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1. 19 International Finance CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to • 1 Define exchange rates and demonstrate their use in converting amounts in one currency into another. • 2 Present a theory of exchange rates movement, and show the relationship between exchange rates and monetary policy.

2. 19.1 THE EXCHANGE RATE • Foreign exchange rateis the price at which one currency exchanges for another. • For example, on May 09, 2017, one U.S. dollar bought 0.92 Euros. The exchange rate was 0.92 euros per dollar. • This exchange rate can be expressed in terms of dollars (or cents) per euro. On May 09, 2017, the exchange rate was \$1.087 per euro.

3. 19.1 THE EXCHANGE RATE • Notation: • - means Euros per dollar (the price of \$1 in Euros) • - means dolalrs per Euro (the price of 1 Euro in \$) • In general: • - means the price of a dollar in units of currency c • - means the price of 1 unit of currency c in dollars

4. 19.1 THE EXCHANGE RATE • Euros per dollar • dollars per Euro

5. 19.1 THE EXCHANGE RATE • Foreign exchange marketis the market in which the currency of one country is exchanged for the currency of another. • The foreign exchange market is made up of importers and exporters, banks, and specialist dealers who buy and sell currencies.

6. 19.1 THE EXCHANGE RATE • Currency appreciationis the rise in the value of one currency in terms of another currency. • For example, when the dollar rose from 1.00 euros to 1.17 euros in 2000, the dollar appreciated by 17 percent. • Currency depreciationis the fall in the value of one currency in terms of another currency. • For example, when the dollar fell from 1.17 euros in 2001 to 0.63 euros in 2008, the dollar depreciated by 46 percent.

7. 19.1 THE EXCHANGE RATE • Figure 19.1 shows the U.S. dollar exchange rate in against the euro.

8. 19.1 THE EXCHANGE RATE • The value of the foreign exchange rate fluctuates. • Sometimes the U.S. dollar depreciates and sometimes it appreciates. Why? • The foreign exchange rate is a price and, like all prices, demand and supply in the foreign exchange market determine its value.

9. 19.1 THE EXCHANGE RATE • Using exchange rates to convert one currency into another Q. Suppose a television in the U.S. cost \$500. What is the price of this TV in Japanesne Yen, if the exchange rate is (i.e. 114 Yen per dollar). A. Remark. This does not have to be the price of TV in Japan. We only converted the \$500 to Japanes Yen.

10. 19.1 THE EXCHANGE RATE • Using exchange rates to convert one currency into another Q. Suppose that the price of a Big Mac Meal in Japan is 700. What is the price of this meal in dollars, if the exchange rate is (i.e. 114 Yen per dollar). A. Remark. This does not have to be the price of Big Mac Meal in the U.S. We only converted the 700 to dollars.

11. 19.2 Theory of Exchange Rate Determination • Purchasing Power Parity (PPP) We say that PPP holds between the U.S. and another country, for some bundle of goods, if \$1, when converted to foreign currency buys the same amount of the bundle as \$1 buys in the U.S. or – exchange rate (price of domestic currency in terms of foreign currency) – domestic and foreign prices of the same bundle.

12. 19.2 Theory of Exchange Rate Determination • Purchasing Power Parity (PPP) Q. Suppose that TVs are traded goods. The price of TV in the U.S. is \$500 and the price of the same TV in Japan is 60,000. What should be the exchange rate between the \$ and if PPP holds for TVs? A. Using the definition of PPP,

13. 19.2 Theory of Exchange Rate Determination • Exchage Rates and Money Supply Assuming that PPP holds for traded goods only, and a few other assumptions, we can show that - rate of change in the value of domestic currency - domestic and foreigh inflation Intuitively, inflation is the loss of value of money (currency). If foreign inflation is higher than domestic inflation, the domestic currency appreciates relative to foreign currency.

14. 19.2 Theory of Exchange Rate Determination • Exchage Rates and Money Supply Assuming that PPP holds for traded goods only, and a few other assumptions, we can show that Q. Suppose the U.S. inflation 2% and inflation in China is 10%. What does our theory predict about the change in the value of the dollar? A.. The dollar is expected to appreciate by 8% relative to the Chinese Yuan.

15. Testing the theory. If , then we expect that . 19.2 Theory of Exchange Rate Determination

16. 19.2 Theory of Exchange Rate Determination • Exchage Rates and Money Supply Using the quantity theory of money, we can show that - rate of change in the value of domestic currency - rate of growth in domestic and foreign money supply - rate of growth in domestic and foreign RGDP - rate of growth in domestic and foreign velocity of circulation

17. 19.2 Theory of Exchange Rate Determination • Exchage Rates and Money Supply Intuitively, faster growth rate of supply of foreing currency, relative to domestic currency,, leads to appreciation of the domestic currency, holding all other effects the same.

18. 19.2 Theory of Exchange Rate Determination • Exchage Rates and Money Supply Q. Suppose that money supply in the U.S. grows at 4% and money supply in the Euro area is growing at 3%. If other influences remain the same, what is the expected change in the value of the dollar relative to Euro? A. . We expect the dollar to depreciate by 1% relative to Euro.

19. 19.2 Theory of Exchange Rate Determination • Floating v.s. fixed exchange rates Notice that fixing the exchange rate, essentially restricts the growth rate of the domestic money supply. Such policy is often used to combat inflation, and it is called nominal anchor.

20. 19.2 Theory of Exchange Rate Determination • Floating v.s. fixed exchange rates Q. Suppose that the money supply in the U.S. is growing at 4% and the U.S. real GDP growth is 2%. In China the real GDP is growing at 10%, and the velocities of the two countries change at the same rate. If China adopts a fixed exchange rate between Yuan and the dollar, what will be the growth rate on the Chinese money supply? A. Thus, the Chinese money supply should grow at .

21. 19.2 Theory of Exchange Rate Determination