10. Foreign Exchange10. Foreign Exchange10. Foreign Exchange10. Foreign Exchange

• The basics

• Long run / PPP

• Short run / Demand & Supply

• Gov’t intervention

• The basics

• Long run / PPP

• Short run / Demand & Supply

• Gov’t intervention

Exchange rates (XR)Exchange rates (XR)Exchange rates (XR)Exchange rates (XR)

• Price of one countries currency in terms of another

• Impacts Relative prices of imports/exports Attractiveness of domestic vs.

foreign assets

• Price of one countries currency in terms of another

• Impacts Relative prices of imports/exports Attractiveness of domestic vs.

foreign assets

Two ways to quote XRTwo ways to quote XRTwo ways to quote XRTwo ways to quote XR

• Foreign currency per 1 US $

• Used to quote Yen (Japan) Yuan (China) Won (S. Korea) Peso (Mexico) Rupees (India) Canadian $

• Foreign currency per 1 US $

• Used to quote Yen (Japan) Yuan (China) Won (S. Korea) Peso (Mexico) Rupees (India) Canadian $

• US $ per 1 unit of foreign currency Euro British Pound

• US $ per 1 unit of foreign currency Euro British Pound

XR marketXR marketXR marketXR market

• Worldwide market

• $1 trillion in transactions daily

• 90% involve US $ Size of economy Store of value World price of oil in US $

• Worldwide market

• $1 trillion in transactions daily

• 90% involve US $ Size of economy Store of value World price of oil in US $

Nominal XRNominal XRNominal XRNominal XR

• Rate of one country’s currency exchanges for another

• Rate of one country’s currency exchanges for another

Amount of foreign currency per US $

  2000 2008

China (Yuan) 8.28 7.24

Euro 1.11 .68

Japan (Yen) 112.21 107.82

Canadian $ 1.52 1.01

Mexico (Peso) 9.47 10.91

British Pound 0.68 .51

US $ DepreciationUS $ DepreciationUS $ DepreciationUS $ Depreciation

• US $ buys less of foreign currency

• 2000-2008 Canada, Euro, UK, China . . . Most major trading partners

• US $ has fallen

• US $ is weaker

• US $ buys less of foreign currency

• 2000-2008 Canada, Euro, UK, China . . . Most major trading partners

• US $ has fallen

• US $ is weaker

US $ appreciationUS $ appreciationUS $ appreciationUS $ appreciation

• US $ buys more of foreign currency

• 2000-2008 Mexico

• US $ has risen

• US $ is stronger

• US $ buys more of foreign currency

• 2000-2008 Mexico

• US $ has risen

• US $ is stronger

• Example: Yen/$

• If $ appreciates, the Yen must depreciate

• XR are a “seesaw”

• XR changes have winners and losers

• Example: Yen/$

• If $ appreciates, the Yen must depreciate

• XR are a “seesaw”

• XR changes have winners and losers

Real XRReal XRReal XRReal XR

• Relative cost of certain goods in two countries

• Changes in the nominal XR

• Relative cost of certain goods in two countries

• Changes in the nominal XR

Example: U.S. $ vs. Can $Example: U.S. $ vs. Can $Example: U.S. $ vs. Can $Example: U.S. $ vs. Can $

• SUNY tuition, nonresident Fall 2000: $4150/sem Fall 2007: $5305/sem The finest system of public higher ed

in the nation: priceless

• XR Fall 2000: $1.50 C$ per 1 US $ Fall 2007: $1.10 C$ per 1 US $

• SUNY tuition, nonresident Fall 2000: $4150/sem Fall 2007: $5305/sem The finest system of public higher ed

in the nation: priceless

• XR Fall 2000: $1.50 C$ per 1 US $ Fall 2007: $1.10 C$ per 1 US $

How much is tuition to a Canadian How much is tuition to a Canadian student?student?How much is tuition to a Canadian How much is tuition to a Canadian student?student?

• Convert US $ tuition to Can $

• 2000: 4150(1.50) = C$ 6225

• 2007: 5305(1.10) = C$ 5835.50

• Can $ appreciation means an actual fall in tuition for Canadian students

• Convert US $ tuition to Can $

• 2000: 4150(1.50) = C$ 6225

• 2007: 5305(1.10) = C$ 5835.50

• Can $ appreciation means an actual fall in tuition for Canadian students

• U.S. $ depreciation Imported goods more expensive Less purchasing power abroad Exports less expensive abroad Foreign visitors have more

purchasing power

• U.S. $ depreciation Imported goods more expensive Less purchasing power abroad Exports less expensive abroad Foreign visitors have more

purchasing power

• Univ of W. Ontario, nonresident Fall 2000: C$ 5190/sem Fall 2007: C$ 7300/sem

• Tuition costs for a U.S. student 2000: 5190/1.5 = $3460 2007: 7300/1.1 = $6636

• Univ of W. Ontario, nonresident Fall 2000: C$ 5190/sem Fall 2007: C$ 7300/sem

• Tuition costs for a U.S. student 2000: 5190/1.5 = $3460 2007: 7300/1.1 = $6636

XR in the long runXR in the long runXR in the long runXR in the long run

• Primarily depends on relative inflation

• Law of One Price Identical goods should be about

the same price everywhere in the world

• Primarily depends on relative inflation

• Law of One Price Identical goods should be about

the same price everywhere in the world

• Pack of gum

• If $1 = 115 yen Then gum should cost $1 in U.S.

and 115 Y in Japan

• Pack of gum

• If $1 = 115 yen Then gum should cost $1 in U.S.

and 115 Y in Japan

• Now suppose prices double in US, so gum is $2.

