Market for foreign exchange 1  Introduction  Nominal exchange rate  Real exchange rate  Trade and the real exchange rate

Introduction 2 Suppose we wish to purchase more foreign assets and goods. First, we need to obtain foreign currency to make this happen.

Introduction 3 What if foreigners wish to purchase more of our assets and goods? They need U.S. dollars to accomplish this.

Introduction 4 Where do we obtain currency of another country? In the market for foreign exchange (forex market). Currencies are traded one for another in the forex market.

Exchange rate 5 Like any market, the market for foreign exchange has a price, a demand, and a supply. The nominal exchange rate is the price in this market. The nominal exchange rate is the rate at which two currencies trade for each other.

Current exchange rates 6 Currency Units of foreign currency per U.S. dollar Japanyen123 Mexicopeso16.7 United Kingdom pound0.658 Franceeuro0.937

Exchange rate 7 A currency that increases in exchange value relative to another currency has appreciated. Example: one euro now trades for 1.08 U.S. dollars. One year ago, one euro exchanged for 1.25 dollars. The dollar has appreciated relative to the euro.

Exchange rate 8 A currency that loses value relative to other currencies has depreciated. Example: currently16.7 Mexican pesos trades for one U.S. dollar. One year ago, one dollar exchanged for 13.5 pesos. The peso has lost value, or depreciated, relative to the dollar.

Foreign exchange market for dollars 9 Euros per dollar Quantity of dollars Demand e0e0 Q0Q0 Supply Forex market for dollars

Demand for currency 10 Foreigners need U.S. currency to purchase domestic assets or domestic goods and services. Changes in currency demand are caused by: 1) a change in preferences for U.S. goods 2) higher rate of growth of foreign incomes

Foreign exchange market for dollars 11 Euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 S0S0 D1D1 Q1Q1 e1e1 Increase in the demand for dollars. Dollar appreciates. Euro depreciates.

Supply of currency 12 We need foreign currency to purchase foreign assets or foreign goods and services. Changes in supply are caused by: 1) a change in preferences for foreign goods 2) higher rate of growth of income in the U.S. 3) higher real interest rates overseas

Foreign exchange market for dollars 13 Euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 S0S0 Q1Q1 e1e1 Increase in the supply of dollars. Dollar depreciates. Euro appreciates. S1S1

Euros per dollar exchange rate 14

Trade weighted dollar index 15

Real exchange rate 16 Nominal exchange rate – rate at which currencies trade Real exchange rate – rate at which goods and services trade. Trade depends on the real exchange rate.

Real exchange rate 17 Real exchange rate = nominal exchange rate x P / P* P = domestic price level P* = foreign price level We adjust for price levels in both trading partners.

Big Mac 1 18 A Big Mac sells for $4.50 in New York and £5.00 in London. The nominal exchange rate is 0.8 pounds per dollar. What is the real exchange rate (in terms of Big Macs)? In other words, if Big Macs were to trade between New York and London, what would be the exchange rate?

Big Mac 1 19 Real exchange rate = 0.8 pounds per dollar * $4.50 / £5.00 Real exchange rate = 0.72 to one 0.72 Big Macs in London exchange for one big Mac in New York. This means that the real price of a Big Mac in London is higher than in New York.

Big Mac 2 20 A Big Mac sells for $4.50 in New York and Y654 in Tokyo. The nominal exchange rate is 123 yen per dollar. What is the real exchange rate (in terms of Big Macs)?

Big Mac 2 21 Real exchange rate = 123 yen per dollar * $4.50 / Y654 Real exchange rate = 0.85 to one 0.85 Big Macs in Tokyo exchange for one big Mac in New York. This means that the real price of a Big Mac in Tokyo is higher than in New York.

Big Mac 2 22 What is the dollar price of a Big Mac in Tokyo? Dollar price = dollars per yen * big mac price in yen Dollar price = 1/ 123 * Y654 = $5.32 per Big Mac

Example: Chanel hand bags 23 Price for a Chanel classic bag Paris : $3,750 China: $6,095 Real exchange rate = $3,750/$6,095 = 0.62 Bags are more valuable in China. What incentive is created?

Example: Chanel hand bags 24 Incentive: purchase bags in Paris, sell them in China on Taobao website at a price less than the local price Suppose the cost of the transaction is $1,000 per bag. What is the potential profit for trading 100 bags?

Example: Chanel hand bags 25 Revenue: 100 * $6,095 = $609,500 Cost: 100 * ($3,750 + $1,000) = $475,000 Profit: $609,500 - $475,000 = $134,500 !

Example: Chanel hand bags 26 Making profit by trading an identical item or asset at different prices is called arbitrage profit. Idea: buy low in one location, sell high in a different location. Be the first or the fastest before no one else notices the profit opportunity.

Example: Chanel hand bags 27 Chanel is aware of the practice. What do you think Chanel did about it?

