Exchange Rates Lecture notes 8 Instructor: MELTEM INCE

Nominal exchange rates The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency For example, if the nominal exchange rate is 110 yen per dollar, one dollar can be exchanged for 110 yen Transactions between currencies take place in the foreign exchange market

Real exchange rates  The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good  If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger

Real exchange rates  The real exchange rate is the price of domestic goods relative to foreign goods or to simplify matters, we’ll assume that each country produces a unique good  In reality, countries produce many goods, so we must use price indexes to get P and P For  If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country

Real exchange rates Real exchange rates are reported as index numbers with one year chosen as the base year.

Equilibrium in the Market for Foreign Exchange The demand curve for dollars in exchange for yen has downward slope while the supply curve has upward slope. The foreign exchange market is in equilibrium at the exchange rate where the quantity supplied equals the quantity demanded. Currency appreciation occurs when the market value of a country’s currency increases relative to the value of another country’s currency. Currency depreciation occurs when the market value of a country’s currency decreases relative to the value of another country’s currency.

Equilibrium in the Market for Foreign Exchange

Purchasing power parity PPP holds in the long run but not in the short run Countries produce different goods Some goods aren’t traded Transportation costs Legal barriers to trade

When PPP doesn’t hold, using Equation, we can decompose changes in the real exchange rate into parts Δe/e = Δe nom /e nom + ΔP/P – ΔP For /P For This can be rearranged as Δe nom /e nom = Δe/e + π For – π

Price of a Big Mac As a test of the PPP hypothesis, the Economist magazine periodically reports on the prices of Big Mac hamburgers in different countries The prices, when translated into dollar terms using the nominal exchange rate, range from just over $1 in China to over $5 in Switzerland (using 2006 data), so PPP definitely doesn’t hold

Price of a Big Mac

The real exchange rate and net exports The real exchange rate also affects a country’s net exports (exports minus imports) An increase in the real exchange rate means people in a country can get more foreign goods for a given amount of domestic goods Changes in net exports have a direct impact on export and import industries in the country Changes in net exports affect overall economic activity and are a primary channel through which business cycles and macroeconomic policy changes are transmitted internationally