Foreign Currency Exchange Rates

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Foreign Currency Exchange Rates
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Currency Markets

• An exchange rate tells you how much of one
  currency you must give up to get a unit of
  another currency. This is also called the nominal
  exchange rate.
• The real exchange rate is the rate at which a
  person can trade the goods and services of one
  country for the goods and services of another
  country.

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Calculating the real exchange rate

• Real exchange rate
• Nominal exchange rate X domestic price
• foreign price

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• Suppose a bushel of American rice sells for 100,
  and a bushel of Japanese rice sells for 16,000
  yen. And suppose the nominal exchange rate is 80
  yen/dollar. What is the real exchange rate of
  Japanese rice to American rice?
• Real Exchange Rate
• (80 yen/dollar) x (100 per bushel of American
  rice)
• 16,000 yen per bushel of Japanese rice
• _8,000 yen per bushel of American rice
• 16,000 yen per bushel of Japanese rice
• ½ bushel of Japanese rice per bushel of
  American rice

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Macroeconomic focus on the price level

• Macro exchange rates focus instead on the
  relative price levels of each country.
• Real exchange rate (e x P) /P
• Where P is the price index for a U.S. market
  basket, and P is the price index for a foreign
  market basket, and e is the nominal exchange rate
  between U.S. and foreign currencies.

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Purchasing power parity and the law of one price

• The theory states that a unit of any given
  currency should be able to buy the same quantity
  of goods in all countries.
• That is because, if a currency bought more in one
  place than in another, clever people would take
  advantage of arbitrage opportunities to buy a
  good for less in one country and sell it in
  another, with the only difference being the
  different values of currencies in each country.

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PPP

• This processbuying low and selling highwould
  continue until the prices were the same in the
  two markets.
• Thus the theory of PPP says that a currency
  should have the same purchasing power in all
  countries. At least, it should have the same real
  value in every country.
• But that also means that the nominal exchange
  rates between the currencies of the two countries
  depends on the price levels in those two
  countries.

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Inflation and currency exchange rates

• The nominal exchange rate between two currencies
  must reflect the different price levels in those
  countries.
• BUT, when the central bank prints large
  quantities of money, that money loses value in
  terms of the amount of foreign currency it can
  buy.
• When one country experiences inflation, prices in
  that country rise faster relative to prices in
  other countries.

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Big Mac Index

• Started in half-jest by The Economist, the Big
  Mac Index measures exchange rates based on the
  price of a Big Mac in each country. Its now
  published regularly.
• The predicted exchange rate is the one that makes
  the cost of a Big Mac the same in both countries.

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Other determinants that affect currency
appreciation and depreciation

1. Consumer tastes
2. Relative incomes
3. Relative inflation
4. Speculation