Money, Banking, and Financial Markets : Econ. 212

Money, Banking, and Financial Markets : Econ. 212 Stephen G. Cecchetti: Chapter 10Foreign Exchange

Foreign Exchange Basics • The Nominal Exchange Rate • The exchange rate is the price paid in one currency to obtain an amount of another currency. Exchange rates change every day. • A decline in the value of one currency relative to another is called a depreciation; an increase is called an appreciation. • When one currency goes up in value relative to another, the other currency must go down. • Exchange rates can be quoted in units of either currency; for example, as the number of dollars needed to buy one euro (direct rate in USA) or as the number of euro needed to buy one dollar (indirect rate).

The two prices are equivalent (one is simply the reciprocal of the other) and there is no rule for determining which way a particular exchange rate should be quoted. • In practice, most rates tend to be quoted in the way that yields a number larger than one. • The Real Exchange Rate • The real exchange rate is the rate at which one can exchange the goods and services from one country for the goods and services from another country. • The real exchange rate is the cost of a basket of goods in one country relative to the cost of the same basket of goods in another country.

To compute the real exchange rate we take the dollar price of a good in the United States divide it by the dollar price of the same good in another country (the dollar price in the other country is found by taking the local price and multiplying by the nominal exchange rate). • The real exchange rate is calculated using the following formula: e = Phome / Pforeign * R • e = real exchange rate • Phome= price at home • Pforeign= price in the foreign country • R = nominal exchange rate Example • If product X price in Kuwait is KWD 16, The price of product X in the USA is $ 50, and R = KWD .3/$, then: • e =16/(50*.3) = 1.066667 • Interpretation!

Whenever the real exchange rate as calculated above is greater than one(the real exchange rate has no units), foreign products will seem cheap. • The real exchange rate is more importantthan the nominal exchange rate because it measures the relative price of goods and services across countries, telling us where things are cheap and where they are expensive. • The real exchange rate is the guiding forcebehind international transactions (competitiveness). • The competitiveness of Kuwait’s exports (except for oil) depends on the real exchange rate; if it appreciates, Kuwaiti exports (except for oil) become less competitive and if it depreciates they become more competitive.

Foreign Exchange Markets • The daily volume of foreign exchange transactions is enormous. According to the Bank of International Settlements, the daily turnover of global foreign exchange transactions in 2007 is 3.1 trillion US dollars. • Because of its liquidity, the U.S. dollar is one side of roughly 90 percent of the currency transactions that occur. • The most important center for such transactions is London; other significant foreign exchange trading occurs in New York, Tokyo, Singapore, Frankfurt, and Zurich.

Figure 1: Daily Turnover of global foreign exchange transactions BIS "Triennial Central Bank Survey Foreign exchange and derivatives market activity in 2007" December 2007

Exchange Rates in the Long Run • The Law of One Price • The law of one price is the starting point for understanding how long-run exchange rates are determined. • PX,K = PX,US . ekwd/$ • The law is based on arbitrage, the idea that identical products should sell for the same price anywhere in the world. • If the same good did not sell for the same price in two places there would be an opportunity for someone to profit by purchasing the item where it is cheap and reselling it where its price is higher (this is known as commodity arbitrage), but by doing that, the relative supplies would change and move the two prices to equality.

The law of one price fails almost all the time; the same commodity or service sells for vastly different prices in different countries as a result of transportation costs, taxes, differences in technical specifications, differences in tastes, and that fact that some things simply cannot be traded (like haircuts). • Purchasing Power Parity • Even with its obvious flaws the law of one price is extremely useful in explaining the behavior of exchange rates over long periods, like ten or twenty years. • Extending the law from a single commodity to a basket of goods and services results in the theory of purchasing power parity (PPP), which means that one unit of Kuwait’s domestic currency will buy the same basket of goods and services anywhere in the world.

Again the law of one price states: • PX,K = PX,US . ekwd/$ • Using the price of a basket of goods ands in Kuwait and USA, PPP implies • ekwd/$ =PK / PUS • PPP implies that the real exchange rate is always equal to one. • PPP implies that when prices change in one country but not in another the exchange rate should change as well.

Changes in exchange rates are therefore tied to differences in inflation from one country to another; the currency of a country with high inflation will depreciate. • Over weeks, months, and even years, nominal exchange rates candeviate substantially from the levels implied by purchasing power parity. Such short-term movements have other explanations. • A current market rate that deviates from purchasing power parity results in a currency being considered undervalued or overvalued (sometimes it is called misalignment).

Exchange Rates in the Short Run • The Supply of KWD • Someone who wants to exchange KWD for another currency supplies them to the foreign exchange markets. • The two reasons for such an exchange would be to purchase foreign goods and services or to invest in foreign assets. • The more valuable the KWD, the cheaper foreign goods, services, and assets are, and the higher will be the supply of KWDs in the foreign exchange market.

The Demand for KWD • Foreigners who want to purchase Kuwaiti-made goods, assets, or services need KWD to do so and so represent the demand for KWD. • The cheaperthe KWD the more attractive such goods, assets, or services are and the higher the demand for KWD with which to buy them. • Equilibrium in the Market for KWDs • Equilibrium in the market for KWDs occurs where the supply and demand are equal.

