10. Foreign Exchange

1. 10. Foreign Exchange • The basics • Long run / PPP • Short run / Demand & Supply • Gov’t intervention

2. Exchange rates (XR) • Price of one countries currency in terms of another • Impacts • Relative prices of imports/exports • Attractiveness of domestic vs. foreign assets

3. Two ways to quote XR • Foreign currency per 1 US $ • Used to quote • Yen (Japan) • Yuan (China) • Won (S. Korea) • Peso (Mexico) • Rupees (India) • Canadian $

7. US $ per 1 unit of foreign currency • Euro • British Pound

11. XR market • Worldwide market • $1 trillion in transactions daily • 90% involve US $ • Size of economy • Store of value • World price of oil in US $

12. Nominal XR • Rate of one country’s currency exchanges for another

13. US $ Depreciation • US $ buys less of foreign currency • 2000-2008 • Canada, Euro, UK, China . . . • Most major trading partners • US $ has fallen • US $ is weaker

14. US $ appreciation • US $ buys more of foreign currency • 2000-2008 • Mexico • US $ has risen • US $ is stronger

15. Example: Yen/$ • If $ appreciates, the Yen must depreciate • XR are a “seesaw” • XR changes have winners and losers

16. Real XR • Relative cost of certain goods in two countries • Changes in the nominal XR

17. Example: U.S. $ vs. Can $ • SUNY tuition, nonresident • Fall 2000: $4150/sem • Fall 2007: $5305/sem • The finest system of public higher ed in the nation: priceless • XR • Fall 2000: $1.50 C$ per 1 US $ • Fall 2007: $1.10 C$ per 1 US $

18. How much is tuition to a Canadian student? • Convert US $ tuition to Can $ • 2000: 4150(1.50) = C$ 6225 • 2007: 5305(1.10) = C$ 5835.50 • Can $ appreciation means an actual fall in tuition for Canadian students

19. U.S. $ depreciation • Imported goods more expensive • Less purchasing power abroad • Exports less expensive abroad • Foreign visitors have more purchasing power

20. Univ of W. Ontario, nonresident • Fall 2000: C$ 5190/sem • Fall 2007: C$ 7300/sem • Tuition costs for a U.S. student • 2000: 5190/1.5 = $3460 • 2007: 7300/1.1 = $6636

21. XR in the long run • Primarily depends on relative inflation • Law of One Price • Identical goods should be about the same price everywhere in the world

22. Pack of gum • If $1 = 115 yen • Then gum should cost $1 in U.S. and 115 Y in Japan

23. Now suppose prices double in US, so gum is $2. • At the XR of 115Y/$, gum is cheaper in Japan • Gum is 115Y or $1 in Japan • Run on gum in Japan

24. To equalize things, • XR moves: $ must depreciate • 57.5Y/$ then gum is same price

25. Purchasing power parity (PPP) • XR adjust to relative price changes in two countries, so law of one price holds • If US inflation is higher than other countries • $ depreciate • If lower, then $ appreciates

26. Does PPP hold? • In the long run, yes • In the short run, no way • Big Mac Index (240-41) • Not all goods identical or traded across countries

28. Other LR factors • Trade barriers—tariffs/quotas • Boost domestic demand • $ appreciates • Productivity -- GDP/labor hour • Higher relative productivity in US • $ appreciates

29. XR in the Short Run • Supply and Demand, US $ • Explains short term volatility

30. Who supplies $ to XR market? • People buying foreign goods • People investing in foreign assets • As $ appreciates (Price of $ rises) • People buy more foreign goods because they are cheaper • Supply slopes up

31. E/$ Q of $ S

32. Who demands $ in XR market? • People wanting to buy U.S. goods or dollar assets • As $ depreciates (Price of $ falls) • People buy more US goods because they are cheaper • Demand slopes down

33. E/$ Q of $ S D

34. What causes the $ to depreciate? • An increase in the supply of $ • A decrease in the demand for $

35. What increases $ supply? • Increase in preference for foreign goods • An increase in US GDP and income • Buy more imports • An increase in real interest rate on foreign bonds relative to US OR decrease in relative foreign investment risk • Investors supply more $ to buy them • Expectation of $ depreciation • People supply $ now

36. What decreases $ demand? • Decrease in preference for US goods in foreign countries • A decrease in foreign GDP/income • A decrease in real interest rate OR increase in relative risk of U.S. bonds and investments • An expected depreciation of the $

37. E/$ S’’ Q of $ Increase in $ supply S D

38. E/$ D’’ Q of $ Decrease in $ demand S D

39. So what is causing $ depreciation? • Trade deficit • US imports > US exports As $ depreciates, this will narrow the trade deficit • Federal deficit • World market believes the US borrows too much?

40. Consequences? • The good: • Rising US exports • Tourism in US • Less pressure for trade barriers

41. The bad: • Possible inflation (higher import prices) • US tourists abroad • US debt less attractive • Pressure to move oil pricing to Euros

42. Government Intervention • Can the government affect XR markets? • Yes, but interventions are rare • Only effective if nations cooperate, scale is large • At best interventions are short run solutions