchange rate = Exchange Rates and Trade

Nominal Exchange Rates versus Real Exchange Rates Rearranging the terms of the real exchange rate equation, the relationship between the nominal and real exchange rates: where E = nominal exchange rate (units of foreign currency per unit of domestic currency) e = real exchange rate PDomestic = domestic price level PForeign = foreign price level Exchange Rates and Trade 12

8.2 Learning Objective Explain how markets for foreign exchange operate.

Foreign-Exchange Markets The foreign-exchange market is an over-the-counter market where international currencies are traded. Large commercial banks are market makers because they are willing to buy and sell major currencies at any time. Most foreign-exchange trading takes place among commercial banks located in London, New York, and Tokyo, with secondary centers in Hong Kong, Singapore, and Zurich. With daily trading in the trillions of dollars, the foreign-exchange market is one of the largest financial markets in the world. Participants include investment portfolio managers and central banks. Foreign-Exchange Markets

Forward and Futures Contracts in Foreign Exchange Spot market transactions involve an exchange of currencies immediately at the current exchange rate. In forward transactions, traders agree today to a forward contract to exchange currencies on a specific future date at an exchange rate known as the forward rate. Futures contracts are traded on exchanges (e.g., CBOT), and they reduce counterparty risk, and thus default risk. The amount of trading in forward contracts is at least 10 times greater than the amount of trading in futures contracts. Call and put options contracts are also available on foreign exchange. Foreign-Exchange Markets

Exchange-Rate Risk, Hedging, and Speculating Exchange-rate risk is the risk that a firm will suffer losses because of fluctuations in exchange rates. The forward rate reflects what traders in the forward market expect the spot exchange rate to be in the future, so it may not equal the current spot rate. To hedge against a fall (rise) in the value of a currency, a firm sells (buys) that currency in the forward market. A hedger uses derivatives markets to reduce risk, while a speculator uses derivatives markets to place a bet on the future value of a currency. Firms and investors can also use options contracts to hedge or to speculate. The disadvantage of speculating with options contracts is that their prices are higher than are the prices of forward contracts. Foreign-Exchange Markets

Can Speculators Drive Down the Value of a Currency? Making the Connection Can Speculators Drive Down the Value of a Currency? In February 2010, the managers of four hedge funds met in New York City to discuss whether it would be profitable to use derivatives to bet that the value of the euro would fall. In response to criticisms from U.S. and European government officials, those fund managers claimed that they were just exchanging ideas on an investment opportunity. Over the following years, the euro-dollar exchange rate never dropped significantly Exchange rates among major currencies are determined by factors that a few hedge fund managers probably can’t affect, however large those funds are. Foreign-Exchange Markets

Explain how exchange rates are determined in the long run. 8.3 Learning Objective Explain how exchange rates are determined in the long run. We saw in chapter 3 that when similar securities have different yields, the opportunity for arbitrage profits causes prices of securities to change until similar securities have the same yields.

Exchange Rates in the Long Run The Law of One Price and the Theory of Purchasing Power Parity The law of one price is the idea that identical products should sell for the same price everywhere. The law of one price is the basis for the theory of purchasing power parity (PPP). Theory of purchasing power parity (PPP) states that exchange rates move to equalize the purchasing power of different currencies. In the long run, an exchange rate should be at a level that the equivalent amount of any country’s currency can buy the same amount of goods and services. Exchange Rates in the Long Run

The Law of One Price and the Theory of Purchasing Power Parity In the long run, arbitrage activity in the foreign exchange market causes PPP to hold. PPP makes an important prediction: If one country has a higher inflation rate than another country, its currency will depreciate relative to the currency of the other country. Recall the real exchange rate equation: If Domestic is the domestic inflation rate and Foreign is the foreign inflation rate, then % change in e = % change in E + Domestic – Foreign. If PPP holds, e =1, so that % change in E = Foreign – Domestic Notes: We saw in chapter 3 that when similar securities have different yields, the opportunity for arbitrage profits causes prices of securities to change until similar securities have the same yields. Arbitrage activity can also occur in the foreign exchange market. Exchange Rates in the Long Run

