TOPIC 15
Exchange Rates
Thursday, April 19, 12
BIG PICTURE
• How
do we evaluate currency across countries?
• How
is the exchange rate determined?
• What
is the relationship of the foreign exchange market and
the foreign trade market?
• How
is the exchange market related to domestic savings and
investment?
Thursday, April 19, 12
Government
Expenditure
Loans
Government
Taxes
Consumption
Expenditure
Repayment
Transfers
Households
Save
Income
Interest
Profits
Output
Market
Factor
Market
Economic
Investment
Financial
Market
Repayment
Revenue
Firms
Thursday, April 19, 12
Costs
Repayment
Exports
Imports
Loans
Rest of the World
Loans
BASICS OF EXCHANGE
Thursday, April 19, 12
WHY? EXCHANGE RATES
•
•
Why do we need exchange rates? What are they representing?
•
Think about Zimbabwe and money inflation, what if the cost of exports from Zimbabwe
increased 1,000% with hyperinflation
•
It would artificially inflate the value of goods in Zimbabwe because of their inflation;
remember people in Zimbabwe got an enormous increase in money supply to pay for 1
billion dollar bread
Why not have one currency?
•
Independent currency is one valuable tool in managing a country’s own monetary and
fiscal policy
•
Useful because the US does not always have a recession at the same time as other
countries, etc.
Thursday, April 19, 12
NOMINAL EXCHANGE RATES
•
Nominal exchange rate (e): The rate at which the currency of one nation can be
exchanged for the currency of another nation
•
Specifically, how much foreign currency can I buy for 1 USD (home currency) would be the
US-Mexico exchange rate, e.g. e=10 pesos / USD
•
So price of a foreign good is
•
P = P*/e
•
Why, say price of iPhones in Japan in 10,000 yen and exchange rate is 120 yen / USD
•
10,000 yen / (120 yen / 1 USD) = 10,000 yen * 1 USD / 120 yen = 83.33 dollars
•
Because 1 yen is not worth much in USD or 1 USD can buy a lot of yen, price should
decrease from yen to USD
Thursday, April 19, 12
EXAMPLE: ZIMBABWE
•
Suppose the exchange rate is 100 million ZD / 1 USD (makes
sense? Zimbabwe dollars were worth close to nothing)
•
Let’s buy Zimbabwe bottled water
•
The cost is 95 million ZD
•
How much does it cost in USD?
•
95 million ZD * (1 USD / 100 million ZD) = .95 USD
•
Very cheap!
Thursday, April 19, 12
CHANGING VALUE
•
What if the exchange rate changes from 100 million ZD / USD to 120 million ZD / USD?
•
It now takes more Zimbabwe dollars to buy US currency
•
US currency is either more expensive or the Zimbabwe dollar is less valuable
•
Depreciation: a decrease in the value of a currency as measured by the amount of foreign
currency it can buy
•
So relative to US currency Zimbabwe dollar has depreciated; compared to others who knows
•
Appreciation: an increase in the value of a currency as measured by the amount of foreign
currency it can buy
•
Here relative to Zimbabwe currency, US dollar has appreciated
•
So when comparing two currencies, if one appreciates, the other must depreciate
Thursday, April 19, 12
GET REAL
•
So what if 1 USD gets me 120 million Zimbabwe dollars; we are
interested in goods
•
Real exchange rate: the rate at which a person can trade the
goods and services of one country for the goods and services of
another
•
Real exchange rate formula (RER): eP/P*
•
So the real exchange rate will tell us how many goods and services
we can get in Zimbabwe dollars in comparison to American dollars
Thursday, April 19, 12
EXAMPLE: GERMANY
• Suppose: Starbucks
coffee costs 2 USD here, in germany 1
Euro, and the nominal exchange rate is . 5 Euros / USD
• What
is the real exchange rate in terms of coffee?
• RER
= (.5 Euros / 1 USD) * 2 USD per coffee / 1 Euro per
coffee = 1 German coffee / 1 US Coffee
• Notice
that we simply need units to cancel to ensure foreign
goods / domestic goods
Thursday, April 19, 12
REAL EXCHANGE RATE
• In
trade people care about the real exchange rate (remember
we only care about what we can actually eat and money has
no nutritional value)
• Now
if the RER is 2 German coffee / US coffee, I can buy 2
German coffee for each US coffee
• So
German coffee is cheaper
• Since
German Starbucks coffee is cheaper, we expect the US
would want to import
Thursday, April 19, 12
EXCHANGE AND TRADE
• If
the RER is 1 German coffee / 2 US coffee
• US
coffee is cheaper so the US would export to Germany
• In
general, if the RER < 1, the domestic country exports (here
US)
• If
the RER > 1, the domestic country imports
Thursday, April 19, 12
PURCHASING POWER PARITY
•
Purchasing power parity: a theory of nominal exchange rates so a unit of any given currency should be able
to buy the same quantity of goods in all countries
•
Equation: (1/P)=(e/P*)
•
•
Originally, we had nominal e = .50 Euros / 1 USD
•
Suppose there is a US expansionary monetary policy so prices double in the US, then e = .25 Euros / 1 USD
(why..?)
•
US dollar has depreciated
•
Examine PPP, before 1 / 2 = (.5 / 1) so we are safe
•
Now 1 / 4 = (. 25) / 1 so we are still safe
•
Basically price changes here are reflected in the exchange rate and as nominal price increases in the US, nominal
prices to buy German goods increases
PPP implies RER = 1
Thursday, April 19, 12
OTHER INDICES
Thursday, April 19, 12
DETERMINING EXCHANGE
RATES
Thursday, April 19, 12
FOREIGN EXCHANGE
MARKETS
•
How do we actually determine the exchange rate?