Fluctuations in the values of currencies are the result of shifts in supply or demand. • Shifts in the Supply and Demand for KWDs • Shifts in supply: the supply of KWDs will increase the more Kuwaitis want to import goods and services from abroad or the higher their preference for foreign stocks and bonds. These can result from: • an increase in Kuwaitis’ preference for foreign goods. • an increase in Kuwait’s real GDP and real income. • an increase in the real interest rate on foreign bonds. • an increase in Kuwaiti wealth.

a decrease in the riskiness of foreign investments relative to Kuwaitis investments. • an expected depreciation of the KWD. • Shifts in Demand: the demand will increase if there is an increased desire by foreigners to buy Kuwaiti-made goods and services or to invest in Kuwaitiassets. This can be the result of: • an increase in foreigners’ preference for Kuwaiti goods. • an increase in foreign real GDP and real income. • an increase in the real interest rate on Kuwaiti bonds. • an increase in foreign wealth. • a decrease in the riskiness of Kuwaiti investments relative to foreign investments. • an expected appreciation of the KWD.

Explaining exchange rate movements: • The supply and demand model helps to explain short-run movements in currency values. • Shifts in supply and demand can both occur at the same time, and the movement of the exchange rate will depend on which effect is stronger. • Government Policy and Foreign Exchange Intervention • Government officials can intervene in foreign exchange markets in several ways. • Some countries adopt a fixed exchange rate and act to maintain it at a level of their choosing. • Large industrialized countries generally allow markets to determine the exchange rate but may intervene at times to influence the value (managed floating). • When policymakers buy or sell currency to affect demand or supply it is called foreign exchange intervention.

Appendix: Interest Rate Parity and Short‑Run Exchange Rate Determination • Another way to think about the determinants of exchange rates over the short term is to focus on them from an investor’s point of view. • If the bonds issued in different countries are perfectsubstitutes for each other, then arbitrage will equalize their returns. Since investing abroad means exchanging currencies, the result is a relationship among domestic interest rates, foreign interest rates, and the exchange rate. • The interest parity condition (derived in this appendix) tells us that the Kuwaiti interest rate equals the rate on a foreign bond minus the KWD’s expected appreciation.

If the interest parity condition did not hold, people would have an incentive to shift their investments until it did. • Knowing current Kuwaiti and foreign interest rates allows us to calculate what the exchange rate should be. • The current value of the KWD will be higher the higher Kuwaiti interest rates are, the lower foreign interest rates are, and the higher the expected future value of the KWD is.

Lessons of Chapter 10 • Different areas and countries of the world use different currencies in their transactions. • The nominal exchange rate is the rate at which the currency of one country can be exchanged for the currency of another. • A decline in the value of one currency relative to another is called depreciation. • An increase in the value of one currency relative to another is called appreciation. • If the dollar appreciates relative to the euro, the euro will have depreciated relative to the dollar. • The real exchange rate is the rate at which the goods and services of one country can be exchanged for the goods and services of another. • Enormous quantities of currency are traded every day in markets run by brokers and foreign exchange dealers. • In the long run, the value of a country’s currency is tied to the price of goods and services in that country. • The law of one price states that two identical goods should sell for the same price, regardless of location. • The law of one price fails because of transportation costs, differences in taxation and technical specifications, and the fact that some goods cannot be moved. • The theory of purchasing power parity applies the law of one price to international transactions; it states that the real exchange rate always equals one. • Purchasing power parity implies that countries with higher inflation than other countries will experience exchange rate depreciation.

Over decades, exchange rate changes are approximately equal to differences in inflation, implying that purchasing power parity holds. • In the short run, the value of a country’s currency depends on supply and demand for the currency in foreign exchange markets. • When people in the United States wish to purchase foreign goods and services or invest in foreign assets, they must supply dollars to the foreign exchange market. • The more foreign currency that can be exchanged for one dollar, the greater will the supply of dollars will be; that is, the supply curve for dollars is upward sloping. • Foreigners who wish to purchase American‑made goods and services or invest in U.S. assets will demand dollars in the foreign exchange market. • The fewer units of foreign currency needed to buy one dollar, the higher the demand for dollars – that is, the demand curve for dollars is downward sloping. • Anything that increases the desire of Americans to buy foreign-made goods and services or invest in foreign assets will increase the supply of dollars (shift the supply curve for dollars to the right), causing the dollar to depreciate. • Anything that increases the desire of foreigners to buy American-made goods and services or invest in U.S. assets will increase the demand for dollars (shift the demand curve of dollars to the right), causing the dollar to appreciate. • Some governments buy and sell their own currency in an effort to affect the exchange rate. Such foreign exchange interventions are usually ineffective.

Key Terms

Key Terms Appreciation Big Mac index capital account capital account deficit/surplus current account current account deficit/surplus demand for KWDs depreciation foreign exchange intervention Law of One Price nominal exchange rate overvalued currency purchasing power parity (PPP) real exchange rate supply of KWDs undervalued currency

Money, Banking, and Financial Markets : Econ. 212