Exchange Rates 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 domesticcurrency • Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies
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
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
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
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
Purchasing Power Parity PPP impliescurrencies of countries that experience significant inflation will tend to depreciate
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?
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
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
Inflation and Currency DepreciationFive Year Window Currency Depreciation (% pa) Inflation Differential
Inflation and Currency DepreciationTwenty Year Window Currency Depreciation (% pa)
Power Purchasing Parity • McParity & the Big Mac Index • The Economist's Big Mac index is based on the 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.
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