Chapter 19. The Foreign Exchange Market Exchange rates Long run factors Short run factors Exchange rates Long run factors Short run factors

I. Exchange rates definitions, data, examples typically exchange rate = definitions, data, examples typically exchange rate = Mexican Peso, Japanese Yen

also quoted as British pound, Canadian dollar, euro

exchange rate market spot exchange rates  currency exchanges w/in 2 days forward exchange rates  currency exchange at future date, but ratio is set today spot exchange rates  currency exchanges w/in 2 days forward exchange rates  currency exchange at future date, but ratio is set today

why care? determines relative prices  imports in U.S.  our exports abroad determines relative returns  U.S. investments vs. foreign investments  financing U.S. debt determines relative prices  imports in U.S.  our exports abroad determines relative returns  U.S. investments vs. foreign investments  financing U.S. debt

exampleexample GM Saturn  $13,500 in U.S. Toyota Corolla  1.8 million yen GM Saturn  $13,500 in U.S. Toyota Corolla  1.8 million yen

case 1: 120 yen/$ price of Corolla in U.S.: 1.8 million/120 = $15,000 price of Saturn in Japan: 13,500 x 120 = 1.62 million yen price of Corolla in U.S.: 1.8 million/120 = $15,000 price of Saturn in Japan: 13,500 x 120 = 1.62 million yen

case 2: 110 yen/$ $ has depreciated against yen  yen has appreciated against $ $ has fallen  yen has risen $ is weaker  yen is stronger $ has depreciated against yen  yen has appreciated against $ $ has fallen  yen has risen $ is weaker  yen is stronger

price of Corolla in U.S. 1.8 million/110 = $16,364 price of Saturn in Japan 13,500 x 110 = million yen $ depreciated  Corolla is more expensive here  Saturn is cheaper in Japan price of Corolla in U.S. 1.8 million/110 = $16,364 price of Saturn in Japan 13,500 x 110 = million yen $ depreciated  Corolla is more expensive here  Saturn is cheaper in Japan

In general, $ appreciates  imports cheaper, exports pricier  U.S. trade deficit rises $ depreciates  imports pricier, exports cheaper  U.S. trade deficit falls $ appreciates  imports cheaper, exports pricier  U.S. trade deficit rises $ depreciates  imports pricier, exports cheaper  U.S. trade deficit falls

exchange rate movement  short-run volatility  long-run trends exchange rate movement  short-run volatility  long-run trends

II. Exchange rates in LR A. Purchasing power parity (PPP) if countries have different inflation rates,  exchange rate movement law of one price  identical goods should have same value all over world A. Purchasing power parity (PPP) if countries have different inflation rates,  exchange rate movement law of one price  identical goods should have same value all over world

exampleexample pack of gum 120 yen/$ gum = $1 in U.S. gum = 120 yen in Japan pack of gum 120 yen/$ gum = $1 in U.S. gum = 120 yen in Japan

U.S. prices double  gum = $2 if still 120 yen/$  gum is cheaper in Japan (120 yen)  everyone buys gum in Japan exchange rate moves,  120 yen/$2 or 60 yen/$ U.S. prices double  gum = $2 if still 120 yen/$  gum is cheaper in Japan (120 yen)  everyone buys gum in Japan exchange rate moves,  120 yen/$2 or 60 yen/$

PPPPPP if U.S. prices rise faster than world, $ depreciates if U.S. prices rise more slowly, $ appreciates if U.S. prices rise faster than world, $ depreciates if U.S. prices rise more slowly, $ appreciates

PPP works in LR PPP lousy in SR why?  assumes goods transportable cheaply -- gum, yes -- haircuts, no  assumes goods identical PPP works in LR PPP lousy in SR why?  assumes goods transportable cheaply -- gum, yes -- haircuts, no  assumes goods identical

B. Other factors anything impacting relative demand for U.S. stuff vs. foreign stuff increase demand U.S. stuff, increase demand for $, $ appreciates anything impacting relative demand for U.S. stuff vs. foreign stuff increase demand U.S. stuff, increase demand for $, $ appreciates

tariffs and quotas U.S. tariffs increase domestic demand $ appreciates (but other nations could retaliate) U.S. tariffs increase domestic demand $ appreciates (but other nations could retaliate)

preferencespreferences U.S. consumers prefer foreign SUVs increase import demand, decrease $ demand, $ depreciates U.S. consumers prefer foreign SUVs increase import demand, decrease $ demand, $ depreciates

productivityproductivity U.S. more productive, make goods at lower cost, U.S. goods more desirable, $ demand increases, $ appreciates U.S. more productive, make goods at lower cost, U.S. goods more desirable, $ demand increases, $ appreciates

