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Explore the role of the foreign exchange market and the exchange rate in international trade. Learn about nominal and real exchange rates, the law of one price, and the factors that influence exchange rates. Discover how changes in exchange rates affect prices and the current account.
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The role of the foreign exchange market and the exchange rate • The importance of real exchange rates and their role in the current account
Exchange Rates and the Foreign Exchange • When individuals or firms in the United States import or export goods or invest in other countries, they need to convert dollars into foreign currencies. A nominal exchange rate is the price of one currency in terms of another currency. • Changes in the exchange rate between the dollar and foreign currencies affect the prices that U.S. consumers pay for foreign imports. Appreciation is an increase in the value of a currency in exchange for another currency. Depreciation is a decrease in the value of a currency in exchange for another currency.
Is It Dollars per Yen or Yen per Dollar? • Direct quotations are exchange rates quoted as units of domestic currency per unit of foreign currency. • 1 GBP = 1.32 USD • Indirect quotations are exchange rates as units of foreign currency per unit of domestic currency. • 0.76 GBP = 1 USD • In financial news, the conventions in reporting exchange rates are a mixture of direct and indirect quotations.
Figure 8.2 Fluctuations in Exchange Rates, 2004−2016 Source: Federal Reserve Bank of St. Louis. • The panels show the exchange rates between the United States dollar and the yen, the Canadian dollar, and the euro. • An increase in the exchange rate represents a depreciation of the dollar.
Exchange Rates in the Long Run The Law of One Price and the Theory of Purchasing Power Parity (1 of 2) The law of one price is the idea that identical products should sell for the same price everywhere. • The law of one price is the basis for the theory of purchasing power parity (PPP). Theory of purchasing power parity (PPP) states that exchange rates move to equalize the purchasing power of different currencies. • In the long run, an exchange rate should be at a level that the equivalent amount of any country’s currency can buy the same amount of goods and services.
The Law of One Price and the Theory of Purchasing Power Parity (2 of 2)
Is PPP a Complete Theory of Exchange Rates? • Real-world complications keep PPP from being a complete explanation of exchange rates: 1. Not all products can be traded internationally 2. Products are differentiated 3. Governments impose barriers to trade, e.g., tariffs and quotas A tariffis a tax a government imposes on imports. A quotais a limit a government imposes on the quantity of a good that can be imported.
A Demand and Supply Model of Short-Run Movements in Exchange Rates (1 of 2) A Demand and Supply Model of Exchange Rates • The model determines both the equilibrium nominal exchange rate and the equilibrium real exchange rate, holding price levels constant. • The demand for U.S. dollars represents the demand by foreign households and firms for U.S. goods and U.S. financial assets. • The supply of dollars in exchange for a foreign currency is determined by the willingness of households and firms that own dollars to exchange them for the foreign currency.
A Demand and Supply Model of Exchange Rates (2 of 2) Figure 8.3 The Demand and Supply of Foreign Exchange The demand curve for dollars in exchange for yen is downward sloping because the lower the dollar exchange rate, the more dollars demanded. The supply curve of dollars in exchange for yen is upward sloping because the quantity of dollars supplied will increase as the dollar exchange rate increases.
Shifts in the Demand and Supply for Foreign Exchange (1 of 2) Figure 8.4 The Effect of Changes in the Demand and Supply for Dollars (1 of 2) Panel (a) illustrates the effect of an increase in the demand for dollars in exchange for yen.
Shifts in the Demand and Supply for Foreign Exchange (2 of 2) Figure 8.4 The Effect of Changes in the Demand and Supply for Dollars (2 of 2) Panel (b) illustrates the effect of an increase in the supply of dollars in exchange for yen.
Table 8.1 Factors that Shift Demand and Supply for Dollars in Exchange for Foreign Currencies(1 of 2)
Table 8.1 Factors that Shift Demand and Supply for Dollars in Exchange for Foreign Currencies(2 of 2)
Currencies are traded in the foreign exchange market; the prices at which they are traded are exchange rates. • When a currency rises against another currency, it appreciates; when it falls, it depreciates. • The equilibrium exchange rate matches the quantity of that currency supplied to the foreign exchange market to the quantity demanded. • To correct for international differences in inflation rates, economists calculate real exchange rates, which multiply the exchange rate between two countries’ currencies by the ratio of the countries’ price levels.
The current account responds only to changes in the real exchange rate, not the nominal exchange rate. • Purchasing power parity is the exchange rate that makes the cost of a basket of goods and services equal in two countries. It is a good predictor of actual changes in the nominal exchange rate.
