19 International Finance CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Define exchange rates and demonstrate their use in converting amounts in one currency into another. 2 Present a theory of exchange rates movement, and show the relationship between exchange rates and monetary policy. Notes and teaching tips: 7, 13, 18, 20, 58, and 66. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure. To enhance your lecture, check out the Lecture Launchers, Land Mines, and Class Activities in the Instructor’s Manual.

19.1 THE EXCHANGE RATE Foreign exchange rate is the price at which one currency exchanges for another. For example, on May 09, 2017, one U.S. dollar bought 0.92 Euros. The exchange rate was 0.92 euros per dollar. This exchange rate can be expressed in terms of dollars (or cents) per euro. On May 09, 2017, the exchange rate was $1.087 per euro.

19.1 THE EXCHANGE RATE Notation: 𝑒 € $ - means Euros per dollar (the price of $1 in Euros) 𝑒 $ € - means dolalrs per Euro (the price of 1 Euro in $) In general: 𝑒 𝑐 $ - means the price of a dollar in units of currency c 𝑒 $ 𝑐 - means the price of 1 unit of currency c in dollars

19.1 THE EXCHANGE RATE 𝑒 € $ =0.9196 Euros per dollar 𝑒 $ € =1.0874 dollars per Euro

19.1 THE EXCHANGE RATE Foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The foreign exchange market is made up of importers and exporters, banks, and specialist dealers who buy and sell currencies. A lot of silly ideas about the exchange rate find their way into the popular media. The most notable one is that the strength of a nation’s currency on the foreign exchange market is somehow a sign of the nation’s overall strength. Explain that the exchange rate is just a price. And it is the relative price of two currencies that ultimately depends on the price levels in two countries. A downward trend in an exchange rate means that a country is experiencing more rapid inflation that another country. That is all. The exchange rate trend tells us nothing—absolutely nothing—about productivity and real income growth in the two countries.

19.1 THE EXCHANGE RATE Currency appreciation is the rise in the value of one currency in terms of another currency. For example, when the dollar rose from 1.00 euros to 1.17 euros in 2000, the dollar appreciated by 17 percent. Currency depreciation is the fall in the value of one currency in terms of another currency. For example, when the dollar fell from 1.17 euros in 2001 to 0.63 euros in 2008, the dollar depreciated by 46 percent.

19.1 THE EXCHANGE RATE Figure 19.1 shows the U.S. dollar exchange rate in against the euro.

19.1 THE EXCHANGE RATE The value of the foreign exchange rate fluctuates. Sometimes the U.S. dollar depreciates and sometimes it appreciates. Why? The foreign exchange rate is a price and, like all prices, demand and supply in the foreign exchange market determine its value.

Using exchange rates to convert one currency into another 19.1 THE EXCHANGE RATE Using exchange rates to convert one currency into another Q. Suppose a television in the U.S. cost $500. What is the price of this TV in Japanesne Yen, if the exchange rate is e ¥ $ =114 ¥ $ (i.e. 114 Yen per dollar). A. $500∙114 ¥ $ =¥57,000 Remark. This does not have to be the price of TV in Japan. We only converted the $500 to Japanes Yen.

Using exchange rates to convert one currency into another 19.1 THE EXCHANGE RATE Using exchange rates to convert one currency into another Q. Suppose that the price of a Big Mac Meal in Japan is ¥700. What is the price of this meal in dollars, if the exchange rate is e ¥ $ =114 ¥ $ (i.e. 114 Yen per dollar). A. ¥700∙ 1 114 $ ¥ =$6.14 Remark. This does not have to be the price of Big Mac Meal in the U.S. We only converted the ¥ 700 to dollars.

19.2 Theory of Exchange Rate Determination Purchasing Power Parity (PPP) We say that PPP holds between the U.S. and another country, for some bundle of goods, if $1, when converted to foreign currency buys the same amount of the bundle as $1 buys in the U.S. 1 𝑃 = 1∙𝑒 𝑃 ∗ or 𝑃∙𝑒= 𝑃 ∗ 𝑒 – exchange rate (price of domestic currency in terms of foreign currency) 𝑃, 𝑃 ∗ – domestic and foreign prices of the same bundle.

