Topic 15 Exchange Rates Kailin Clarke University of Minnesota clar0955 umn edu April 24 2013 Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 1 27 We will look at Nominal and Real Exchange Rates Definitions calculations Purchasing Power Parity Definitions calculations Net Capital Outflow NCO and Exchange Rates Different forms of Capital Outflow and what influences NCO Capital Flows and Savings and Investment Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 2 27 Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 3 27 Exchange Rates what do they mean So is this an expensive meal How would you know Need to get the price in USA dollars How do we do this We use exchange rates Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 4 27 Exchange Rates how to use them Nominal Exchange Rate e The rate at which the currency of one nation can be exchanged for the currency of another nation measured in foreign currency per unit of domestic currency e g e 10 pesos per US 1 Let s start with the mineral water About Z 95 million In 2008 exchange rate is Z 100 million for US 1 So Z 95mill Kailin Clarke U of M US 1 Z 100mil US 0 95 Topic 15 Exchange Rates April 24 2013 5 27 Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 6 27 Exchange Rates Intuition The exchange rate tells us about the rate at which we can exchange one currency for the other it is like a price If I live in Zimbabwe I need to give up a lot of Zimbabwean dollars to get US 1 What does this literally mean in terms of prices From previous slide we see the exchange rate used to be a lot lower This means that price of the American Dollar has gone up in terms of Zimbabwean dollars In other words for every Zimbabwe Dollar you can buy fewer US Dollars This is called Depreciation A decrease in the value of a currency as measured by the amount of foreign currency it can buy So the Zimbabwe dollar has depreciated relative to the US dollar Appreication An increase in the value of a currency as measured by the amount of foreign currency it can buy The US dollar has appreciated relative to the Zimbabwe dollar Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 7 27 Real Exchange Rate RER But the important thing as we all know by now is not whether I get 100 or 100 billion dollars it s how much I can buy with the currency I receive This is known as Real Exchange Rate The rate at which a person can trade the goods and services of one country for the goods and services of another country Formula Real Exchange Rate RER e PP P is the domestic price of a good P is foreign price of the same good Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 8 27 Real Exchange Rate Example Suppose that in the US a cup of Starbucks coffee costs US 2 Suppose that in Germany it costs e1 Suppose the NOMINAL Exchange rate is 1 00 e0 75 e e0 75 1 0 75 Euros per dollar Then we can calculate the Real Exchange Rate for Starbucks coffee e0 75 2 1 US coffee 1 e1 1 German coffee e0 75 2 1 German coffee 1 1 US coffee e1 1 5 German Coffee US Coffee RER Notice that it is important to make sure that the units cancel out Since we always use e to mean foreign currency units per unit of domestic currency we will always be calculating RER as number of foreign goods per domestic good Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 9 27 Real Exchange Rate Interpretation Which one do people consider with trade The REAL exchange rate It doesn t matter what the nominal exchange rate between Zimbabwe and the USA is what matters is the real exchange rate How many goods and services you can get with Zimbabwe dollars in comparison with American dollars In the last slide we found that for every cup of USA coffee you could have purchased 1 5 German coffees German coffee is cheaper What would we expect to see in terms of imports exports We would expect to see USA importing coffee from Germany Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 10 27 Real Exchange Rate Interpretation Suppose RER 1 German coffee 1 5 USA coffee This is the reverse for 1 German Coffee you could have had 1 5 cups of USA coffee USA should export coffee to Germany RER 1 Export RER 1 Import What if RER 1 Then there needn t be any imports or exports Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 11 27 Purchasing Power Parity PPP Purchasing Power Parity A theory of nominal exchange rates whereby a unit of any given currency should be able to buy the same quantity of the same goods in all countries This is true when the following equation holds Equation Purchasing Power Parity P eP eP is the amount of foreign currency I get if I convert P units of domestic currency So suppose we have the prices before US 2 in US e1 in Germany but now suppose e PP e1 2US or e US 10 5 Now let s check that PPP holds P e1 So as long as e Kailin Clarke U of M P P e1 US 2 eP US 2 PPP holds Topic 15 Exchange Rates April 24 2013 12 27 So suppose that here in the US there is some kind of expansionary policy so aggregate demand shifts to the right and therefore price of coffee increases from 2 to 4 According to PPP exchange rate will become e e1 4 or e e0 25 1 USA dollar depreciates Suppose Eurozone was also running expansionary policy at the same time so price of coffee in Germany increased from e1 to e2 at the same time According to PPP exchange rate will become e e2 4 or e e0 5 1 same exchange rate as before Suppose Eurozone used more expansionary policy than USA so that price becomes e4 According to PPP exchange rate will become e e4 4 or e e1 1 USA dollar appreciates Note that whenever PPP holds RER 1 Kailin Clarke U of M Topic 15 Exchange Rates April 24 2013 13 27 Review from previous class Nominal Exchange Rate The rate at which the currency of one nation can be exchanged for the currency of another nation Measured in Foreign currency per unit of domestic currency Example 77 Euros per dollar Real Exchange Rate The rate at which a person can trade the goods and services of one country for the goods and services of another country Measured in Foreign goods per domestic good Example 1 5 German Starbucks …
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