Ch. 29: Open Economy: Foreign Exchange

1. Ch. 29: Open Economy:Foreign Exchange

2. The Prices for International Transactions: Real and Nominal Exchange Rates • Nominal Exchange Rates: • Rate you can trade one currency for another • 80 yen per dollar or 1/80 = .0125 dollar per yen

3. “appreciation” or stronger: dollar buys…… more foreign currency • “depreciation” or weaker: dollar buys….. less foreign currency

4. When exchange rate changes from 80 yen per dollar to 90 yen per dollar: the dollar has…… appreciated because ….. the dollar can now buy more yen • When exchange rate changes from 90 yen per dollar to 80 yen per dollar: the dollar has….. depreciated because …… the dollar can now buy less yen

5. FOREX: Who, What, Where, When, Why • Exchange rates are determined in the foreign exchange market • open to a wide range of different types of buyers and sellers • currency trading is continuous: 24 hours a day except weekends. • The spot exchange rate refers to the current exchange rate. • The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. (*not responsible for this info*)

6. People may need to exchange currencies in a number of situations. • Example: travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveller'scheques or a travel-card. • From a local money changer they can only buy foreign cash (*not responsible for this info*)

7. At the destination, the traveler can buy local currency at the airport, either from a dealer or through an ATM. • They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. • When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. • If they have traveler's cheques or a travel card in the local currency, no currency exchange is necessary. (*not responsible for this info*)

8. If a traveler has any foreign currency left over on their return home, may want to sell it, which they may do at their local bank or money changer. • The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. (*not responsible for this info*)

9. A currency pair is the ….. • quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. (= e = nominal exchange rate) • The quotation EUR/USD 1.2500 means that 1 Euro is exchanged for 1.2500 US dollars.

10. An exchange rate index - • way of measuring the performance of a currency against a basket of other currencies. • US Dollar Index • For example, the US dollar index measures the US dollar against 6 main currencies.

11. Real Exchange Rate • Rate you can trade goods/services of one country for that of another • Ex: for every case of American beer you can buy, you would get 2/3 case of German beer Real and Nominal Exchange Rates working together Ex: American rice = $100/bushel Japanese rice = 16,000 yen/bushel • What is the real exchange rate? = nominal x domestic P / foreign P • e x P / P* • use to convert prices into a common currency

12. e x P / P* (80 yen/$) x ($100/bushel US rice) (16,000yen/bushel Japanese rice) = 8,000 yen / per bushel US rice 16,000 yen/per bushel Japanese rice = ½ bushel Japanese rice per bushel of American rice

13. Real Exchange Rate = key determinant of how much a country imports or exports • Use the Price of basket of goods for both US price (P) and foreign price (P*) and the nominal exchange rates (e) • Measures the price of a basket of goods domestically relative to the price of foreign goods

14. Finding the nominal exchange rate: e = P* / P (-assuming there is purchasing power parity) • Convert foreign price of good to US $: P*/ e

15. Purchasing Power Parity • Purchasing power of the dollar is = to that of other currencies • According to the theory: The ( e ) between two countries must reflect the different price levels in those countries • ( e ) change when PL changes **When increase MS, PL increases = value decreases = depreciate vs. other currencies

16. If Britain pursues tighter MS and less inflation than the US, then the value of the Pound will appreciate vs. the US $ If the US pursues easy MS and allows more inflation than Britain, then the value of the US$ will depreciate vs. the Pound

17. Purchasing Power Parity does not always hold true • Many goods are not easily traded • Not always perfect substitutes

18. Case Study: Increasing Openness of the US Economy • Transportation (ships/jets) • Telecommunications • Technology – change in kinds of goods (easily transported) • Govt. policies – more free trade : NAFTA, GATT

19. Case Study: Are US Trade Deficits a National Problem? Trade deficit a problem? Maybe a symptom of the problem …= reduce national savings …. = not providing for future

20. FOREX Market • Demand curve = Demand for US $ …comes from • Foreign Demand for : • US exports • US financial investments (savings) • Speculation • Ex : if D for US goods increases, shift D for US $ to right = appreciate • Ex: if Int. Rates in US increase, shift D for US $ to right = appreciate …..why? .. • Higher int rates = incentive for foreigners to buy US $ to save (bonds) ….= higher return on their financial investments

21. Supply curve = Supply of US $...comes from: • Americans buy imports • US buy foreign financial investments (savings) • Speculation • If US imports (M) increase = increase Supply of US $ = Supply shifts right = depreciate • If Foreign int. rates increase = increase Supply of US $ = Supply shifts right = depreciate..why… • If foreign int rates increase = incentive for Americans to supply $ to buy foreign bonds (savings