# Exchange Rates 20 2 Exchange Rates Nominal exchange

• Slides: 18

Exchange Rates

20 -2 Exchange Rates • Nominal exchange rate: price of one currency in terms of another currency (bilateral exchange rate) – – example: 1. 30 dollars per euro or 76. 92 euros per dollar determines price of imports foreign exchange market denote as enom , units of the foreign currency per unit of domestic currency • Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies

20 -3 Exchange Rates

20 -4 Exchange Rates • Real Exchange Rate (RER): the price of domestic goods relative to foreign goods – says how much foreign good you could get for domestic good • The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency

20 -5 Exchange Rates • RER Example – Should you buy a Japanese or American computer for your company? • Price of U. S. computer = \$2, 400 • Price of Japanese computer = 242, 000 yen • Exchange rate = 110 yen/dollar • Price in dollars = price in yen/yen-dollar exchange rate – Price in yen = price in dollars x value of dollar in terms of yen – Price in dollars = 242, 000 yen/110 = \$2, 200 – Japanese computer is cheaper. – Real exchange rate = \$2, 400/\$2, 200 = 1. 09

20 -6 Exchange Rates Real Exchange Rate (RER) • If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country – NX will tend to be low when the real exchange rate is high. • Real exchange rate = “terms of trade” => competitiveness • Real exchange rate is an index and is unit-less

20 -7 Exchange Rates

20 -8 Purchasing Power Parity Law of One Price and Purchasing Power Parity • Identical goods & services should sell at same price no matter where they are sold…otherwise opportunity for profits (i. e. arbitrage) – Law of one price: same price for a commodity • Candy bar in Port-of-Spain versus San Fernando • Purchasing Power Parity (PPP) – The theory that nominal exchange rates are determined as necessary for the law of one price to hold – Exchange rates should move to equalize prices across countries

20 -9 Purchasing Power Parity PPP implies currencies of countries that experience significant inflation will tend to depreciate

20 -10 Purchasing Power Parity • Example – How many Indian rupees equal to one Australian dollar? • Bushel of grain cost 5 Australian dollars or 150 rupees • 5 Australian dollars = 150 rupees – Or, a 30 rupee to 1 Aus. Dollar ratio • Nominal exchange rate should equal 30 rupees/Australian dollar – If not 30: 1, what should happen?

20 -11 Purchasing Power Parity – How many Indian rupees equal one Australian dollar? • Suppose price of grain in India increases from 150 to 300 rupees • Price of grain in Australia still equals 5 Australian dollars – Originally: implied exchange rate 5: 150 or 1: 30 – Now: implied exchange rate 5: 300 or 1: 60 • 1 Australian dollar = 60 rupees • Nominal exchange rate increased from 30 to 60 rupees/Australian dollar • Indian currency depreciated • Australian currency appreciated

20 -12 Purchasing Power Parity • Does not hold up well in short run – Transportation costs – Border effect – tariffs, technical requirements, regional monopoly power – Pricing to market • Goods prices are “sticky” • Reduces exchange rate “pass through” – Nontradable sector • Higher productivity, higher nontradable wages, higher nontradable inflation • Works better in the long run

20 -13 Price differences between US and Canadian Cities. Figure 19. 4

20 -14 Inflation and Currency Depreciation (% pa) Five Year Window Inflation Differential

20 -15 Currency Depreciation (% pa) Inflation and Currency Depreciation Twenty Year Window

20 -16 Power Purchasing Parity • Mc. Parity & the Big Mac Index – The Economist's Big Mac index is based on theory of purchasing-power parity (PPP) using the Big Mac – The cheapest burger in the chart is in China, at \$1. 26, compared with an average American price of \$3. The PPP implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.

20 -17 Mc. Parity

20 -18 Exchange Rate • RER reflects competitiveness—the higher a country’s RER, the more expensive its goods and services are to foreigners. • => as the RER↑, a country’s NX growth will ↓, leading to a current account deficit (and vice versa) – Note: nominal exchange rate can fall but be offset by higher domestic inflation so that RER stays constant