19.2 Theory of Exchange Rate Determination Purchasing Power Parity (PPP) Q. Suppose that TVs are traded goods. The price of TV in the U.S. is $500 and the price of the same TV in Japan is ¥ 60,000. What should be the exchange rate between the $ and ¥ if PPP holds for TVs? A. Using the definition of PPP, 𝑃∙𝑒= 𝑃 ∗ $500∙𝑒 ¥ $ =¥60,000 𝑒= 60,000 500 =120 ¥ $

19.2 Theory of Exchange Rate Determination Exchage Rates and Money Supply Assuming that PPP holds for traded goods only, and a few other assumptions, we can show that 𝑒 = 𝜋 ∗ −𝜋 𝑒 - rate of change in the value of domestic currency 𝜋, 𝜋 ∗ - domestic and foreigh inflation Intuitively, inflation is the loss of value of money (currency). If foreign inflation is higher than domestic inflation, the domestic currency appreciates relative to foreign currency.

19.2 Theory of Exchange Rate Determination Exchage Rates and Money Supply Assuming that PPP holds for traded goods only, and a few other assumptions, we can show that 𝑒 = 𝜋 ∗ −𝜋 Q. Suppose the U.S. inflation 2% and inflation in China is 10%. What does our theory predict about the change in the value of the dollar? A. 𝑒 = 𝜋 ∗ −𝜋=10%−2%=8%. The dollar is expected to appreciate by 8% relative to the Chinese Yuan.

19.2 Theory of Exchange Rate Determination Testing the theory. If 𝑒 = 𝜋 ∗ −𝜋, then we expect that 𝑒 − (𝜋 ∗ −𝜋)=0. 𝑒 − (𝜋 ∗ −𝜋)

19.2 Theory of Exchange Rate Determination Exchage Rates and Money Supply Using the quantity theory of money, we can show that 𝑒 = 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 𝑒 - rate of change in the value of domestic currency 𝑀 , 𝑀 ∗ - rate of growth in domestic and foreign money supply 𝑌 , 𝑌 ∗ - rate of growth in domestic and foreign RGDP 𝑉 , 𝑉 ∗ - rate of growth in domestic and foreign velocity of circulation

19.2 Theory of Exchange Rate Determination Exchage Rates and Money Supply 𝑒 = 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 Intuitively, faster growth rate of supply of foreing currency, relative to domestic currency, 𝑀 ∗ − 𝑀 ↑, leads to appreciation of the domestic currency, holding all other effects the same.

19.2 Theory of Exchange Rate Determination Exchage Rates and Money Supply 𝑒 = 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 Q. Suppose that money supply in the U.S. grows at 4% and money supply in the Euro area is growing at 3%. If other influences remain the same, what is the expected change in the value of the dollar relative to Euro? A. 𝑒 = 𝑀 ∗ − 𝑀 =3%−4%=−1%. We expect the dollar to depreciate by 1% relative to Euro.

19.2 Theory of Exchange Rate Determination Floating v.s. fixed exchange rates 𝑒 = 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 Notice that fixing the exchange rate, essentially restricts the growth rate of the domestic money supply. Such policy is often used to combat inflation, and it is called nominal anchor.

19.2 Theory of Exchange Rate Determination Floating v.s. fixed exchange rates 𝑒 = 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 Q. Suppose that the money supply in the U.S. is growing at 4% and the U.S. real GDP growth is 2%. In China the real GDP is growing at 10%, and the velocities of the two countries change at the same rate. If China adopts a fixed exchange rate between Yuan and the dollar, what will be the growth rate on the Chinese money supply? A. 0= 𝑀 ∗ − 𝑀 + 𝑌 − 𝑌 ∗ + 𝑉 ∗ − 𝑉 = 𝑀 ∗ −4% + 2%−10% Thus, the Chinese money supply should grow at 12%.

19.2 Theory of Exchange Rate Determination