Is PPP a Complete Theory of Exchange Rates? Real-world complications keep PPP from being a complete explanation of exchange rates: 1. Not all products can be traded internationally 2. Products are differentiated 3. Governments impose barriers to trade, e.g., tariffs and quotas A tariff is a tax a government imposes on imports. A quota is a limit a government imposes on the quantity of a good that can be imported. Exchange Rates in the Long Run

Should Big Macs Have the Same Price Everywhere? Solved Problem 8.3 Should Big Macs Have the Same Price Everywhere? The Economist magazine tracks the prices of the McDonald’s Big Mac around the world. The table shows the Big Mac’s prices in the different countries, along with the exchange rate with the U.S. dollar. a. Explain whether the statistics in the table are consistent with the theory of purchasing power parity. b. Explain whether your results in part (a) mean that arbitrage profits exist in the market for Big Macs. Exchange Rates in the Long Run

Should Big Macs Have the Same Price Everywhere? Solved Problem 8.3 Should Big Macs Have the Same Price Everywhere? Solving the Problem Step 1 Review the chapter material. Step 2 Answer part (a) by determining whether the theory of purchasing power parity applies to Big Macs. We can convert the price of a Big Mac in a given country to its price in dollars. For example, in the case of Japan: ¥320/(¥78.22/$) = $4.09, which is close to the U.S. price. However, this is not the case for the majority of other countries, so that PPP does not hold in general for Big Macs. Teaching Tips: Ask the students to calculate the dollar price for countries other than Japan, and discuss possible reasons for the differences between those dollar prices and the U.S. price. Step 3 Answer part (b) by explaining whether arbitrage profits exist in the market for Big Macs. It is not possible to make arbitrage profits by buying low-price Big Macs in one country and selling them in another. Exchange Rates in the Long Run

8.4 Learning Objective Use a demand and supply model to explain how exchange rates are determined in the short run.

A Demand and Supply Model of Short-Run Movements in Exchange Rates A Demand and Supply Model of Exchange Rates The model determines both the equilibrium nominal exchange rate and the equilibrium real exchange rate, holding price levels constant. The demand for U.S. dollars represents the demand by foreign households and firms for U.S. goods and U.S. financial assets. The supply of dollars in exchange for a foreign currency is determined by the willingness of households and firms that own dollars to exchange them for the foreign currency. A Demand and Supply Model of Short-Run Movements in Exchange Rates

A Demand and Supply Model of Exchange Rates Figure 8.3 The Demand and Supply of Foreign Exchange The demand curve for dollars in exchange for yen is downward sloping because the lower the dollar exchange rate, the more dollars demanded. The supply curve of dollars in exchange for yen is upward sloping because the quantity of dollars supplied will increase as the dollar exchange rate increases. Teaching Tips: Ask students why a lower dollar exchange rate results in more dollars demanded, and why a higher dollar exchange rate results in more dollars supplied. A Demand and Supply Model of Short-Run Movements in Exchange Rates

Shifts in the Demand and Supply for Foreign Exchange Figure 8.4 (1 of 2) The Effect of Changes in the Demand and Supply for Dollars Panel (a) illustrates the effect of an increase in the demand for dollars in exchange for yen. A Demand and Supply Model of Short-Run Movements in Exchange Rates

Shifts in the Demand and Supply for Foreign Exchange Figure 8.4 (2 of 2) The Effect of Changes in the Demand and Supply for Dollars Panel (b) illustrates the effect of an increase in the supply of dollars in exchange for yen. A Demand and Supply Model of Short-Run Movements in Exchange Rates

