Michael M. Knetter

UW-Madison School of Business

Manufacturing Prospects and Midwest Public Policy

Federal Reserve Bank of Chicago

Real Effects of Currency Fluctuations

As quoted in the Wall Street Journal…

Honda Motor claims that “every ¥en the dollar rises against the Japanese currency adds about $40 million to its profits.”

Does this relationship make sense?

Is this a big deal or a small deal?

Price and Output Response to a Depreciation of the Exporter’s Currency

quantity

¥en/$

MC

MR1

q1

p1

optimal price and quantityrise as a result of depreciationof the exporter’s currencyfor a given MC

MR2

q2

p2

Profit Response to a Depreciation of the Exporter’s Currency

quantity

¥en

MC

q2q1

p2

p1

depreciation of exporter’scurrency increases price, quantity, and profit

Yen/$, Monthly 1990-99

60.0090.00120.00150.00180.00

1990M1

1990M1

1991M7

1992M4

1993M1

1993M1

1994M7

1995M4

1996M1

1996M1

1997M7

1998M4

1999M1

1999M1

Is this a big deal for Honda??

¥en/$ in the 1990s: Implications for Honda’s Profits

1990 to 1995: 150 ¥en/$ to 90 ¥en/$

Profit change = ($40 mill)*(-60) = -$2.4 billion

1995 to 97: 90 ¥en/$ to 125 ¥en/$

Profit change = ($40 mill)*(+35) = +$1.4 billion

Consequences of a Weaker $ for U.S. Manufacturing Sector

• Reduction in costs of production relative to foreign competitors.

• Higher $ prices and profit margins?• Higher production volume and employment?• Higher imported input costs?• Higher cash flows/profits. • Higher stock prices? • Less spending on lobbyists?

Determinants of PTM/Pass-Through

• Potential for arbitrage.– No PTM in gold.

– Lots of PTM in autos.

• Who is your competition?– Local competitors may force you to keep local prices

stable (lots of PTM)

• Is the market regulated?– Threat of trade sanctions may lead to stable local price

strategy.

How Widespread is Exposure to Currency Risk?

• Demand side– Exports– Import competition– Indirect examples (restaurant in Miami Beach)

• Supply side– Foreign input sourcing

How much has the $ depreciated?

• $ was worth 1.19 euros in summer 2001

• $ is worth about 0.80 euros today

• 40% depreciation in nominal terms—approximately same in real terms

• This should have large positive impact on manufacturers and farmers in the Midwest.