•
There is a market ! (of course)
•
The foreign exchange market trades domestic and foreign currency
•
What is price?
•
Exchange rate! This obviously indicates how much domestic currency
I get for foreign currency and vice versa
•
Specifically, RER. PPP assumption is very strict and in general RER ≠ 1
Thursday, April 19, 12
FOREIGN EXCHANGE
MARKETS
•
•
•
How about supply of dollars?
•
Remember supply of dollars is determined by the Federal Reserve and government
•
But WE use that money, only leftover money can be exchanged internationally
•
So how much money is leaving the country?
Net capital outflow: purchase of foreign assets by domestic residents - purchase of domestic assets by
foreigners
•
So as we purchase more foreign assets we supply more dollars
•
As foreigners purchase more of our assets, they take dollars and the supply of dollars decreases
2 components of NCO
•
Foreign Direct Investment
•
Foreign Portfolio investment - investment in financial assets
Thursday, April 19, 12
NET CAPITAL OUTFLOW
United States
Oil Refinery
Brazil
Need Dollars
Sell Reals
Petrobras
+
Apple Inc.
Need Reals
Sell Dollars
Factory
=
Assets invested in foreign
countries - US assets sold to
foreigners
Thursday, April 19, 12
FOREIGN EXCHANGE
MARKETS
•
Net capital outflow is impacted by:
•
•
Real interest rates paid on domestic and
foreign assets (higher interest rates make
the asset more attractive)
•
Perceived risk of holding assets abroad
(more risk is less attractive, all else equal)
•
Government policy impacting foreign
ownership of domestic assets
Note that RER (our “price” in this market)
does NOT impact the NCO so supply is
vertical
Thursday, April 19, 12
Real Exchange
Rate
Supply of dollars,
NCO
Net quantity of
US exchanged
FOREIGN EXCHANGE
MARKETS: DEMAND
•
Why would anyone demand dollars in exchange market?
•
Wanted for exports from the US
•
Foreign countries must have dollars to buy US goods
•
So as RER increases, remember that US dollars become more
expensive so will export less
•
So demand for dollars decreases as RER increases
•
Likewise as RER decreases, demand for dollars increases
Thursday, April 19, 12
EQUILIBRIUM
•
•
Now what if the supply of dollars shifts left
because of an increase in interest rates (US
assets more attractive)
The RER increases, what happens to exports?
•
•
•
Supply of dollars,
NCO
Exports decrease because the US is more
expensive
How did the RER increase?
•
Real Exchange
Rate
Increased investment in US financial assets
(will talk about connection with direct
investment next week)
Reduced outflow of capital causes US
currency to appreciate
Thursday, April 19, 12
Demand for dollars
Net quantity of
US exchanged
CAPITAL FLOWS AND
SAVINGS
Thursday, April 19, 12
Government
Expenditure
Loans
Government
Taxes
Consumption
Expenditure
Repayment
Transfers
Households
Save
Income
Interest
Profits
Output
Market
Factor
Market
Economic
Investment
Financial
Market
Repayment
Revenue
Firms
NX
Thursday, April 19, 12
Costs
Repayment
Exports
Imports
Loans
Rest of the World
Loans
~NCO
NCO AND NX
•
Remember that our graph is closed so at each point, things coming in things going out
•
Tells us NX = NCO (with some reinterpretation of ‘repayment’ and ‘loan’)
•
Essentially demand for dollars in net exports and supply is NCO
•
Suppose Japan exports a car to the US for $20000 so NX = -$20000
•
Then the US is basically sending $20000 to Japan to pay for the car
•
Japan could then spend it on the US stock market or in some other asset so NCO = 0 20000 = -$20000
•
If Japan pays US employees with the 20K? Then US is exporting services with value of $20000
so NX = 0 and NCO = 0
•
Or company could give it to some other source, which then takes an option similar to above
Thursday, April 19, 12
INVESTMENT, SAVINGS, NCO
•
Recall that the equation for national savings without taxes
is income less spending (consumption and government) so S = Y - C
-G
•
Since GDP = Y = C + I + G + NX, we can rearrange terms so Y - C
- G = I + NX
•
Then S = I + NX or S = I + NCO since NX = NCO
•
Before with S = I we assumed there was no trade, i.e. S = I + 0
•
So savings must equal investments plus net capital outflow
Thursday, April 19, 12
INVESTMENT, SAVINGS, NCO
•
•
How do we solve a problem like low US savings?
•
Borrow from abroad!
•
S = I + NCO implies that if we save more than domestic investment we must send it
abroad by buying foreign investment
•
Here we save less than domestic investment so since S < I, NCO<0
•
If NCO< 0, foreigners are buying more US assets than US is buying foreign assets,
which is what is the case with the US
What about NX
•
NX = NCO < 0, so the US is a net importer, which we know is true also
Thursday, April 19, 12
THE GOOD AND BAD OF
BORROWING
• Is
it bad to be a net importer?
• We
can have higher level of investments with low savings
• Ultimately
money
depends on investments made with foreign
• E.g. foreigners
could be investing in capital that will improve
long-term growth
Thursday, April 19, 12
REVIEW
• Various
exchanges rates are measures of the rate at which we
convert domestic money / goods and services to foreign
• Exchange
rates are set in the foreign exchange markets
• Demand
in the market is set by net exports, while supply is set
by the net outflow of capital, which can be positive or negative
•A
negative NCO implies that the country is an importer and is
borrowing from abroad; the opposite holds for a country with a
positive NCO
Thursday, April 19, 12