Exchange Rates Lecture notes 8 Instructor: MELTEM INCE

1. Exchange Rates Lecture notes 8 Instructor: MELTEM INCE

4. Nominal exchange rates The nominal exchange rateis the value of one country’s currency in terms of another country’s currency. The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency • For example, if the nominal exchange rate is 110 yen per dollar, one dollar can be exchanged for 110 yen • Transactions between currencies take place in the foreign exchange market

5. Real exchange rates • The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good • If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger

6. Real exchange rates • The real exchange rate is the price of domestic goods relative to foreign goods orto simplify matters, we’ll assume that each country produces a unique good • In reality, countries produce many goods, so we must use price indexes to get P and PFor • If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country

7. Real exchange rates Real exchange rates are reported as index numbers with one year chosen as the base year.

8. Equilibrium in the Market for Foreign Exchange The demand curve for dollars in exchange for yen has downward slope while the supply curve has upward slope. The foreign exchange market is in equilibrium at the exchange rate where the quantity supplied equals the quantity demanded. Currencyappreciation occurs when the market value of a country’scurrency increases relative to the value of another country’scurrency. Currency depreciation occurs when the market valueof a country’s currency decreases relative to the value of another country’s currency.

9. Equilibrium in the Market for Foreign Exchange

11. Purchasing power parity PPP holds in the long run but not in the short run Countries produce different goods Some goods aren’t traded Transportation costs Legal barriers to trade

12. When PPP doesn’t hold, using Equation, wecan decompose changes in the real exchangerate into parts Δe/e = Δenom/enom + ΔP/P – ΔPFor/PFor This can be rearranged as Δenom/enom = Δe/e + πFor – π

13. Price of a Big Mac As a test of the PPP hypothesis, the Economistmagazine periodically reports on the prices ofBig Mac hamburgers in different countries The prices, when translated into dollar terms using the nominal exchange rate, range from just over $1 inChina to over $5 in Switzerland (using 2006 data), soPPP definitely doesn’t hold

14. Price of a Big Mac

15. The real exchange rate and net exports The real exchange rate also affects a country’s netexports (exports minus imports)An increase in the realexchange rate means people in a country can get moreforeign goods for a given amount ofdomestic goods • Changes in net exports have a direct impact on export and import industries in the country • Changes in net exports affect overall economic activity and are a primary channel through which business cycles and macroeconomic policy changes are transmitted internationally