Chapter 17: The Foreign Exchange Market

2. Chapter 17: The Foreign Exchange Market • Trade between countries involves the mutual exchange of different currencies (bank deposits denominated in different currencies) • When American firms buy foreign goods, services and assets => U.S. $ exchanged for foreign currency • Bank deposits denominated in U.S. $  bank deposits denominated in foreign currency • This trade takes place in foreign exchange markets Definitions: • Exchange Rate - price of one currency in terms of another • Spot exchange rate – exchange rate for the immediate (2-day) exchange of bank deposits • Forward exchange rate – exchange rate for the exchange of bank deposits at some specified future date • Appreciation – currency increases in value • Depreciation – currency decreases in value

3. Euro/$ $/Euro $/Euro Euro/$

4. Exchange rates are important because they affect the relative price of domestic and foreign goods. Example: The $ price of a German BMW to an American is a function of the interaction of 2 factors • The price of BMWs in Euros (50,000 euros) • The exchange rate E = $/euro, If E = $1/1euro => 50,000 euro x ($1/1euro) = $50,000 If euro appreciates to ($1.20/1euro) => $ depreciates => 50,000euro x ($1.20/1euro) = $60,000 Currency appreciates => country’s goods prices  abroad and foreign goods prices  in that country 1. Makes domestic businesses less competitive 2. Benefits domestic consumers

5. ePEU x ($/e) = $PMUS

6. Source: FRB: Exchange Rates G.5 (405)

7. How Movements in the Exchange Rate Affect Exports

8. Law of One Price – if 2 countries produce an identical good and transaction costs and trade barriers are very low => the price of the good should be the same in both countries Example: American computer chip costs $100, Canadian computer chip costs @200 (Canadian dollars = @) If E =$.50/@1, then prices are: American ChipsCanadian Chips If E = $.75/@1 then prices are: American ChipsCanadian Chips The demand for Canadian computer chips goes to zero, so either • Price of Canadian chips must  • Exchange rate must  Law of one price E = $.50/@1

9. Purchasing Power Parity (PPP) • Application of the law of one price to national price levels • Theory of PPP => if foreign country price level increases relative to another => its currency depreciates relative to the other country • Exchange rates between 2 countries will adjust to reflect changes in the price level of the 2 countries (relative price level determines exchange rate) PPP assumptions • Goods are identical • Transaction costs are low • Trade barriers are low PPP: Foreign price level  10% => foreign currency  10% 1. Application of law of one price to price levels 2. Works in long run, not short run Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy • Many goods and services are not traded across borders (e.g. land, housing, services) So inflation in housing prices => higher price level,.. but will not have effect on E.

10. PPP: U.S. and U.K

11. Exchange Rates in the Short Run Theory of Asset Demand (we will use the asset market approach to determine exchange rates) Exchange Rate – price of domestic bank deposits in terms of foreign bank deposits (the price of one asset in terms of another) Assume Capital Mobility Americans can buy European bank deposits Europeans can buy American bank deposits Deposits are perfect substitutes if: • American and European deposits have similar risk and liquidity characteristics • Few impediments to capital mobility If Re$ > Re@ => Europeans and Americans will want to hold $ deposits If Re$ < Re@ => Europeans and Americans will want to hold @ deposits If Re$ = Re@ => hold both

12. 1. Value of $ and real rates rise and fall together, as theory predicts 2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises The Dollar and Interest Rates

13. Econ 330 Chapter 17 HomeworkDue Friday, April 11 Chapter 17 Questions & Applied Problems 5, 8, 12, 15, 16, 17, 19, 20, 22, 23, 24