1 Econ 340 Lecture 13 Exchange Rates Econ 340, Deardorff, Lecture 13: Exchange Rates 2 Outline: Exchange Rates • In What Forms Are Exchange Rates Reported? – Bilateral Nominal Rates – Multilateral (Trade-Weighted) Rates – Real Rates – Forward Rates • What Determines Exchange Rates? – Markets – Governments/Central Banks • Theories of Exchange Rates – Purchasing Power Parity – Asset Theory – Supply and Demand Model Econ 340, Deardorff, Lecture 13: Exchange Rates 3 Forms of Exchange Rates • What Is an Exchange Rate? – The price of one currency in terms of another – Examples • Recent rates for the US $ vs the € (euro) and ¥ (yen) were Mar 3, 2014 Feb 22, 2013 $/ € 1.3734 1.3190 €/$ 0.7281 0.7581 $/ ¥ 0.00986 0.01071 ¥/$ 101.44 93.412 Econ 340, Deardorff, Lecture 13: Exchange Rates 4 Forms of Exchange Rates • What Is an Exchange Rate? – Rates are reported both ways, which can be confusing: • i.e., “The Japanese yen rose today from 95 to 90” • Makes sense because the numbers are understood to be ¥/$, not $/¥, so the change from 95 to 90 is in fact a rise in the value of the yen Econ 340, Deardorff, Lecture 13: Exchange Rates 5 Forms of Exchange Rates • Sources of Exchange Rates – Wall Street Journal • Each day includes a table with rates for yesterday and the day before for a few dozen currencies • Also forward rates and trade-weighted indexes for major currencies (see later) – IMF, online and in various publications – x-rates.com flexible tool for rates in various forms Econ 340, Deardorff, Lecture 13: Exchange Rates 6 Forms of Exchange Rates • Bilateral Nominal Exchange Rates – These are what we normally see: the actual rate between a pair of currencies • Don’t need to say “bilateral” or “nominal” except when comparing to something other than these. – Note that the size of an exchange rate means very little • Whether euro is worth more, or less, than a dollar is not important • That the yen is worth about one US cent means nothing • But see reading on “Currency Envy”. People do care!3 Econ 340, Deardorff, Lecture 13: Exchange Rates 7 Outline: Exchange Rates • In What Forms Are Exchange Rates Reported? – Bilateral Nominal Rates – Multilateral (Trade-Weighted) Rates – Real Rates – Forward Rates • What Determines Exchange Rates? – Markets – Governments/Central Banks • Theories of Exchange Rates – Purchasing Power Parity – Asset Theory – Supply and Demand Model Econ 340, Deardorff, Lecture 13: Exchange Rates 8 Forms of Exchange Rates • Multilateral Exchange Rates – Bilateral rates only tell value of a currency relative to a single other currency – If you want the overall value of a currency, you need an index relative to many others – An index requires weighting by the importance of the other currencies – Typically, multilateral exchange rates are Trade Weighted (weighted by bilateral exports and/or imports between the countries) Econ 340, Deardorff, Lecture 13: Exchange Rates 9 Source: Federal Reserve, “Broad Index” based on a large group of currencies, monthly data 0 20 40 60 80 100 120 140 Jan-73 Jan-75 Jan-77 Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Trade-Weighted Dollar Index (Nominal)4 Econ 340, Deardorff, Lecture 13: Exchange Rates 10 Forms of Exchange Rates • Interpretation – From the graph, until 2002 the dollar rose relative to other currencies • By 2002 it was 4 times higher than in 1973 • Why? – We’ll see later that rates of inflation (of prices) are important for exchange rates – This suggests looking at real exchange rates, as well as nominal Econ 340, Deardorff, Lecture 13: Exchange Rates 11 Outline: Exchange Rates • In What Forms Are Exchange Rates Reported? – Bilateral Nominal Rates – Multilateral (Trade-Weighted) Rates – Real Rates – Forward Rates • What Determines Exchange Rates? – Markets – Governments/Central Banks • Theories of Exchange Rates – Purchasing Power Parity – Asset Theory – Supply and Demand Model Econ 340, Deardorff, Lecture 13: Exchange Rates 12 Forms of Exchange Rates • Real Exchange Rates – Like real wages or real incomes, a real exchange rate is simply • Corrected for inflation, or equivalently • Deflated by a price index – But an exchange rate involves two currencies: Whose prices do you use? • Answer: Both!5 Econ 340, Deardorff, Lecture 13: Exchange Rates 13 Forms of Exchange Rates • Real Exchange Rates – Let • E = €/$ be the euro/dollar nominal exchange rate • Pe = price level (index) in Europe (€ per EU-good) • Pu = price level (index) in US ($ per US-good) – Then Real Exchange rate is R = EPu/Pe – Note that this divides each currency by its own price level: R= (€/Pe) / ($/Pu) =(€/$) ($/US-good)/(€/EU-good) = (EU-good/US-good) Econ 340, Deardorff, Lecture 13: Exchange Rates 14 Source: Federal Reserve, “Broad Index” based on a large group of currencies, monthly data 0 20 40 60 80 100 120 140 Jan-73 Jan-75 Jan-77 Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Trade-Weighted Dollar Index (Real) Econ 340, Deardorff, Lecture 13: Exchange Rates 15 Forms of Exchange Rates • Real Exchange Rates – From the graph, note that • Decline of the dollar since 2002 was real • So was the more recent rise (during the crisis), and then fall • But the real value of the dollar today is not unusually low or high – Though it is below its long-term average6 Econ 340, Deardorff, Lecture 13: Exchange Rates 16 Outline: Exchange Rates • In What Forms Are Exchange Rates Reported? – Bilateral Nominal Rates – Multilateral (Trade-Weighted) Rates – Real Rates – Forward Rates • What Determines Exchange Rates? – Markets – Governments/Central Banks • Theories of Exchange Rates – Purchasing Power Parity – Asset Theory – Supply and Demand Model Econ 340, Deardorff, Lecture 13: Exchange Rates 17 Forms of Exchange Rates •
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