In the real world, do currencies matter?

In the real world, do currencies matter? Adding some reality

Exchange rate as a price? Exchange rates are the price of a currency eus,Euro = $/€ eus,yen= $/¥ eus,pound=$/£

Exchange rate markets • Google “ FX” markets or FOREX markets • Today, foreign exchange markets are the representative of state-of-the-art information and trading technology, they operate 24/7

Let’s review – exchange rates and international product prices • Sources for exchange rates? • Federal Reserve Bank is best source of historical series annual, monthly, weekly, daily are available. • Yahoo Finance and other sites also provide data series • Hundreds of on-line sites provide current rates

Spatial arbitrage with differing currencies • Buy product in country j in ¥ Sell product in country i in $ • In the real world, you open a foreign exchange account, convert $ to ¥ on a continuous basis. Why? Averaging effect • In some cases, Pepsi is former Soviet Union, you may not trust the value of the currency, it may not be convertible! So, choose a product (vodka) and ship it back home! Same story with plastic toys and McDonald’s in China In other cases, buy property in the importing country (RCA Building and Rockafellar Center, NYC !)

Different currenciestrade of same product REVIEW Define exchange rate with US as i Japan as j Eji = units ith cur/ units jth cur ¥/$ • Suppose we consider profits in = Eji PeiYij - Pj Yij – Cij (Yij ) > 0 = (¥/$) * ($/box)*boxes - (¥/box)*boxes -¥cost • Arbitrage equilibrium if Eji Pei- Pj-C(Y)/Y = 0 Eij Pei = Pj + AC(Yi,j)  exch rates play a role

Implications Exchange Rates and Prices are bound together! Suppose we simplify a bit…… Ejit Pit = Pjt + AC(Yi,j) and suppose AC(Yi,j) ~ 0 then Ejit Pit = Pjt  Ejit = Pjt / Pit = ¥/$ In spatial equilibrium, the prices across locations should reflect the exchange rate….

In fact, the exchange rate reflects relative purchasing power of the two currencies So what does this mean? Ejit = ¥/$= Pjt / Pit The financial world uses this approach to estimate the true value of currencies…its called the real exchange rate, ejit Official market Ejit = ¥/$= Pjt / Pit = ejit real exchg rate

In fact, the exchange rate reflects relative purchasing power of the two currencies If Ejit = ¥/$= Pjt / Pit = ejit If this holds, ejit the real exchange rate is a “barter price” = [¥/bu soy in Tokyo]/ [$/bu soy in U.S.] If soy is soy……..bushels cancel out and we have.. = ¥/$

In fact, the exchange rate reflects relative purchasing power of the two currencies We call this rule Ejit = ¥/$= Pjt / Pit = ejit The purchasing power parity rule, and the real exchange rate as the purchasing power parity value of the exchange rate…PPP for short

Definitions real vs official exchange rates Define the official exchange rate in the market as: Ejit = ¥/$ Define the real exchange rate ejit = ¥/$= Pjt / Pit Why might these two exchange rates differ?

In fact,………. • In the 70’s you could take jeans to Poland and sell them for 300 times their value in the U.S. • You can still take advantage on many distortions of the purchasing power parity rule! • Google your favorite product in 5 countries, compute the PPP or “real” exchange rate and compare vs. official exchange rate! • Why does this happen?

If exchanges rates are regulated, what is the true value of a currency? • Use PPP to compute the “real exchange rate” E • Compare vs. the actual official exchange rate e • Economist BigMac index Define a currency (e.g. ¥) as “overvalued” vs $ if E = ¥/$ > e “undervalued” vs $ if E < e why??

Purchasing Power Parity http://www.economist.com/markets/currency/

So, PPP column 3 tells you the true exchange rate Column 4 is official As we can see, many exchange rates are distorted. Why????? Can you circle the currencies that are undervalued vs. the dollar?

Exchange rate distortion Define e as the PPP or real exchange rate, E as official……..then For China, we see eyuan/$ = 3.23 <<< E yuan/$ =7.60  $ is undervalued vs yuan = yuan is overvalued vs $

Why do governments distort their exchange rates? Suppose Ejit Pit = Pjt + AC(Yi,j) then, trade flow is optimal at say Yij * Suppose you would like to increase exports from j you could advertise, you give tax credits for exporters or, you could reduce the value of your currency, making your products cheaper for foreign buyers

Why distort your exchange rate? Suppose the real exchange rate is ejit then if the official rate Eojit =ejit arbitrage would force ejit Pit = Pit + AC(Yi,j) then, trade flow is optimal at say Yij * Suppose the government reduces the value of the yen, (undervalues it) making it cheaper so Ejit > Eojit = ejit more ¥/$! So,…… Ejit Pit > ejit Pit = Pjt + AC(Yi,j) (yen/$) $ = yen + yen cost This means an exporter would earn more ¥ profits/unit shipped to the U.S. So……exports would increase! Undervalued currency  exports will increase (So why did the Bush Admin allow the dollar to lose value in 2007-2009? )

Why distort your exchange rate? Suppose Japan faced inflation, not enough supply relative to demand……….they would like to increase imports, shut off exports…. They could increase the value of their currency, making it more expensive (overvalued) Ejit < ejit less ¥/$! So,…… Ejit Pit < ejit Pit = Pit + AC(Yi,j) This would mean Japanese exporters would bring fewer yen home per export sale Overvalued currency  exports will decrease, and imports are encouraged

Cutting to the chase………. • If you undervalue your currency, you are putting your economy on sale! (can you explain?) • If you overvalue your currency, you are making your economy’s products more expensive and will reduce exports and increase imports! • Suppose you would like to see an increase in employment in the U.S., a young senator rails for a strong $. Would you recommend he take some economics?

Lets take another look at the BigMac PPPs • What countries have their currencies undervalued? Are they known as major exporters? • Why did the Bush admin allow the $ to substantially weaken in value over the past two years of that admin?

Under valued  exports encouraged Imports discouraged Overvalued  exports discouraged, imports encouraged

A minor complication! • While exchange rates affect product trade they can have an inverse effect on financial flows! • A strong currency (perhaps overvalued) means interest earned in that country can buy more in other countries……..so, money flows into countries with overvalued exchange rates! • This can offset the effects on product flows!@

In the real world, do currencies matter?