International Monetary
Relations
Tutorial 2 The Foreign Exchange market
Convention of exchange rates
• Exchange rates in this course are expressed as home currency per unit
of foreign currency.
• When this exchange rate increases, it means that you need to pay
more domestic currency for one unit of foreign currency. The home
currency depreciates. When the exchange rate decreases, you need
to pay less home currency for a unit of foreign currency, the home
currency appreciates.
Nominal versus real exchange rate
• Let eH / F denote the nominal exchange rate between home and
foreign currency (home currency per unit of foreign currency.)
• The real exchange rate  H / F will be the purchasing power of the home
currency relative to the foreign currency. Or, how much domestic
goods I can buy at the price of one foreign good.
 H / F  eH / F
PF
price of foreign goods in home currency


PH price of domestic goods in home currency
domestic goods

foreign goods
Real exchange rate
• If 𝜀𝐻 𝐹 >1 then one can buy more domestic goods than foreign goods
using the same amount of money. Goods are cheapr at home than
aborad.
• If 𝜀𝐻 𝐹 <1 then one can buy less domestic goods than foreign goods
using the same amount of money. Goods are cheaper aborad than
home.
• If 𝜀𝐻 𝐹 >1 one could make profit by buying home currency and export
goods abroad. If 𝜀𝐻 𝐹 >1 it would be profitable to exhcange home
currency to foreign currency and import goods.
• This is arbitrage.
Example
• A mobile phone costs 100 EUR in the Netherlands, and 100 GBP in
the UK.
• The official exchang rate is e=1.18 EUR/GBP. Can you make money?
Yes, since the real exchange rate is:
 NL /UK
100
 1.18
 1.18
100
• You can buy a mobile in the Netherlands, sell it for GBP in the UK, and
exchange the 100 GBP to 118 EUR. You made a profit of 18%.
• This goes as long as the real exchange rate becomes one by either an
adjustment of prices or nominal exchange rate.
Purchasing Power Parity (PPP)
• If goods are tradable and homogenous, and thre are no transaction
costs, prices shoudl equalize internationally. This is the Law of One
Price (LOP).
• That is:
PF
price of foreign goods in home currency
 H / F  eH / F

1
PH price of domestic goods in home currency
• This means that nominal exchange rates should reflect the price
differentials across countries, which is the PPP:
𝑃𝑃𝑃
𝑒𝐻/𝐹
𝑃𝐻
=
𝑃𝐹
FOREX market
• The nominal XR is
determined on the
foreign exchange
market.
• Agents who wish
to import or invest
abroad will
demand foreign
currency.
• Agents who export
or foreigners who
wish to invest in
our country will
offer foreign
currency.
eH/F
DF
SF
e*H/F
Q*F
Foreign
currency
Changes in exchange rate 1.
• If for some
reason imports
grow, ceteris
paribus, the
demand for
foreign currency
increases even
at given
exchange rate.
• As a result the
home currency
depreciates.
eH/F
DF
D’F
SF
e’*H/F
e*H/F
Q*F Q’*F
Foreign
currency
Changes in exchange rate 2
• If for some
reason exports
grow, ceteris
eH/F
paribus, the
supply for
foreign currency
increases even e*H/F
at given
e’*H/F
exchange rate.
• As a result the
home currency
apreciates.
DF
SF
Q*F Q’*F
S’F
Foreign
currency
Exercise 1
Country
Big Mac Price Exchange Rate Real exch
(per 1 USD)
rate
Norway
46.80 Kroner
8.36
Eurozone
Russia
3.72 Euro
0.88
114.00 Rouble 69
4.93 41.21
 N /US  8.36

 0.881
46.8 46.8
4.93 4.338
 EU /US  0.88

 1.166
3.72 3.72
4.93 340.17
 R /US  69

 2.983
114
114
Exercise 1
• The Norwegian kronor is overvalued in terms of PPP:  N /US  0.881  1
For the price of one US burger you could only by 88.1% of a Norwegian
burger. Obviously, if big mac were tradeable, it would be profitable to
import American burgers to Norway.
• The euro is undervalued with respect to the USD in terms of PPP. For
the price of one US big mac, I cold buy 1.166 big macs in the EMU.
• Finally, the rouble is undervalued w.r.t. USD in terms of PPP: for the
price of one US burger one can buy almost 3 burgers in Russia.
Pugel 17.8
Solution
• Assume I have 1,000 USD initially. I would buy 5,000 krone for this at
0.2 USD/krone, then I would exchange this to 125,000 yen at 25
yen/krone and finally I would exchange the 125,000 yen to 1,250 USD
at 0.01 USD/yen. This is 25% profit (if we had no costs).
• A cross-rate of 20 yen/krone would eliminate this arbitrage
opportunity.
Pugel 19.2
Solution
• The uncovered interest rate parity (UIP) requires that exchange rate
move so that they eradicate the possibility of making profit by using
interest rate differentials.
X
• Or
H /F
t
e
1  iF  e
H /F
t 1
H /F
t 1
H /F
t
e
e
 (1  ih ) X
1  ih

1  iF
Solution
H /F
t 1
e
1  ih H / F 1  0.02
$
$

et 
1
 1.0049
1  iF
1  0.015 EUR
EUR
• Which is indeed roughly 1.005 USD/EUR. The UIP holds.
• If the interest rate in the US would fall by 1% annually, then we should not have
depreciation of the USD. Simply because there is no profit to make. As such the demand
for dollar should increase and the demand for euro should decrease now and the spot
rate should go up to 1.005 USD/EUR even now.