• At the XR of 115Y/$, gum is cheaper in Japan Gum is 115Y or $1 in Japan Run on gum in Japan

• Now suppose prices double in US, so gum is $2.

• At the XR of 115Y/$, gum is cheaper in Japan Gum is 115Y or $1 in Japan Run on gum in Japan

• To equalize things, XR moves: $ must depreciate 57.5Y/$ then gum is same price

• To equalize things, XR moves: $ must depreciate 57.5Y/$ then gum is same price

Purchasing power parity (PPP)Purchasing power parity (PPP)Purchasing power parity (PPP)Purchasing power parity (PPP)

• XR adjust to relative price changes in two countries, so law of one price holds

• If US inflation is higher than other countries $ depreciate If lower, then $ appreciates

• XR adjust to relative price changes in two countries, so law of one price holds

• If US inflation is higher than other countries $ depreciate If lower, then $ appreciates

• Does PPP hold? In the long run, yes In the short run, no way

• Big Mac Index (240-41)• Not all goods identical or traded across

countries

• Does PPP hold? In the long run, yes In the short run, no way

• Big Mac Index (240-41)• Not all goods identical or traded across

countries

Other LR factorsOther LR factorsOther LR factorsOther LR factors

• Trade barriers—tariffs/quotas Boost domestic demand $ appreciates

• Productivity -- GDP/labor hour Higher relative productivity in US $ appreciates

• Trade barriers—tariffs/quotas Boost domestic demand $ appreciates

• Productivity -- GDP/labor hour Higher relative productivity in US $ appreciates

XR in the Short RunXR in the Short RunXR in the Short RunXR in the Short Run

• Supply and Demand, US $

• Explains short term volatility• Supply and Demand, US $

• Explains short term volatility

Who supplies $ to XR market?Who supplies $ to XR market?Who supplies $ to XR market?Who supplies $ to XR market?

• People buying foreign goods

• People investing in foreign assets

• As $ appreciates (Price of $ rises) People buy more foreign goods

because they are cheaper Supply slopes up

• People buying foreign goods

• People investing in foreign assets

• As $ appreciates (Price of $ rises) People buy more foreign goods

because they are cheaper Supply slopes up

Q of $

E/$S

Who demands $ in XR market?Who demands $ in XR market?Who demands $ in XR market?Who demands $ in XR market?

• People wanting to buy U.S. goods or dollar assets

• As $ depreciates (Price of $ falls) People buy more US goods

because they are cheaper Demand slopes down

• People wanting to buy U.S. goods or dollar assets

• As $ depreciates (Price of $ falls) People buy more US goods

because they are cheaper Demand slopes down

Q of $

E/$S

D

What causes the $ to depreciate?What causes the $ to depreciate?What causes the $ to depreciate?What causes the $ to depreciate?

• An increase in the supply of $

• A decrease in the demand for $• An increase in the supply of $

• A decrease in the demand for $

What increases $ supply?What increases $ supply?What increases $ supply?What increases $ supply?

• Increase in preference for foreign goods• An increase in US GDP and income

Buy more imports• An increase in real interest rate on foreign

bonds relative to US OR decrease in relative foreign investment risk Investors supply more $ to buy them

• Expectation of $ depreciation People supply $ now

• Increase in preference for foreign goods• An increase in US GDP and income

Buy more imports• An increase in real interest rate on foreign

bonds relative to US OR decrease in relative foreign investment risk Investors supply more $ to buy them

• Expectation of $ depreciation People supply $ now

What decreases $ demand?What decreases $ demand?What decreases $ demand?What decreases $ demand?

• Decrease in preference for US goods in foreign countries

• A decrease in foreign GDP/income

• A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments

• An expected depreciation of the $

• Decrease in preference for US goods in foreign countries

• A decrease in foreign GDP/income

• A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments

• An expected depreciation of the $

Increase in $ supplyIncrease in $ supplyIncrease in $ supplyIncrease in $ supply

Q of $

E/$S

D

S’’

Decrease in $ demandDecrease in $ demandDecrease in $ demandDecrease in $ demand

Q of $

E/$S

DD’’

So what is causing $ depreciation?So what is causing $ depreciation?So what is causing $ depreciation?So what is causing $ depreciation?

• Trade deficit US imports > US exportsAs $ depreciates, this will narrow

the trade deficit

• Federal deficit World market believes the US

borrows too much?

• Trade deficit US imports > US exportsAs $ depreciates, this will narrow

the trade deficit

• Federal deficit World market believes the US

borrows too much?

Consequences?Consequences?Consequences?Consequences?

• The good: Rising US exports Tourism in US Less pressure for trade barriers

• The good: Rising US exports Tourism in US Less pressure for trade barriers

• The bad: Possible inflation (higher import

prices) US tourists abroad US debt less attractive Pressure to move oil pricing to

Euros

• The bad: Possible inflation (higher import

prices) US tourists abroad US debt less attractive Pressure to move oil pricing to

Euros

Government InterventionGovernment InterventionGovernment InterventionGovernment Intervention

• Can the government affect XR markets? Yes, but interventions are rare Only effective if nations cooperate,

scale is large At best interventions are short run

solutions

• Can the government affect XR markets? Yes, but interventions are rare Only effective if nations cooperate,

scale is large At best interventions are short run

solutions