Download What is the nominal exchange rate?

Midterm 2 topics
1.
2.
3.
4.
5.
6.
GDP
Cost of living, CPI, Inflation
Unemployment
Production and growth
The financial system: saving and investment
The open economy
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MIDTERM 2
FRIDAY May 16
TIME & FORMAT
•The exam will start at 18:30
•50 multiple choice questions, 60 minutes
•Closed book exam
•For each question/answer:
Correct: 2 pts, Wrong: 0 pts, Unmarked: ½ point
•Bring your pocket calculator
REVIEW OF PAST MIDTERM
•Cihan will do a review sessions at 18.30 in room SOS 103
•He will solve the midterm exam 2013
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Studying for the second midterm
o Do the midterms for 2013 and then 2012 (These are already
posted on course webpage with answers)
o (re)Do the exercise sets
o Come to office hours
o Go to KOLT
o Read the slides
o Read the book (last resort if nothing else works)
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Make up exam policy
• Same format, same topics, same level of difficulty as the regular
midterm exam #2
• Must have valid excuse
• Will be scheduled either before or during the first days of the
final exam period, which is May 22 to June 1
• Email Murat Usman ([email protected]) immediately!
• No make up for the make up!
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Open-Economy Macroeconomics:
Basic Concepts
An Open Economy
An open economy interacts with other countries in two ways:
i. It buys and sells goods & services in world product markets.
ii. It buys and sells capital assets in world financial markets.
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Exchange Rates
Exchange rates are the most important “prices” that
determine international trade (exports - imports).
There are “two” exchange rates!
the nominal exchange rate and
the real exchange rate.
TL / USD rates, 2012 Jan - April
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Exchange Rates
What is reported daily in the news media is
 the nominal exchange rate
But, the exchange rate that plays the crucial role in
determining net exports is
 the real exchange rate.
Nominal Exchange Rates
• The nominal exchange rate is the rate at which a
person can trade the currency of one country for the
currency of another.
e = nominal exchange rate,
e is the relative price of domestic currency (say, TL) in
terms of a foreign currency (say, US$).
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The nominal exchange rate
EXAMPLE with TL as the domestic currency against US$:
e = 0,55
This means that
1 TL can be exchanged for 0,55 US$
But the current “kur” is 1.80!
So what goes on here?
The nominal exchange rate can be expressed in two
ways:
Domestic currency: TL; Foreign currency: US$
1.
In units of foreign currency per 1 unit of domestic currency.
We can say e = 0,55
We mean that 1TL = 0,55 US$
2.
In units of domestic currency per 1 unit of the foreign currency.
We can say e = 1,80
We mean that 1 US$ = 1,80TL
Real Exchange Rates
• The real exchange rate is the rate at which a
person can trade the goods and services of one
country for the goods and services of another.
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The real exchange rate
ε = real exchange rate,
the lowercase
Greek letter
epsilon
the relative price of
domestic goods
in terms of foreign goods
Real Exchange Rates
The real exchange rate compares the prices of domestic goods
and foreign goods in the domestic economy.
If a kilo of Swiss cheese beer is twice as expensive as a kilo
of English cheese, the real exchange rate is 1/2 a kilo of
Swiss cheese per kilo of English cheese.
The real exchange rate depends on the nominal exchange
rate and the prices of goods in the two countries measured in
local currencies.
Nominal exchange rate  Domestic price
Real exchange rate =
Foreign price
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The formula
exP
Real exchange rate ε =
e
P
P*
= nominal exchange rate
= domestic price of the good in domestic currency
P* = foreign price of the good in foreign currency
Home country: Turkey
Foreign country: US
EXAMPLE WITH ONE GOOD: BIG MAC
Example with one good, Le BIG MAC
The real exchange rate with the bigmac
e
x
P
ε=
e = 0,55 (means 1TL = 0,55$)
P*
P = Price of the Big Mac in domestic country (Turkey) in TL
P = 8,45TL
P* = Price of the Big Mac in foreign country (US) in US$
P* = $4.37
e x P = 0.55 x 8.45= $ 4,65 (US)
The real exchange rate with the bigmac
e
x
P
ε=
e = 0,55 (means 1TL = 0,55$)
P*
P = Price of the Big Mac in domestic country (Turkey) in TL
P = 8,45TL
P* = Price of the Big Mac in foreign country (US) in US$
P* = $4.37
e x P = 0.55 x 8.45= 4,65  price of the Turkish BigMac in
US$
Finally
ε = (e x P)/ P*
= 4,65 / 4,37 = 1,06
Interpreting the Real Exchange Rate
The real exchange rate ε = 1,06 means what exactly?
1 Turkish Big Mac = 1.06 U.S. Big Macs
This means that …
To buy one Big Mac in Turkey a US citizen must pay an amount
that could purchase 1.06 Big Macs in the US.
Question:
Which country has the cheaper Big Mac?
One more time: Interpreting the Real Exchange Rate
The real exchange rate ε = 1,06 means what exactly?
1 Turkish Big Mac = 1.06 U.S. Big Macs
We can say that
the “amount of money” that buys one Big Mac in Turkey buys
1.06 Big Macs in the US.
THE BIG MAC INDEX AROUND
THE WORLD
The Big Mac Index
Compute the real exchange
rate with Norway as the
domestic country and
US as the foreign country.
ε = 1,70
Compute a real exchange rate using a cup of Latte
Home country US, foreign country Mexico
The price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
Which country has the cheaper latte?
What is the nominal exchange rate?
e = 10 pesos per $
Calculate the real exchange rate, as the number of Mexican lattes
per 1 units of US latte. Please determine which country has the
more expensive latte.
Answers
e = 10 pesos per $
price of a tall Starbucks Latte
P = $3 in U.S., P* = 24 pesos in Mexico
The price of a US latte in pesos is
e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US latte
The real exchange rate is…
exP
30 pesos per U.S. latte
=
P*
24 pesos per Mexican latte
= 1.25 Mexican lattes per US latte
A FIRST THEORY OF
EXCHANGE RATE DETERMINATION:
PURCHASING POWER PARITY
• The purchasing power parity theory is the simplest and
most widely accepted theory explaining the variation of
currency exchange rates:
A unit of any given currency should be able to buy the
same quantity of goods in all countries.
• The theory of purchasing power parity is based on a
principle called the law of one price.
According to the law of one price, a good must sell for
the same price in all locations.
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Basic Logic of Purchasing Power Parity
• If the law of one price were not true, unexploited profit
opportunities (arbitrage) would exist.
• The process of taking advantage of differences in
prices in different markets is called arbitrage.
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Basic Logic of Purchasing Power Parity
• If arbitrage occurs, eventually prices that differed in
two markets would necessarily converge.
• According to the theory of purchasing power parity, a
currency must have the same purchasing power in all
countries and exchange rates move to ensure that.
ex P=P
*
® Purchasing power should be the same
exP
= 1 ® Modify above (assuming PPP)
*
P
e = 1 ® If PPP holds, real exchange rate should be
equal to one
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Implications of Purchasing Power Parity
• If the purchasing power of the YTL is always the same
at home and abroad, then the exchange rate cannot
change.
• The nominal exchange rate between the currencies of
two countries must reflect the different price levels in
those countries.
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Implications of Purchasing Power Parity
• When the central bank prints large quantities of
money, the money loses value both in terms of the
goods and services it can buy and in terms of the
amount of other currencies it can buy.
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Limitations of Purchasing Power Parity
• Many goods are not easily traded or shipped from one
country to another.
• Tradable goods are not always perfect substitutes
when they are produced in different countries.
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