Foreign Exchange Chapter 10

Chapter Ten: Foreign Exchange

• This chapter covers foreign exchange, including nominal and real exchange rates, the relationship between exchange rates, price levels, and inflation, currency supply and demand, and government intervention in foreign exchange.
• Global business involves goods, services, stocks, bonds, etc., traded across the globe.
• Understanding these transactions requires familiarity with exchange rates.
• All cross-border transactions involve a buyer and a seller using their own currency.
• The exchange rate is the price of one currency in terms of another.

Learning Objectives

• Students will understand nominal and real exchange rates.
• Students will understand the relationship between exchange rates, price levels, and inflation.
• Students will understand currency supply and demand.
• Students will understand government intervention in foreign exchange.

Introduction

• This chapter discusses how foreign exchange rates are determined.
• It will explain what accounts for fluctuations in exchange rates over various timeframes (days, months, years, decades).
• It will cover the connection between foreign exchange rates and exchange markets.

Foreign Exchange Basics

• When traveling, goods and services are usually bought using the local currency.
• In Europe, the euro (€) is the common currency for most countries in the European Monetary Union.
• The dollar-euro exchange rate is the price of one euro in dollars.

The Nominal Exchange Rate

• Exchanging currency is like any other transaction, but in different countries.
• The nominal exchange rate is the price paid in one currency for the currency of another.
• Exchange rates change daily.
• Figure 10.3 shows the dollar-euro exchange rate from January 1999 to January 2013.
• The figure shows how many dollars are needed to buy one euro.
• A decline in one currency relative to another is called depreciation.
• A rise in one currency relative to another is called appreciation.
• A currency's value going up means the other currency's value goes down.
• The price of the British pound and Japanese yen are quoted in a similar way as the euro, using the number of dollars that can buy one pound (£) or Japanese yen (¥).

The Real Exchange Rate

• When visiting another country, you need to know how much you can buy with the local currency.
• The real exchange rate is the rate at which goods and services from one country can be exchanged for goods and services from another.
• It's the cost of a basket of goods in one country compared to the cost of the same basket in another.
• There's a simple relationship between the real and nominal exchange rates.
• A real exchange rate calculation uses the price of a domestic good (e.g., espresso in the U.S.) compared to the price of the same good in a foreign country (e.g., Italy) in terms of their respective currencies.
• The ratio (in dollars) of a domestic product to a foreign product provides a real exchange rate for the countries.
• Foreign goods are cheap compared to domestic goods when the real exchange rate is greater than 1.
• The competitiveness of U.S. exports depends on the real exchange rate.
• An appreciation of the real exchange rate makes exports more expensive to foreigners, reducing their competitiveness.
• Conversely, a depreciation of the real exchange rate makes exports seem cheaper, improving competitiveness.

Tools of the Trade

• The Wall Street Journal has a Foreign Exchange column with recent exchange rates between the U.S. dollar and various foreign currencies.
• Spot rates are current exchange rates.
• Forward rates are rates for future exchange.

Purchasing Power Parity (PPP)

• The law of one price applies to identical goods in different locations.
• PPP is an extension of this; a currency unit buys the same basket of goods globally.
• The exchange rate should change when prices change in one country but not another.
• According to the theory of purchasing power parity in the U.S.:
  • dollar price of basket = dollar price of basket of goods in U.K.
  • (Dollar price of basket of goods in U.S.)/(Dollar price of basket of goods in U.K.) = 1.
• On a given day, PPP might not hold true for specific items, but it is useful to understand exchange rate movements over the long term.
• If one country has high inflation, its currency will likely depreciate.

Figure 10.4

• This figure shows data for 62 countries from the International Monetary Fund spanning 1980-2010.
• The 45-degree line represents that on this line exchange rate movements equal inflation differences.

Foreign Exchange Markets

• The U.S. dollar is highly liquid and used in roughly 85% of currency transactions.
• Most foreign exchange transactions may need steps, such as converting to USD to buy other currencies.
• A large amount of foreign exchange trades take place in the UK.

Exchange Rates in the Short Run

• Short-term exchange rates are explained with supply and demand analysis.
• Nominal currency movements represent changes in the real exchange rate.
• A small change in exchange rate per day or week roughly corresponds to a similar real-exchange rate change.

The Supply of Dollars

• The supply of dollars slopes upward.
• The higher the dollar price, the greater the supply in the foreign exchange market, reflecting foreign demand for American goods/services.

The Demand for Dollars

• Foreigners demanding American goods/services need dollars, so supply slopes downward.
• The cheaper the dollar, the more attractive U.S. investments are for foreigners.

Equilibrium in the Market for Dollars

• Equilibrium exchange rates balance dollar supply and demand.
• Exchange rates shift due to market forces.
• Fluctuations in the currency value stem from supply or demand shifts.
• Figure 10.5 graphically illustrates the dollar-euro market with supply and demand curves.

Shifts in the Supply of and Demand for Dollars

• Factors affecting the supply of dollars include American preference for foreign goods, shifts in real interest rates on foreign bonds, changes in American wealth, shifting riskiness in foreign investments, and expectations of dollar depreciation.
• Factors affecting demand include foreign preference for American goods, shifts in the real interest rates on U.S. bonds, changes in foreign wealth, shifting riskiness in U.S. investments, and expectations of future dollar appreciation.
• These shifts cause changes on equilibrium in the markets.

Government Policy and Foreign Exchange Intervention

• Currency appreciation hurts domestic businesses, impacting export prices.
• Some countries maintain a fixed exchange rate.
• Policymakers can buy or sell currency to influence market demand or supply, which is known as foreign exchange intervention.

In the News

• Country examples illustrate how exchange rate policies and interventions have changed throughout the period analyzed.