The “Flight to Quality” during the Financial Crisis Figure 8.5 Notes: The increase in demand was not primarily due to higher U.S. interest rates but to problems in the international financial system. Currency crises in several East Asian countries, including South Korea, Thailand, Malaysia, and Indonesia, had resulted in sharp declines in the values of these currencies. When the currencies of Argentina and Russia also experienced sharp declines, many foreign investors engaged in a “flight to quality” in which they purchased assets denominated in U.S. dollars, particularly U.S. Treasury securities, because they appeared to be safe investments. Teaching Tips: Make use of this section to illustrate the global nature of the financial system. Have students discuss how changes in risk perceptions resulted in major movements of financial flows, causing significant changes in the value of currency during the financial crisis. Movements in the Trade-Weighted Exchange Rate of the U.S. Dollar During the financial crisis of 2007–2009, many foreign investors sought a safe haven in U.S. Treasury securities. As a result, the demand for dollars and thus the dollar exchange rate increased. A Demand and Supply Model of Short-Run Movements in Exchange Rates

The Interest-Rate Parity Condition Investors account for more than 95% of demand for foreign exchange, reflecting the importance of international capital mobility. To purchase Japanese bonds, you assume some exchange-rate risk: While your funds are invested in Japanese bonds, the value of the yen might decline relative to the dollar. To eliminate any arbitrage profits, the difference between the interest rates on a Japanese bond and a U.S. bond must equal the expected change in the exchange rate between the yen and the dollar. A Demand and Supply Model of Short-Run Movements in Exchange Rates

The Interest-Rate Parity Condition The interest-rate parity condition holds that differences in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates. This condition also means: Interest rate on domestic bond = Interest rate on foreign bond – Expected appreciation of the domestic currency. If the expected returns (including expected changes in the exchange rate) from the domestic and foreign bonds are not the same, then investors can make arbitrage profits. A Demand and Supply Model of Short-Run Movements in Exchange Rates

The Interest-Rate Parity Condition Differences in interest rates in different countries do not always reflect expectations of future changes in exchange rates for several reasons: 1. Differences in default risk and liquidity. 2. Transactions costs. 3. Exchange-rate risk. To account for the additional risk of investing in a foreign asset we can include a currency premium in the interest-rate parity equation: Interest rate on the domestic bond = Interest rate on the foreign bond – Expected appreciation of the domestic currency – Currency premium A Demand and Supply Model of Short-Run Movements in Exchange Rates

Can You Make Money Investing in Japanese Bonds? Solved Problem 8.4 Can You Make Money Investing in Japanese Bonds? Suppose you read the following investment advice: “One strategy for earning an above-average return is to borrow money in the United States at 3% and invest it in Japan in a comparable investment at 6%.” Would you follow this strategy? A Demand and Supply Model of Short-Run Movements in Exchange Rates

Can You Make Money Investing in Japanese Bonds? Solved Problem 8.4 Can You Make Money Investing in Japanese Bonds? Solving the Problem Step 1 Review the chapter material. Step 2 Use the interest-rate parity condition to answer the question by explaining the relationship between expected changes in exchange rates and differences in interest rates across countries. If the interest-rate parity condition holds, then a 3-percentage-point gap between the U.S. bond and Japanese bond rates means that investors must be expecting that the value of the dollar will appreciate against the yen by 3%. A U.S. investor who borrows money at 3% in the U.S. and invests it at 6% in Japan will not gain anything if the dollar appreciates by 3%. A Demand and Supply Model of Short-Run Movements in Exchange Rates

Should You Invest in Emerging Markets? Making the Connection In Your Interest Should You Invest in Emerging Markets? Emerging markets refer to developing countries with rapid economic growth rates (e.g., China and India). Many investors have responded to low U.S. interest rates by diversifying their portfolios with stocks and bonds of emerging-market companies. But high economic growth does not necessarily mean high long-term investment returns. Also, economic growth typically results in a larger number of stocks, which in turn creates a “dilution effect” in financial investments. Still, investors can minimize risk by (1) buying an index fund that includes stocks from both developed and emerging markets, and (2) combine emerging market investments with conventional investments. A Demand and Supply Model of Short-Run Movements in Exchange Rates

Answering the Key Question At the beginning of this chapter, we asked the question: “Why has the value of the dollar declined against other major currencies during the past 10 years?” Relatively higher inflation rates in the United States and lower interest rates have caused the value of the dollar to decline against other major currencies. Lower real interest rates in the United States reduced foreign investors’ demand for U.S. bonds and thus their demand for dollars. The dollar exchange rate declined as a result.