Exchange Rates

20-2

Exchange Rates

Exchange Rates• Nominal exchange rate: price of one currency in terms of

another currency (bilateral exchange rate)– example: 1.30 dollars per euro or 76.92 euros per dollar– determines price of imports– foreign exchange market– denote as enom , units of the foreign currency per unit of domestic

currency

• Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies

20-3

Exchange Rates

Nominal and Nominal Effective Exchange Rate

0

20

40

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Nom

inal E

ffec

t E

xch

ange

Rate

0.00

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Yen

Per

Dollar

Nominal Effective Exchange Rate Japanese Yen

20-4

Exchange Rates

• Real Exchange Rate (RER): the price of domestic goods relative to foreign goods– says how much foreign good you could get for domestic

good

• The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency

20-5

Exchange Rates

• RER Example– Should you buy a Japanese or American computer for your

company?• Price of U.S. computer = $2,400• Price of Japanese computer = 242,000 yen• Exchange rate = 110 yen/dollar• Price in dollars = price in yen/yen-dollar exchange rate

– Price in yen = price in dollars x value of dollar in terms of yen– Price in dollars = 242,000 yen/110 = $2,200

– Japanese computer is cheaper.– Real exchange rate = $2,400/$2,200 = 1.09

20-6

Exchange Rates

Real Exchange Rate (RER)

• If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country– NX will tend to be low when the real exchange rate is high.

• Real exchange rate = “terms of trade” => competitiveness

• Real exchange rate is an index and is unit-less

foreign

domestic

nomRER P

Pee

foreigndomestic

nomRERPPee %%%%

20-7

Exchange Rates

U.S. Nominal and Real Exchange Rates

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60

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160

Jan-7

3

Jan-7

5

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Nominal Effective Exchange Rate Real Effective Exchange Rate

20-8

Purchasing Power Parity

Law of One Price and Purchasing Power

Parity• Identical goods & services should sell at same price no

matter where they are sold…otherwise opportunity for profits (i.e. arbitrage)– Law of one price: same price for a commodity

• Candy bar in Port-of-Spain versus San Fernando

• Purchasing Power Parity (PPP)– The theory that nominal exchange rates are determined as

necessary for the law of one price to hold– Exchange rates should move to equalize prices across

countries

20-9

Purchasing Power Parity

domestic

foreignc

nomforeign

domestic

nomRER P

Pe

P

Pee 1

0%%%% foreigndomestic

nomRERPPee

domesticforeign

nomPPe %%%

PPP implies currencies of countries that experience

significant inflation will tend to depreciate

20-10

Purchasing Power Parity

• Example– How many Indian rupees equal to one Australian

dollar?• Bushel of grain cost 5 Australian dollars or 150 rupees

• 5 Australian dollars = 150 rupees– Or, a 30 rupee to 1 Aus. Dollar ratio

• Nominal exchange rate should equal 30 rupees/Australian dollar

– If not 30:1, what should happen?

20-11

Purchasing Power Parity

– How many Indian rupees equal one Australian dollar?

• Suppose price of grain in India increases from 150 to 300 rupees

• Price of grain in Australia still equals 5 Australian dollars

– Originally: implied exchange rate 5:150 or 1:30

– Now: implied exchange rate 5:300 or 1:60

• 1 Australian dollar = 60 rupees

• Nominal exchange rate increased from 30 to 60 rupees/Australian dollar

• Indian currency depreciated

• Australian currency appreciated

20-12

Purchasing Power Parity

• Does not hold up well in short run– Transportation costs– Border effect – tariffs, technical requirements,

regional monopoly power– Pricing to market

• Goods prices are “sticky”

• Reduces exchange rate “pass through”

– Nontradable sector• Higher productivity, higher nontradable wages,

higher nontradable inflation

• Works better in the long run

20-13

Price differences between US and Canadian Cities. Figure 19.4

20-14

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-3

3

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30

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Currency Depreciation (% pa)

Inflation and Currency DepreciationFive Year Window

Inflation Differential

20-15

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-10 -5 0 5 10 15Inflation Differential

Inflation and Currency DepreciationTwenty Year Window

Currency Depreciation (% pa)

20-16

Power Purchasing Parity

• McParity & the Big Mac Index– The Economist's Big Mac index is based on the theory

of purchasing-power parity (PPP) using the Big Mac– The cheapest burger in the chart is in China, at $1.26,

compared with an average American price of $3. The PPP implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.

20-17

McParity

20-18

Exchange Rate

• RER reflects competitiveness—the higher a country’s RER, the more expensive its goods and services are to foreigners.

• => as the RER↑, a country’s NX growth will ↓, leading to a current account deficit (and vice versa)– Note: nominal exchange rate can fall but be offset by

higher domestic inflation so that RER stays constant