III. Exchange rates in SR driven by investor behavior capital mobility  investors chose assets globally driven by investor behavior capital mobility  investors chose assets globally

example: Japanese investor U.S. CD ($) or Japanese CD (yen) i$ = 7%, iyen = 5% currently 105 yen/$ expect 90 yen/$ in 1 year U.S. CD ($) or Japanese CD (yen) i$ = 7%, iyen = 5% currently 105 yen/$ expect 90 yen/$ in 1 year

Japanese CD deposits 105,000 yen in one year 105,000 (1+.05) = 110,250 yen deposits 105,000 yen in one year 105,000 (1+.05) = 110,250 yen

U.S. CD convert yen to $ (105 yen/$): 105,000/105 = $1000 deposit $1000 in CD in one year: $1000(1+.07) = $1070 convert back to yen (90 yen/$): $1070 x 90 = 96,300 yen convert yen to $ (105 yen/$): 105,000/105 = $1000 deposit $1000 in CD in one year: $1000(1+.07) = $1070 convert back to yen (90 yen/$): $1070 x 90 = 96,300 yen

U.S. interest rate is higher BUT given expected depreciation of $, investor better off w/ Japanese CD U.S. interest rate is higher BUT given expected depreciation of $, investor better off w/ Japanese CD

U.S. investor U.S. CD: $1070 Japanese CD: $1000 x 105 = 105,000 yen 105,000(1.05) = 110,250 yen 110,250/90 = $1225 U.S. investor better off holding Japanese CD U.S. CD: $1070 Japanese CD: $1000 x 105 = 105,000 yen 105,000(1.05) = 110,250 yen 110,250/90 = $1225 U.S. investor better off holding Japanese CD

in this example,  no one would hold a U.S. CD so it must be the case that  expected returns equalize across countries  interest rate parity in this example,  no one would hold a U.S. CD so it must be the case that  expected returns equalize across countries  interest rate parity

Interest Rate Parity exp. returns equalize across countries  based on interest rate, exchange rates so a change in interest rate will cause exchange rate to change exp. returns equalize across countries  based on interest rate, exchange rates so a change in interest rate will cause exchange rate to change

Interest rates & exchange rates nominal interest rate = real interest rate + exp. inflation rate if nominal interest rate rises, either real interest rate increased or exp. inflation rate increased nominal interest rate = real interest rate + exp. inflation rate if nominal interest rate rises, either real interest rate increased or exp. inflation rate increased

U.S. real interest rate rises  increase demand for $  $ appreciates foreign real interest rate rises  decrease demand for $  $ depreciates U.S. real interest rate rises  increase demand for $  $ appreciates foreign real interest rate rises  decrease demand for $  $ depreciates

U.S. expected inflation rises  under PPP, $ depreciates U.S. money supply rises  increase exp. inflation  decrease nominal interest rate  $ depreciates U.S. expected inflation rises  under PPP, $ depreciates U.S. money supply rises  increase exp. inflation  decrease nominal interest rate  $ depreciates

Why has the U.S. dollar fallen since 2002? decline in private foreign investment  EU becoming more attractive? twin deficits  U.S. trade deficit  U.S. federal budget deficits  large amount of borrowing makes our currency less attractive decline in private foreign investment  EU becoming more attractive? twin deficits  U.S. trade deficit  U.S. federal budget deficits  large amount of borrowing makes our currency less attractive

Why do we care? U.S. $ as world reserve currency  allows us to borrow cheaply  falling $ place this status as risk Currency instability  huge disruptions to trade, financial markets U.S. $ as world reserve currency  allows us to borrow cheaply  falling $ place this status as risk Currency instability  huge disruptions to trade, financial markets

The future? some predict continued decline of $  compare to British pound 60 years ago… however, $ has been lower…  mid 1990s dollar much lower against yen, deutschmark some predict continued decline of $  compare to British pound 60 years ago… however, $ has been lower…  mid 1990s dollar much lower against yen, deutschmark