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Chapter 19. The Foreign Exchange Market

Chapter 19. The Foreign Exchange Market. Exchange rates Long run factors Short run factors. I. Exchange rates. definitions, data, examples typically exchange rate =. Mexican Peso, Japanese Yen. also quoted as. British pound, Canadian dollar, euro. exchange rate market.

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Chapter 19. The Foreign Exchange Market

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  1. Chapter 19.The Foreign Exchange Market • Exchange rates • Long run factors • Short run factors

  2. I. Exchange rates • definitions, data, examples • typically exchange rate = Mexican Peso, Japanese Yen

  3. also quoted as British pound, Canadian dollar, euro

  4. exchange rate market • spot exchange rates • currency exchanges w/in 2 days • forward exchange rates • currency exchange at future date, but ratio is set today

  5. why care? • determines relative prices • imports in U.S. • our exports abroad • determines relative returns • U.S. investments vs. foreign investments • financing U.S. debt

  6. example • GM Saturn • $13,500 in U.S. • Toyota Corolla • 1.8 million yen

  7. case 1: 120 yen/$ • price of Corolla in U.S.: 1.8 million/120 = $15,000 • price of Saturn in Japan: 13,500 x 120 = 1.62 million yen

  8. case 2: 110 yen/$ • $ has depreciated against yen • yen has appreciated against $ • $ has fallen • yen has risen • $ is weaker • yen is stronger

  9. price of Corolla in U.S. 1.8 million/110 = $16,364 • price of Saturn in Japan 13,500 x 110 = 1.485 million yen • $ depreciated • Corolla is more expensive here • Saturn is cheaper in Japan

  10. In general, • $ appreciates • imports cheaper, exports pricier • U.S. trade deficit rises • $ depreciates • imports pricier, exports cheaper • U.S. trade deficit falls

  11. exchange rate movement • short-run volatility • long-run trends

  12. II. Exchange rates in LR A. Purchasing power parity (PPP) • if countries have different inflation rates, • exchange rate movement • law of one price • identical goods should have same value all over world

  13. example • pack of gum • 120 yen/$ • gum = $1 in U.S. • gum = 120 yen in Japan

  14. U.S. prices double • gum = $2 • if still 120 yen/$ • gum is cheaper in Japan (120 yen) • everyone buys gum in Japan • exchange rate moves, • 120 yen/$2 or 60 yen/$

  15. PPP • if U.S. prices rise faster than world, $ depreciates • if U.S. prices rise more slowly, $ appreciates

  16. PPP works in LR • PPP lousy in SR • why? • assumes goods transportable cheaply -- gum, yes -- haircuts, no • assumes goods identical

  17. B. Other factors • anything impacting relative demand for U.S. stuff vs. foreign stuff • increase demand U.S. stuff, increase demand for $, $ appreciates

  18. tariffs and quotas • U.S. tariffs • increase domestic demand • $ appreciates • (but other nations could retaliate)

  19. preferences • U.S. consumers prefer foreign SUVs • increase import demand, decrease $ demand, $ depreciates

  20. productivity • U.S. more productive, make goods at lower cost, U.S. goods more desirable, $ demand increases, $ appreciates

  21. III. Exchange rates in SR • driven by investor behavior • capital mobility • investors chose assets globally

  22. example: Japanese investor • U.S. CD ($) or • Japanese CD (yen) • i$ = 7%, iyen = 5% • currently 105 yen/$ • expect 90 yen/$ in 1 year

  23. Japanese CD • deposits 105,000 yen • in one year 105,000 (1+.05) = 110,250 yen

  24. U.S. CD • convert yen to $ (105 yen/$): 105,000/105 = $1000 • deposit $1000 in CD • in one year: $1000(1+.07) = $1070 • convert back to yen (90 yen/$): $1070 x 90 = 96,300 yen

  25. U.S. interest rate is higher BUT • given expected depreciation of $, • investor better off w/ Japanese CD

  26. U.S. investor • U.S. CD: $1070 • Japanese CD: $1000 x 105 = 105,000 yen 105,000(1.05) = 110,250 yen 110,250/90 = $1225 • U.S. investor better off holding Japanese CD

  27. in this example, • no one would hold a U.S. CD • so it must be the case that • expected returns equalize across countries • interest rate parity

  28. Interest Rate Parity • exp. returns equalize across countries • based on interest rate, exchange rates • so a change in interest rate will cause exchange rate to change

  29. Interest rates & exchange rates • nominal interest rate = real interest rate + exp. inflation rate • if nominal interest rate rises, either real interest rate increased or exp. inflation rate increased

  30. U.S. real interest rate rises • increase demand for $ • $ appreciates • foreign real interest rate rises • decrease demand for $ • $ depreciates

  31. U.S. expected inflation rises • under PPP, $ depreciates • U.S. money supply rises • increase exp. inflation • decrease nominal interest rate • $ depreciates

  32. Why has the U.S. dollar fallen since 2002? • decline in private foreign investment • EU becoming more attractive? • twin deficits • U.S. trade deficit • U.S. federal budget deficits • large amount of borrowing makes our currency less attractive

  33. Why do we care? • U.S. $ as world reserve currency • allows us to borrow cheaply • falling $ place this status as risk • Currency instability • huge disruptions to trade, financial markets

  34. The future? • some predict continued decline of $ • compare to British pound 60 years ago… • however, $ has been lower… • mid 1990s dollar much lower against yen, deutschmark

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