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Questions and Answers
What does the nominal exchange rate represent?
What does the nominal exchange rate represent?
What is the outcome when a currency depreciates?
What is the outcome when a currency depreciates?
Which factor is NOT typically associated with the determination of foreign exchange rates?
Which factor is NOT typically associated with the determination of foreign exchange rates?
In Europe, which currency do most member countries of the European Monetary Union use?
In Europe, which currency do most member countries of the European Monetary Union use?
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How frequently do exchange rates typically change?
How frequently do exchange rates typically change?
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What is the relationship between exchange rates and inflation?
What is the relationship between exchange rates and inflation?
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Which of the following describes a cross-border transaction?
Which of the following describes a cross-border transaction?
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What is typically a significant factor in government intervention in foreign exchange?
What is typically a significant factor in government intervention in foreign exchange?
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What is the term used for the rise in the value of one currency relative to another?
What is the term used for the rise in the value of one currency relative to another?
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How is the nominal exchange rate for the British pound typically quoted?
How is the nominal exchange rate for the British pound typically quoted?
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What characterizes spot rates in foreign exchange markets?
What characterizes spot rates in foreign exchange markets?
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What does the real exchange rate measure?
What does the real exchange rate measure?
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What is one reason the law of one price often fails?
What is one reason the law of one price often fails?
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What percentage of currency transactions involve the U.S. dollar?
What percentage of currency transactions involve the U.S. dollar?
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If the real exchange rate is more than one, what does this indicate?
If the real exchange rate is more than one, what does this indicate?
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When exchanging Thai baht for Japanese Yen, what is generally required?
When exchanging Thai baht for Japanese Yen, what is generally required?
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What happens to U.S. exports when there is an appreciation of the real exchange rate?
What happens to U.S. exports when there is an appreciation of the real exchange rate?
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How can you calculate the real exchange rate using espresso prices?
How can you calculate the real exchange rate using espresso prices?
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What is the primary justification for investing in foreign stocks?
What is the primary justification for investing in foreign stocks?
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Which of the following factors does NOT contribute to the law of one price failing?
Which of the following factors does NOT contribute to the law of one price failing?
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What is the effect of a depreciation of the real exchange rate on U.S. exports?
What is the effect of a depreciation of the real exchange rate on U.S. exports?
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What does the forward rate represent in foreign currency transactions?
What does the forward rate represent in foreign currency transactions?
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What is a potential implication of a real exchange rate less than one?
What is a potential implication of a real exchange rate less than one?
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Why might identical goods have different prices in different countries?
Why might identical goods have different prices in different countries?
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What does holding foreign stocks do to investor risk?
What does holding foreign stocks do to investor risk?
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What does the theory of purchasing power parity (PPP) imply?
What does the theory of purchasing power parity (PPP) imply?
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According to purchasing power parity, what should happen when inflation occurs in one country but not another?
According to purchasing power parity, what should happen when inflation occurs in one country but not another?
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What does the solid 45-degree line in Figure 10.4 represent?
What does the solid 45-degree line in Figure 10.4 represent?
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What does the law of one price help explain?
What does the law of one price help explain?
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What happens when there is a significant inflation differential between two countries?
What happens when there is a significant inflation differential between two countries?
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Which is true about the purchasing power of a dollar over time?
Which is true about the purchasing power of a dollar over time?
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How does purchasing power parity relate to the price of a basket of goods in two different countries?
How does purchasing power parity relate to the price of a basket of goods in two different countries?
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What effect does currency appreciation have on a country's exports?
What effect does currency appreciation have on a country's exports?
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What is a common reason for government intervention in foreign exchange markets?
What is a common reason for government intervention in foreign exchange markets?
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Which country is noted as the most frequent participant in the foreign exchange market?
Which country is noted as the most frequent participant in the foreign exchange market?
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What has Brazil's recent change in foreign exchange policy been characterized as?
What has Brazil's recent change in foreign exchange policy been characterized as?
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What is the effect of loose monetary policy in developed countries on developing nations?
What is the effect of loose monetary policy in developed countries on developing nations?
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Why might Brazil consider manipulating its currency?
Why might Brazil consider manipulating its currency?
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What is foreign exchange intervention?
What is foreign exchange intervention?
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During the period between 1997 and 2009, how many times did the U.S. intervene in the foreign exchange market?
During the period between 1997 and 2009, how many times did the U.S. intervene in the foreign exchange market?
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What is the equilibrium exchange rate?
What is the equilibrium exchange rate?
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Which factor would NOT increase the supply of dollars?
Which factor would NOT increase the supply of dollars?
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What typically happens to the dollar when there is an increase in its supply?
What typically happens to the dollar when there is an increase in its supply?
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Which of the following can increase the demand for dollars?
Which of the following can increase the demand for dollars?
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What is the best forecast of the future exchange rate?
What is the best forecast of the future exchange rate?
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Which scenario would most likely lead to an increase in the supply of dollars?
Which scenario would most likely lead to an increase in the supply of dollars?
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What typically influences fluctuations in the value of major currencies?
What typically influences fluctuations in the value of major currencies?
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Which of the following is NOT a cause of a rise in the demand for dollars?
Which of the following is NOT a cause of a rise in the demand for dollars?
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Study Notes
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.
Introduction
- Global business involves goods, services, stocks, bonds, etc., traded globally.
- Understanding these international transactions requires familiarity with exchange rates.
- All cross-border transactions involve a buyer and a seller using their respective currencies.
- Exchange rates are tools for measuring the price of one currency in terms of another.
Introduction (continued)
- The chapter will discuss how foreign exchange rates are determined, factors influencing their fluctuations, and the connection between exchange rates and exchange markets.
Foreign Exchange Basics
- When traveling internationally, vendors typically prefer payment in their local currency.
