McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 Foreign Exchange

10-2 Exchange Rates The exchange rate is the tool we use to measure the price of one currency in terms of another. Expressed as: $/unit of foreign currency - $/pound Units of foreign currency/$ - Won/$ Web site

10-3 Exchange Rates

10-4 Exchange Rates

10-5 Exchange Rates The nominal exchange rate is the rate at which one can exchange the currency of one country for the currency of another country. For Example : The dollar-euro exchange rate is the number of dollars you can get for each euro.

10-6 Exchange Rates

10-7 Exchange Rates Depreciation A decline in the value of one currency relative to another is called depreciation. Appreciation The rise in the value of one currency relative to another is called an appreciation. Note: When one currency goes up in value relative to another, the other currency must go down.

10-8 Exchange Rates Spot rates are the rates for an immediate exchange (subject to a two-day settlement period). Forward rates are the rates at which foreign currency dealers are willing to commit to buying or selling a currency in the future, so they give some indication of whether market participants expect currencies to appreciate or depreciate over time.

10-9 Exchange Rates Real Exchange Rates The rate at which one can exchange the goods and services from one country for the goods and services from another country. It is the cost of a basket of goods in one country relative to the cost of the same basket of goods in another country.

10-10 Exchange Rates From this definition of the real exchange rate, we can see that whenever the solution to the equation more than one, foreign products will seem cheap.

10-11 Exchange Rates Foreign Exchange Markets On an average day in 2001, $1.2 trillion in foreign currency was traded in a market that operates 24 hours a day The U.S. dollar is one side of roughly 90% of these currency transactions. Majority of transactions take place in London.

10-12 Exchange Rate in the Long-run The law of one price. The law of one price is based on the concept of arbitrage – the idea that identical products should sell for the same price.

10-13 Exchange Rate in the Long-run Example:

10-14 Exchange Rate in the Long-run The same commodity or service sells for vastly different prices in different countries. This is because: Significant Transportation costs Tariffs Technical Specifications Different tastes and preferences Non-traded goods

10-15 Exchange Rate in the Long-run Purchasing Power Parity (PPP). The dollar price of a basket of goods and services in the United States should be the same as the dollar price of a basket of goods and services in Mexico, Japan, or the United Kingdom.

10-16 Exchange Rate in the Long-run Or the Real Exchange rate =1

10-17 Exchange Rate in the Long-run

10-18 Exchange Rate in the Long-run PPP Implies: If prices change in one country but not in another the exchange rate should change as well. The currency of a country with high inflation will depreciate

10-19 Exchange Rate in the Long-run

10-20 Exchange Rate in the Long-run Undervalued or Overvalued Currency A current market rate that deviates from what is consider to be purchasing power parity. Web Link – Big Mac Index

10-21 Exchange Rate in the Short-run

10-22 Exchange Rate in the Short-run The supply curve for dollars slopes upward. The more valuable the dollar, the cheaper foreign goods, services, and assets will be, and the higher the supply of dollars in the dollar ‑ euro market.

10-23 Exchange Rate in the Short-run The demand curve for dollars is downward sloping The fewer euros needed to purchase one dollar, the cheaper are American ‑ made goods and services. The cheaper a good or service, the higher the demand for it. The same is true of investments. The cheaper the dollar - the lower the dollar-euro exchange rate - the more attractive are U.S. investments, and the higher the demand for dollars with which to buy them

10-24 Exchange Rate in the Short-run

10-25 Exchange Rate in the Short-run

10-26 Exchange Rate in the Short-run

10-27 Government Policy and Foreign Exchange Intervention Government officials can intervene in foreign exchange markets in several ways. adopting a fixed exchange rate and act to maintain it at a level of their choosing. policymakers will buy or sell currency in an attempt to affect demand or supply (foreign exchange intervention).

10-28 Exchange Rate in the Short-run Foreign exchange interventions will be ineffective unless they are accompanied by a change in the interest rate. That is the reason countries like the United States rarely intervene in the foreign exchange markets.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 10 End of Chapter