Foreign Exchange Rates Quiz

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.

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.