1. 4/1/2017
Exchange Rates

2. Exchange Rates Exchange Rates
4/1/2017
Exchange Rates
Exchange Rates
Nominal exchange rate: price of one currency in terms of another currency (bilateral exchange rate)
example: 1.30 dollars per euro or euros per dollar
determines price of imports
foreign exchange market
denote as enom , units of the foreign currency per unit of domestic currency
Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies

3. Exchange Rates

4. Exchange Rates
Real Exchange Rate (RER): the price of domestic goods relative to foreign goods
says how much foreign good you could get for domestic good
The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency

5. Exchange Rates RER Example
Should you buy a Japanese or American computer for your company?
Price of U.S. computer = $2,400
Price of Japanese computer = 242,000 yen
Exchange rate = 110 yen/dollar
Price in dollars = price in yen/yen-dollar exchange rate
Price in yen = price in dollars x value of dollar in terms of yen
Price in dollars = 242,000 yen/110 = $2,200
Japanese computer is cheaper.
Real exchange rate = $2,400/$2,200 = 1.09

6. Exchange Rates Real Exchange Rate (RER)
If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country
NX will tend to be low when the real exchange rate is high.
Real exchange rate = “terms of trade” => competitiveness
Real exchange rate is an index and is unit-less

7. Exchange Rates

8. Purchasing Power Parity
Law of One Price and Purchasing Power
Parity
Identical goods & services should sell at same price no matter where they are sold…otherwise opportunity for profits (i.e. arbitrage)
Law of one price: same price for a commodity
Candy bar in Port-of-Spain versus San Fernando
Purchasing Power Parity (PPP)
The theory that nominal exchange rates are determined as necessary for the law of one price to hold
Exchange rates should move to equalize prices across countries

9. Purchasing Power Parity
PPP implies currencies of countries that experience significant inflation will tend to depreciate

10. Purchasing Power Parity
Example
How many Indian rupees equal to one Australian dollar?
Bushel of grain cost 5 Australian dollars or 150 rupees
5 Australian dollars = 150 rupees
Or, a 30 rupee to 1 Aus. Dollar ratio
Nominal exchange rate should equal 30 rupees/Australian dollar
If not 30:1, what should happen?

11. Purchasing Power Parity
How many Indian rupees equal one Australian dollar?
Suppose price of grain in India increases from 150 to 300 rupees
Price of grain in Australia still equals 5 Australian dollars
Originally: implied exchange rate 5:150 or 1:30
Now: implied exchange rate 5:300 or 1:60
1 Australian dollar = 60 rupees
Nominal exchange rate increased from 30 to 60 rupees/Australian dollar
Indian currency depreciated
Australian currency appreciated

12. Purchasing Power Parity
Does not hold up well in short run
Transportation costs
Border effect – tariffs, technical requirements, regional monopoly power
Pricing to market
Goods prices are “sticky”
Reduces exchange rate “pass through”
Nontradable sector
Higher productivity, higher nontradable wages, higher nontradable inflation
Works better in the long run

13. Price differences between US and Canadian Cities. Figure 19.4

14. Inflation and Currency Depreciation Five Year Window
Currency Depreciation (% pa)
Inflation Differential

15. Inflation and Currency Depreciation Twenty Year Window
Currency Depreciation (% pa)

16. Power Purchasing Parity
McParity & the Big Mac Index
The Economist's Big Mac index is based on the theory of purchasing-power parity (PPP) using the Big Mac
The cheapest burger in the chart is in China, at $1.26, compared with an average American price of $3. The PPP implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.

17. McParity

18. Exchange Rate
RER reflects competitiveness—the higher a country’s RER, the more expensive its goods and services are to foreigners.
=> as the RER↑, a country’s NX growth will ↓, leading to a current account deficit (and vice versa)
Note: nominal exchange rate can fall but be offset by higher domestic inflation so that RER stays constant