Exchange Rates

1. Exchange Rates

2. Exchange Rates • Exchange Rate: S - # of domestic currency units purchased for 1 US$. • An increase in S is a depreciation and a decrease in S is an appreciation.

3. International Comparisons Project • Researchers at U. of Pennsylvania periodically choose a representative world market basket and go to different countries to collect prices of that market basket of good. • For a country, we calculate PPP = Purchasing Power Parity as the price of the market basket relative to price of the market basket in US. • For any country, the exchange rate, St, is the number of domestic dollars per US$. Penn World Tables

4. Comparing GDP across Countries • When you compare income in two different countries, each country’s GDP per capita is measured in local currency. You need to measure both with common yardstick to compare. • Typically, the common yardstick will be US$. GDP can be converted to US$ by Exchange Rate Method (divide national GDP by the exchange rate) or PPP Method (divide national GDP by PPP).

5. PPP vs. Exchange Rate Conversion • Exchange rates are easily available so exchange rate is a “quick and dirty” comparison. • Measures how many US dollars someone could buy with average income. • However, money goes farther in some countries as many types of goods are relatively cheap (especially developing countries). • PPP conversion measures how much the goods purchased by the average person would cost in the US. Better measure of living standards.

6. Convert sums into another economy’s currency • Nj is a number measured in country j’s currency & you want to convert it into country REF’s currency. Exchange Rate Conversion PPP Conversion

7. Comparison of China vs. HK World Bank Conversion Factors • Goods are cheaper in China than in HK

8. Which exchange rate conversion to use? • Depends on where the money will be spent. • If you have a value of foreign currency that you will want to spend at home, convert using exchange rate because foreign prices are irrelevant. • If you want to spend the money in foreign country, then using PPP conversion may be more helpful.

9. Problem • You are a Chinese multinational that wants to construct salaries to be paid to employees in Canada that will provide same living standard as salary of RMB20,000. • Canada PPP in 2002 is 1.2.

10. Exchange Rate Model

11. Exchange Rates are Volatile

12. Why do exchange rates change? • Relative values of two currency determined by supply and demand by traders of the two currencies. • People trade currencies to engage in foreign trade and international investment. • Monetary policy is a prime driver of exchange rates. • And vice versa, Some economies structure monetary policy around exchange rate.

13. Forex Market: Supply & Demand Consider the spot foreign exchange market. • Price of US$: S is the price of US$ in terms of DCU. • Supply of US$: Foreign people who want to acquire DCU to buy domestic goods or assets. • When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency. • Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. • When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

14. Equilibrium in Forex MarketSupply Equals Demand S Demand S* Supply

15. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods S S** 2 Domestic Currency Depreciates S* 1 Supply' Demand ' Supply Demand

16. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods S Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand

17. US Monetary Policy Causes US$ Interest Rates Go UpRelative Demand for US$ Goes Up S 2 S** Domestic Currency Depreciates S* 1 Supply' Demand ' Supply Demand

18. Domestic Monetary Policy CausesD.C. Interest Rates Go UpRelative Demand for US$ Goes Down S Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand Demand '

19. Monetary Policy & Exchange Rates • The central impact of the foreign currency intervention is on domestic interest rates. • Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves. • Monetary policy that does not shift interest rates will not shift exchange rates.

20. Foreign Currency Intervention • Foreign currency purchase: • Central bank purchases foreign currency • Credit reserve accounts of counterparty commercial bank • More reserves pushes down interest rates • Increases demand for and reduces supply of US$ in forex market • Foreign currency sale • Central bank sells foreign currency • Debit reserve accounts of purchasing bank • Less reserves pushes up interest rates • Reduces demand for and increases supply of US$ in forex market

21. Excess Demand for Foreign Currency S 1. Domestic Currency Faces Depreciation Pressure A S* Supply Demand ' Demand

22. Forex Sale Supply • Central Bank does Forex Sale maintaining Exchange Rate Stability • Shrinking money supply and higher domestic interest rates S A S* B Demand Supply' Demand '

23. Excess Supply of Foreign Currency S 1. Domestic Currency Faces Appreciation S* A Supply Demand

24. Forex Purchase • Central Bank does Forex Purchase maintaining Exchange Rate Stability • Growing money supply and lower domestic interest rates S B S* Supply' A Demand ' Supply Demand

25. Iron Triangle of International Finance Monetary Policy that Controls The Interest Rate Open to International Capital Flows Fixed Exchange Rates Pick 2 items from this menu

26. Learning Outcomes • Students should be able to • Convert series from one currency to another using the exchange rate or the PPP rate. • Use the Supply-Demand model of the forex model to explain: • the effect of international trade conditions on the exchange rate. • the impact of interest rates and other financial market conditions on exchange rates. • Government policy efforts to stabilize the exchange rate.