Example: Chanel hand bags 28 Chanel raised its prices in Paris and cut its prices in China. By reducing the price differential, Chanel hopes to remove the incentive for arbitrage and capture more of the profits for itself.

Real exchange rate 29 Why does the real exchange rate matter? Exports and imports depend on the real exchange rate.

Real exchange rate 30 When a company buys foreign goods, it will compare importing from Europe with purchasing the same goods in the U.S. Which is lower, the price of the import or the domestic price?

Real exchange rate and trade 31 So the U.S. buyer compares these two prices: Domestic price in the U.S. Dollar price of the import = exchange rate * foreign price

Real exchange rate and trade 32 The import price depends on two things: the nominal exchange rate and the price of the good in Europe.

Real exchange rate and trade 33 The U.S. buyer must take into account: the nominal exchange rate the price of the good in the U.S. and the price of the good in Europe. These are the components of the real exchange rate.

Real exchange rate and trade 34 When the real exchange rate depreciates (declines), U.S. goods becomes relatively less expensive in Europe. When the real exchange rate appreciates (increases), U.S. goods become relatively more expensive in Europe.

Real exchange rate and trade 35 Consequence: the quantity of exports and imports depend on the real exchange rate. Exports and imports also depend on the rates of growth of incomes in the trading partners.

Balance of trade 36 Trade deficit: Imports > Exports Trade surplus: Imports < Exports Trade balance: Imports = Exports

Real exchange rate and trade 37 When the real exchange rate appreciates:  Imports are less expensive for us  Our exports are more expensive for our trading partners  Imports rise, exports decline  The trade balance becomes more negative

Real exchange rate and trade 38 When the real exchange rate depreciates:  Imports are more expensive for us  Our exports are less expensive for our trading partners  Imports decline, exports rise  The trade balance becomes more positive

Real interest rates 39 Euros per dollar Quantity of dollars Demand e0e0 Q0Q0 Supply Forex market for dollars Event: real interest rates rise in the U.S. relative to Europe.

Real interest rates rise in the U.S. 40 Euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 Supply Forex market for dollars Foreigners buy more dollars D1D1

Real interest rates rise in the U.S. 41 Euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 S0S0 Forex market for dollars We supply fewer dollars in the forex market. D1D1 S0S0 e1e1

Real interest rates rise in the U.S. 42 Euros per dollar Quantity of dollars D0D0 e0e0 Q0Q0 S0S0 Forex market for dollars The dollar appreciates. D1D1 S0S0 e1e1

Real interest rates rise in the U.S. 43 So when the real interest rate rises in the U.S., the nominal exchange rate will rise because dollars will be in more demand. Assuming price levels are constant, the real exchange rate will also increase.

Real interest rate, real exchange rate, and trade 44 This means that our exports will decline, since they are no more expensive for Europeans. And our imports from Europe will rise, since our dollars are now more valuable and can purchase more European goods. So, with falling exports and rising imports, our trade balance becomes more negative.

Real interest rate, real exchange rate, and trade 45 This means that our exports will decline, since they are more expensive for Europeans. And our imports from Europe will rise, since our dollars are now more valuable and can purchase more European goods. Thus, our trade balance becomes more negative.

Effect of falling exports, rising imports 46 Real GDP Price level SRAS 0 Y* LRAS 0 AD 1 Y1Y1 P1P1 A Recessionary Gap AD 2 B P0P0 Declining exports shift AD to the left, causing a drop in real GDP.

Real interest rate, real exchange rate, and trade 47 Real world example: The value of the dollar has been on the rise mostly due to weak income growth in Europe and stronger growth in the U.S. The appreciating dollar has hurt U.S. exports and is responsible for slower growth of real GDP. And that is not all…

Real interest rate, real exchange rate, and trade 48 Next month the Fed is widely expected to increase the Federal funds (interest) rate for the first time since The Fed is likely to increase rates because unemployment is probably very near the natural rate. What effect will rising interest rates in the U.S. have on the dollar and export growth?

Real interest rate, real exchange rate, and trade 49 Answer: rising interest rates will cause additional increases in the demand for dollars in the forex market. And rising demand will cause the exchange rate to appreciate more. Export growth will decline further as the dollar appreciates, causing slower growth for the U.S. economy.

Real interest rate, real exchange rate, and trade 50 Of course, it is possible that some other source of aggregate demand will increase and soften the negative impact of falling exports on aggregate demand. Consumption spending could rise, for example, or business spending on capital goods. Government spending is very unlikely to increase.

Real interest rate, real exchange rate, and trade 51 But if household or business spending do not step up, then we can expect slower export growth to result in slower GDP growth in the near future.

Summary 52  Nominal exchange rate – rate at which currencies trade  Demand for currency – to purchase domestic goods and assets  Supply of currency – to buy foreign goods and assets  Real exchange rate – nominal exchange rate adjusted for domestic and foreign prices

Summary 53  Exports and imports are affected by the real exchange rate  Arbitrage – buying and selling the same good at different prices in different places