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Foreign Exchange
Hubbard Chapter 8
The Nominal Exchange Rate
Definition:
The rate at which one can exchange the
currency of one country for the currency of
another country.
Example :
The nominal Euro-dollar exchange rate is the number of
Euros you can purchase for each dollar…
E(t) = Euros/dollar
(The dollar-Euro exchange rate is the number of dollars
you can purchase for each Euro!)
Appreciation and Depreciation
• Depreciation: decline in value
• Appreciation: increase in value
• Currencies change in value relative to one
another.
th
• When one currency goes up in value
relative to another, the other currency
must go down.
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The Real Exchange Rate
Definition:
The rate at which one can exchange
goods and services in one country for goods
and services in another country.
Real Exchange Rate =
Dollar Price of Foreign goods
Dollar Price of Domestic goods
Relationship between nominal
and real FX rates and prices
• Real exchange rate = (Nominal exchange rate x
Domestic price) / Foreign price
EXr = (EX x P)
Pf
• Percent change in real interest rate:
∆EXr ∆EX
∆P - ∆ Pf
=
+
EXr
EX
P
Pf
Or:
∆EX ∆EXr
=
+ (πf – π)
EX
EXr8-9
Exchange Rate Determination
• Long run, driven by trade in goods and
services; affected by
– Price levels
– Productivity
– Preferences
– Trade barriers
• Short run, driven by financial flows
2
Exchange Rates in the Long Run:
Law of One Price
• Prices of identical items same everywhere
(except for transportation costs)
• Detroit,
Detroit Michigan to Windsor
Windsor, Ontario Canada
– Takes roughly one minute to cross the bridge.
– Expect a T.V. to cost the same on both sides.
– Canadian $ price = US $ price x (Canadian $/US$)
Exchange Rates in the Long Run:
Exchange Rate Movements & Inflation Differentials
FX rates in the short run:
Looking at FX Markets
FX markets…
• In recent years, 90% of transactions had dollars
as one side.
• Majority of transactions take place in London.
are huge:
• $1.9 trillion traded per day.
• About 12 times world GDP,
• 22 times annual world trade volume.
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Interest Rate Parity
• Assume that domestic and foreign bonds
are perfect substitutes
• Consider two investment strategies:
1. B
1
Buy a domestic
d
ti ((one-year)) bond
b d
2. Buy Yen, buy a Japanese bond, convert
back to dollars next year.
i = if – ΔEXe/EX
The market for dollars
Euro per dollar
(the “price of
a dollar”)
Mkt for Dollar Exchange
Supply of dollars
Demand for dollars
Qty of dollar FX (dollars exchanged)
FX rates in the short run:
Supply of Dollars
Who “supplies dollars”?
• Americans Supply dollars to
1. Purchase foreign goods services
2 Purchase
2.
P h
fforeign
i assets
t
•
Supply Curve Slopes Up:
The more valuable the dollar, the cheaper
foreign goods, services and assets will be, and
the higher the supply
4
FX rates in the short run:
Demand for Dollars
Who “demands dollars”?
• Foreigners Demand dollars for
1. Purchase American-made goods
2. Purchase American assets
•
Demand Curve Slopes Down:
The fewer euros needed to purchase one
dollar, the cheaper American-made goods,
services and assets will be for foreigners and
the higher the demand for dollars.
Goods:
• Increase US demand for
foreign goods
• Increase in U.S. real
income
Assets:
• Increase in real interest
rate on foreign bonds
• Increase in American
wealth
• Lower risk of foreign
investment
• Expected depreciation of
the dollar
Euro per dollar
FX rates in the short run:
Shifts in Supply
Mkt for Dollar Exchange
S0
S1
D
Qty of dollars exchanged
Goods:
• Increase in foreigners’
demand for U.S. goods
• Increase in Foreign GDP
Assets:
• Increase in real yield on
U.S. assets
• Increase in Foreign
Wealth
• Reduction in risk of U.S.
investment
• Expected appreciation of
the dollar
Euro per dollar
FX rates in the short run:
Shifts in Demand
Mkt for Dollar Exchange
S
D1
D0
Qty of dollars exchanged
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Government intervention
in FX mkts
How?
• adopt a fixed exchange rate.
• buy or sell currency in an attempt to affect
demand or supply (foreign exchange
intervention).
How does a fixed rate work?
Example: The Chinese Peg
Dollar per yuan
(the “price of
a yuan”)
Mkt for Yuan Exchange
Supply of yuan
Pegged rate
Demand for yuan
Qty of yuan FX (yuan exchanged)
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