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Foreign Exchange Rates

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  1. Foreign Exchange Rates Nominal Exchange Rate Real Exchange Rate PPP

  2. Nominal Exchange Rate • Nominal Exchange rate: the rate at which one can exchange the currency of one country for the currency of another. • The “A” – “B” exchange rate is the price of one unit of “B” in terms of “A” • dollar-euro exchange rate is the price of 1 euro in terms of dollars. • peso-dollar exchange rate is the price of 1 dollar in terms of pesos.

  3. Nominal Exchange Rates • If the dollar-euro exchange rate is 1.24 and the peso-dollar exchange rate is 0.05, what is the peso-euro exchange rate?

  4. Nominal Exchange Rate • If the dollar-euro exchange rate is 1.21 and the dollar-pound exchange rate is 1.76, what is the pound-euro exchange rate?

  5. Nominal Exchange Rate • Assume the pound-euro fx-rate is 0.60. • How could you profit? • Euros look cheap in terms of pounds • Buy 100 pounds using dollars • Cost = 176 dollars • Use 100 pound to buy euros • Get 100/0.60 = 167 euros • Use euros to buy dollars • Euro-dollar rate is 1/1.21 = 0.83 • Get 167/0.83 = 201 dollars

  6. Cost of Goods • If a 2007 Hundai costs $10,200 Euros, how much does it cost in dollars? Assume dollar-euro fx-rate is 1.76.

  7. Real Exchange Rate • Real Exchange rate: Rate at which one can exchange the goods and services from one country for the goods and services of another country.

  8. Real Exchange Rate • If a 2007 Hundai costs 11,000 euros, and 28,000 dollars what is the real EU - US fx-rate? Assume dollar-euro fx-rate is 1.76.

  9. Real FX-rate • The real EU-US fx-rate is the cost of real goods in the US in terms of real goods in the EU. • A real EU-US fx-rate of 1.45 implies you could trade 1 Hundai in the US for 1.45 Hundais in Europe • You should buy Hundais in Europe and export them to the U.S. • Make 28000-19360=8,640 per transaction • This raises the price of Hundais in Europe and lowers them in the U.S. until real fx-rate=1

  10. Real Fx-Rate • What prevents the real-fx rate from reaching unity? • Transportation costs, Duties, Tarriffs • Example: Suppose it cost $8640 to import cars from Europe • Some things, such as perishable items, some services, can’t be traded.

  11. Purchasing Power Parity • Assuming no transaction costs Real Exchange rate =1

  12. Purchasing Power Parity • Not true over the short run • Implications over long run: inflation erodes value of currency.

  13. Inflation and Exchange Rates

  14. Big Mac Index • Cost of Big Mac in US: 3.15 dollars • Cost of Big Mac in Japan: 250 yen • Implied yen-dollar exchange rate from PPP: 250/3.15 = 79.37 • Actual yen-dollar exchange rate = 90 • (implied – actual)/actual = 79.37/90 – 1 = -12% • Yen is 12% under-valued relative to dollar

  15. Exchange Rates in the Short Run

  16. Supply and Demand • Home Currency: dollar • Price per dollar: foreign-dollar fx-rate • Who supplies dollars? Primarily U.S. residents. • As price of dollar goes up, U.S. residents are willing to supply more • To buy foreign assets • To invest in foreign financial assets • Supply curve for dollars is upward sloping

  17. Supply of Dollars • Who demands dollars? Foreigners • As price of dollar goes up, foreigners demand less • To buy American assets • To invest in American financial assets • Demand curve for dollars is downward sloping

  18. Supply and Demand for Dollars

  19. Shifts in the Supply of Dollars • Factors that shift supply curve to right • Increase in U.S. preference for foreign goods • Increase in U.S. real G.D.P. • Increase in real interest rate on foreign bonds • Increase in American wealth • Decrease in relative risk of foreign investments • Expected dollar depreciation (e.g. high U.S. inflation)

  20. Shifts in the Supply of U.S. Dollars

  21. Shifts in the Demand of Dollars • Factors that shift demand curve to right • Increase in foreign preference for U.S. goods • Increase in foreign real G.D.P. • Increase in real interest rate on U.S. bonds (relative to foreign) • Increase in foreign wealth • Decrease in relative risk of U.S. investments • Expected dollar appreciation (e.g. low U.S. inflation)

  22. Shifts in Demand for U.S. dollars

  23. Current Account • Current account – measures the country’s trade in currently produced goods and services. • Merchandise (soybeans, perfume, cars . . .) • Services (education, tourism, insurance . . .) • Current Account = Exports – Imports • Imports > Exports : current account deficit • Exports > Imports : current account surplus

  24. Current Account • Current account does not measure trade in assets already existing. • Example: If Japanese investor buys vacation home in Hawaii, this is not included in current account. • Current Account measures • Demand of U.S. for current goods abroad (dollar supply) • Demand of Foreigners for U.S. goods (dollar demand)

  25. Capital Account • Capital account measures trade in all financial assets and other existing assets. • When U.S. sells asset abroad and receives dollars, this is counted as a capital inflow to the home country, and as a credit to the capital account. • Examples: • I sell euros to buy dollars (credit capital account) • I sell a bond to a Chilean investor for dollars (credit capital account)

  26. Capital Account • Capital Account measures • Demand of U.S. for foreign assets (dollar supply) • Demand of Foreigners for U.S. assets (dollar demand) • Capital Account = capital inflows – capital outflows • Inflows > Outflows capital account surplus • Outflows > Inflows capital account deficit

  27. Capital and Current Account • Capital Account + Current Account = 0 • CA=current account • KA=Capital account • You buy a British Sweater for 75 dollars: Debit to CA • The sweater manufacturer can • Use dollars to buy some other U.S. good: Credit CA • Use dollars to buy a U.S. bond: Credit KA • Exchange dollars for pounds at Bank • Bank can sell dollars to someone who wants to buy U.S. good • Bank can buy U.S. financial asset itself • Buy pounds from the Federal Reserve: Credit KA

  28. Current Account Deficit • In U.S. current account deficit is approaching $one trillion • Import more than we export • What are countries doing with extra dollars? • Buying U.S. bonds and other investments, leading to capital account surplus.

  29. Capital and Current Accounts Capital Account Current Account

  30. Exchange Rates in the Short Run

  31. September 20th