Michael M. Knetter UW-Madison School of Business Manufacturing Prospects and Midwest Public Policy Federal Reserve Bank of Chicago Real Effects of Currency Fluctuations

As quoted in the Wall Street Journal… Honda Motor claims that “every ¥en the dollar rises against the Japanese currency adds about $40 million to its profits.” Does this relationship make sense? Is this a big deal or a small deal?

Price and Output Response to a Depreciation of the Exporter’s Currency quantity ¥en/$ MC MR 1 q1q1 p1p1 optimal price and quantity rise as a result of depreciation of the exporter’s currency for a given MC MR 2 q2q2 p2p2

Profit Response to a Depreciation of the Exporter’s Currency quantity ¥en MC q2q2 q1q1 p2p2 p1p1 depreciation of exporter’s currency increases price, quantity, and profit

Is this a big deal for Honda??

¥en/$ in the 1990s: Implications for Honda’s Profits 1990 to 1995: 150 ¥en/$ to 90 ¥en/$ Profit change = ($40 mill)*(-60) = -$2.4 billion 1995 to 97: 90 ¥en/$ to 125 ¥en/$ Profit change = ($40 mill)*(+35) = +$1.4 billion

Consequences of a Weaker $ for U.S. Manufacturing Sector Reduction in costs of production relative to foreign competitors. Higher $ prices and profit margins? Higher production volume and employment? Higher imported input costs? Higher cash flows/profits. Higher stock prices? Less spending on lobbyists?

Determinants of PTM/Pass-Through Potential for arbitrage. –No PTM in gold. –Lots of PTM in autos. Who is your competition? –Local competitors may force you to keep local prices stable (lots of PTM) Is the market regulated? –Threat of trade sanctions may lead to stable local price strategy.

How Widespread is Exposure to Currency Risk? Demand side –Exports –Import competition –Indirect examples (restaurant in Miami Beach) Supply side –Foreign input sourcing

How much has the $ depreciated? $ was worth 1.19 euros in summer 2001 $ is worth about 0.80 euros today 40% depreciation in nominal terms— approximately same in real terms This should have large positive impact on manufacturers and farmers in the Midwest.