ECON 2105 1nd Edition Lecture 25 Outline of Current Lecture I. Exchange Rates II. Appreciation III. Foreign Exchange Markets Current LectureModule 42 The Foreign Exchange Market What we will learn - The role of the foreign exchange market and the exchange rate- The importance of real exchange rates and their role in the current accountI. Exchange rates - Exchange Rate- The value (or price) of one currency relative to another currency. - Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.- $1= ¥100, the price of one dollar= 100 Yen.- Or ¥1= $1/100, or the price of one yen=$0.01- If the rate of exchange is 1€ = US$2.5, thenUS$1 = 1 / 2.5 = 0.4 - If the exchange rate is $1 = ¥180, then, under free trade, a $2,000 Dell laptop costs _________ in JapanII. Depreciation- Depreciation is a decrease in the value of a currency relative to another currency. These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.- $1.35/€1 → $1.50/€1 means that the dollar has depreciated relative to the euro. It now takes $1.50 to buy one euro, so the dollar is less valuable.- The euro has appreciated relative to the dollar: it is now more valuable (one euro can now buy more dollar)- Practice: - If the British pound depreciates against the dollar, this will make:- British goods and services__less___ expensive to US importers of British goods.- US goods and services__more___ expensive to British importers of US goods.III. Appreciation - Appreciation is an increase in the value of a currency relative to another currency. - An appreciated currency is more valuable (more expensive) and thereforecan be exchanged for (can buy) a larger amount of foreign currency.- $1.35/€1 → $1.10/€1 means that the dollar has appreciated relative to the euro. It now takes only $1.10 to buy one euro, so that the dollar is more valuable.- The euro has depreciated relative to the dollar: it is now less valuable.- If the US dollar appreciates against major currencies, - Then, - Americans will buy _____ goods from abroad.- Americans will buy _____ foreign currency.- American imports from other countries will _______.- American exports to other countries will _______.IV. Foreign Exchange Market- Currencies are traded in the foreign exchange market.- Demand for a Currencyo The demand for a nation’s currency arises from:o The desire by residents of other countries to import the country’s goods and services, and/or …o The desire by residents of other countries to invest in a country’s assets.- Supply of a Currencyo The supply of a nation’s currency arises from:o Domestic residents’ desire to import another nation’s goods and services, and/or …o The desire by domestic residents to invest in financial assets of another nation.- The participants o Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes.o Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment.o Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets.o Central banks: conduct official international reserves transactions.o- equilibrium exchange rateo The equilibrium exchange rate is the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied.- Sometimes the exchange rate is measured as the price of a dollar in terms of foreign currency.- Sometimes the exchange rate is measured as the price of foreign currencyin terms of dollars. - Increase in the Demand of US Dollarso-- Real exchange rates are exchange rates adjusted for international differences in aggregate price levels.- Real exchange rate = Mexican pesos per U.S. dollars × PUS /PMex- Purchasing Power Parity (PPP) is a theory of exchange rate.- IF all goods and services are fully and freely tradable across US and Germany. - Then, According to PPP Theorem:o P is the price level in US (Say P=240)o P* is the price level in Germany (say P*=320)o Then, exchange rate is determined by relative price level.o Then, the amount of dollar per one euro= P/P*= 0.75 o OR, the amount of euro per one dollar= P*/P= 1.333- The PPP theory implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries. - In other words, real exchange rate =1- Burgernomics o The Economist’s Big Mac index looks at the price of a Big Mac in local currency and computes the following: o The price of a Big Mac in U.S. dollars using the prevailing exchangerate.o The exchange rate at which the price of a Big Mac would equal theU.S. price.o If purchasing power parity held, the dollar price of a Big Mac would be the same everywhere.o Estimates of purchasing power parity based on the Big Mac index are relatively consistent with more elaborate
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