- Most European countries (especially those in the European Monetary Union) use the euro.
- The dollar-euro exchange rate is the price of one euro in terms of US dollars.
The Nominal Exchange Rate
- Exchanging currencies is an economic transaction, like buying something in another country.
- The price for exchanging currencies is the nominal exchange rate, also simply known as the exchange rate.
- The nominal exchange rate is the rate at which one currency can be exchanged for another.
- Exchange rates fluctuate daily, as evidenced by Figure 10.3 showing the dollar-euro rate from 1999-2013.
- The figure plots the dollars per euro (€), which conventionally represents the dollar-euro exchange rate.
The Nominal Exchange Rate (continued)
- A decline in a currency's value relative to another is called depreciation.
- A rise is called appreciation, where the currency increases in value.
- When one currency increases in value, the other must decrease.
- British pounds and Japanese yen are quoted similarly to euros, with the quantity of dollars needed to purchase one pound or yen.
The Real Exchange Rate
- The real exchange rate is the rate at which one can exchange goods and services from one country for goods and services from another country.
- It reflects the cost of a basket of goods in one country relative to another country.
- This is demonstrated using coffee prices in the US and Italy, highlighting that one cup of Starbucks' espresso equals approximately 1.5 cups of Italian espresso.
- There are no units of measurement for real exchange rate calculations.
- Relative to domestic goods, a higher real exchange rate will make foreign products appear cheaper, and vise-versa.
- The competitiveness of U.S. exports depends on the real exchange rate. Appreciation makes U.S. exports expensive, lowering competitiveness. Depreciation makes U.S. exports cheaper, raising competitiveness.
Tools of the Trade
- The Wall Street Journal's Foreign Exchange column daily reports on market events and the latest exchange rates between the U.S. dollar and various foreign currencies.
- Spot rates represent immediate exchange rates (with a two-day settlement period). Forward rates indicate future exchange rates for foreign currency transactions.
Table 10.1
- Presents US-dollar exchange rates for various countries on November 23, 2012.
Foreign Exchange Markets
- Due to its high liquidity, the U.S. dollar is involved in roughly 85% of currency transactions.
- A transaction to exchange Thai baht for Japanese Yen typically requires two steps: baht to dollars, then dollars to Yen
Exchange Rates in the Long Run
- This section investigates exchange rate determination and long-term movements.
The Law of One Price
- The law of one price states that identical products should sell for the same price.
- Arbitrage (taking advantage of price differences) eliminates price discrepancies.
- The law of one price is mostly theoretical. Differences in transportation costs, tariffs, technical specifications, tastes, and tradeability invalidate the law's application in many instances.
Your Financial World: Investing Abroad
- Diversification of investments across countries can be beneficial.
- Holding foreign stocks can reduce investment risk without necessarily sacrificing return.
Purchasing Power Parity
- Purchasing power parity (PPP) is the theory that one unit of domestic currency buys the same basket of goods anywhere in the world.
- Although this can be applied over larger periods, daily or weekly deviations from PPP are common due to many market factors.
Purchasing Power Parity (continued)
- One can use the law of one price to calculate PPP for given circumstances.
- Differences in inflation between countries will affect exchange rates over time.
Purchasing Power Parity (continued)
- Figure 10.4, using IMF data, shows purchasing power parity's long-run effectiveness (1980-2010).
- Despite theoretical consistency, nominal exchange rates often deviate significantly from the levels predicted by purchasing power parity, particularly over shorter periods.
Purchasing Power Parity (continued)
- Short-run deviations of purchasing power parity can cause a currency to appear undervalued or overvalued.
- A currency is considered undervalued if its current market exchange rate deviates from the theoretically "correct" exchange rate for purchasing power parity.
Applying the Concept: The Big Mac Index
- The Big Mac Index illustrates variations in currency values relative to the U.S. dollar. This index uses Big Mac prices for this comparison.
Exchange Rates in the Short Run
- The short-run analysis of exchange rates frequently relies on supply and demand.
- Nominal short-term exchange rate changes often reflect real exchange rate changes, due to minimal price shifts in a short amount of time.
- A small percentage change in exchange rates can lead to roughly equivalent changes in the real exchange rate.
The Supply of Dollars
- The supply of dollars increases as the dollar's price in foreign markets increases.
The Demand for Dollars
- Foreign demand for U.S. goods, assets, and services increases as the dollar price in foreign markets decreases.
Equilibrium in the Market for Dollars
- The equilibrium exchange rate equates the supply and demand for dollars.
- Market forces determine the values of major currencies, with changes in supply or demand directly influencing values.
Shifts in the Supply of and Demand for Dollars
- Factors affecting dollar supply and demand include Americans' preference for foreign goods, real interest rates on foreign bonds, American wealth, the riskiness of foreign investment relative to U.S. investment, and the dollar's expected depreciation/appreciation
Exchange Rate in Short-run: Shifts in Demand
- Increased demand for a currency leads to its appreciation (a higher exchange rate).
- Changes in demand, such as an increase in the demand for dollars from foreigners, increase the value of the dollar.
Government Policy and Foreign Exchange Intervention
- Currency appreciation affects foreign and domestic prices of goods and services, impacting domestic businesses.
- Governments may intervene in foreign exchange markets through various actions, including influencing exchange rates.
- In some situations, policymakers may actively buy/sell in order to manipulate exchange rates.
Explaining Exchange Rate Movements
- Exchange rate appreciation and depreciation can be explained by changes in supply and demand for a currency.
- Changes in Americans buying foreign goods, as well as international investment are factors to consider.
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Test your knowledge of foreign exchange rates with this quiz. Explore concepts such as nominal exchange rates, currency depreciation, and the factors influencing forex markets. Perfect for students studying economics or finance.
