Exchange Rates

Lecture notes 8

Instructor: MELTEM INCE

Nominal exchange rates

The nominal exchange rate is the value of one country’s

currency in terms of another country’s currency.

The nominal exchange rate tells you how much foreign

currency you can obtain with one unit of the domestic

currency For example, if the nominal exchange rate is 110 yen

per dollar, one dollar can be exchanged for 110 yen Transactions between currencies take place in the

foreign exchange market

Real exchange rates

The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good

If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger

Real exchange rates

The real exchange rate is the price of domestic goods relative to foreign goods or to simplify matters, we’ll assume that each country produces a unique good

In reality, countries produce many goods, so we must use price indexes to get P and PFor

If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country

Domestic price levelReal exchange rate = Nominal exchange rate .

Foreign price level

Domestic price levelReal exchange rate = Nominal exchange rate .

Foreign price level

Domestic price levelReal exchange rate = Nominal exchange rate .

Foreign price level

Real exchange rates

Real exchange rates are reported as index numbers with

one year chosen as the base year.

Domestic price levelReal exchange rate = Nominal exchange rate .

Foreign price level

Equilibrium in the Market for Foreign

Exchange The demand curve for dollars in exchange for yen has downwardslope while the supply curve has upward slope. The foreignexchange market is in equilibrium at the exchange rate where thequantity supplied equals the quantity demanded.Currency appreciation occurs when the market value of acountry’s currency increases relative to the value of anothercountry’s currency. Currency depreciation occurs when the market value of acountry’s currency decreases relative to the value of anothercountry’s currency.

Equilibrium in the Market for Foreign Exchange

Purchasing power parity

PPP holds in the long run but not in the short run

Countries produce different goods

Some goods aren’t traded

Transportation costs

Legal barriers to trade

When PPP doesn’t hold, using Equation, we can

decompose changes in the real exchange rate into

parts

Δe/e = Δenom/enom + ΔP/P – ΔPFor/PFor

This can be rearranged as

Δenom/enom = Δe/e + πFor – π

Price of a Big Mac

As a test of the PPP hypothesis, the Economist magazine

periodically reports on the prices of Big Mac hamburgers in

different countries

The prices, when translated into dollar terms using the

nominal exchange rate, range from just over $1 in China to

over $5 in Switzerland (using 2006 data), so PPP definitely

doesn’t hold

Price of a Big Mac

The real exchange rate and net exports

The real exchange rate also affects a country’s net exports

(exports minus imports) An increase in the real exchange rate

means people in a country can get more foreign goods for a

given amount of domestic goods Changes in net exports have a direct impact on export and import

industries in the country Changes in net exports affect overall economic activity and are a

primary channel through which business cycles and macroeconomic policy changes are transmitted internationally