Chapter 6Chapter 6Chapter 6Chapter 6

Foreign ExchangeForeign Exchange

• Exchange Rates – Rates at which two currencies trade. One currency in terms of another..

– Defining exchange rates• The exchange rate is the number of units of foreign currency (money) that

can be acquired with one unit of domestic money. Foreign currency is supplies of foreign exchange.

• The foreign exchange market is the market for buying and selling the different currencies of the world.

• When a currency has increased (decreased) in value relative to another currency, it has appreciated (depreciated).

• The nominal exchange rate is the price of one country’s exchange rate in terms of another’s.

» The nominal exchange rate is usually called the exchange rate.» An increase in the value of a country’s currency compared to the currencies of

other countries is called appreciation.» A decrease in the value of a country’s currency compared to the currency of

other countries is called depreciation.– The real exchange rate is the purchasing power of a currency relative to the

purchasing power of other currencies.» Dollar per Euro: 1 Euro = $1.00» Real Exchange rates are adjusted for the nation’s inflation rate

– Types • Floating: Supply and Demand

– Appreciation: Currency increases in value and can buy more of the other currency. The other currency costs less.» 1 Euro = $.75» Dollar appreciates

– Depreciation: Currency decreases in value

• Fixed: Set by the governments (1944 to early 1970’s)

• Foreign Exchange Markets– Importance: The global market necessitates more

trading between countries (Transportation and communications)

– International currencies are traded in foreign-exchange markets around the world.

– Foreign-exchange markets are over-the-counter markets that link together by computer traders in commercial banks in many countries.

– Two types of currency transactions are conducted in foreign-exchange markets.

• Spot market transactions involve currency or bank deposits that are exchanged immediately.

• Forward transactions involve currencies or bank deposits that are to be exchanged in the future.

Long Run Exchange Rate Theories

• Law of One Price: With no trade barriers prices for a good will eventually be the same all over the world• Trade barriers are quotas and tariffs

• The theory of purchasing power parity• In the long run, exchange rates are set by economic fundamentals

such as price levels or productivity levels in different countries.• Purchasing power parity (PPP) theory applies the law of one

price to a group of goods.• The theory of purchasing power parity asserts that exchange

rates adjust to varying rates of inflation across countries so that relative purchasing power among countries is equalized.

• With the law of one price, Exchange rates become constant and won’t change

• Theory of interest rate parity• The real interest rate parity condition states that expected

real rates of interest measured in terms of the same group of goods are equal

Foreign Exchange Effects

Factor Change in Factor Exchange Rate Dollar

U.S. Price Levels Increase Increases Depreciates

Tariffs and quotas Increase Decreases Appreciates

Import Demand Increase Increases Depreciates

Export Demand Increase Decreases Appreciates

Productivity Increase Decreases Appreciates

U.S. Interest Rates Increase Decreases Appreciates

Foreign Interest Rates Increase Increases Depreciates

U.S. Money Supply Increase Increases Depreciates

• Special Drawing Rights (SDR) – composite currency of the IMF based on a weighted average of 4 currencies used in the event of a global financial crisis

– World’s reserve currency– 4 Currencies

• US Dollar• Euro• Japan Yen• England Pound Sterling