Zara Mahmood Oct 22 2013 EC102 Lecture 10 Net Exports NX The Fundamental Macro Equation GDP Aggregate Expenditure AE o Y C I G NX Exchange Rates Nominal Exchange Rate Price of one currency in terms of another currency o Number of units of foreign currency per unit of domestic currency What Causes E to Fluctuate 2012 volume of international currency transactions was o 794 Billion per day What accounts for the other 95 98 o Speculation o World trade in assets Equilibrium in the Market for Foreign Exchange Currency appreciation relative to another currency relative to another currency Currency Depreciation An increase in the market value of one currency A decrease in the market value of one currency Shifts in Demand and Supply Affect the Exchange Rate Shifts in the demand for foreign exchange Speculators attempt to profit from changes in exchange rates Currency traders who buy and sell foreign exchange in an Exchange Rates Nominal exchange rate price of one currency in terms of another currency number of units of foreign currency per unit of domestic currency Price x 1 exchange rate Real Exchange Rate in some other country the price of goods in one country in terms of the price of goods Assume a hotel room in Mumbai costs R9 150 per night the current R exchange rate is R61 1 How much does the room cost in dollars R9 150 Room R61 1 R9150 RoomX1 R61 150 Room What Causes E to Fluctuate An important determinant of E is r the real interest rate Zara Mahmood Oct 22 2013 EC102 r US increase relative to the r in the rest of the world o then the Demand for dominated assets bonds stocks increases Demand for goes up Price of a US dollar goes up nominal exchange rate goes up E nominal exchange rate Real Exchange Rate Price of watch in US 100 Price of identical watch in Switzerland SF300 Nominal exchange rate SF1 5 1 o watch in U S costs SF150 Real exchange Rate E P Domestic X E P foreign Swiss watch is worth or will buy 2 American watches the real exchange rate is 1 2 Swiss watch 1 American watch another way an American watch is half as expensive as a Swiss watch E nominal exchange rate e will change if E changes Example E goes from SF 1 5 1 to SF3 1 1 swiss watch now 1 American watch Real exchange rate Sample problem Euro zone price level 288 o U S Price level 240 Nominal echange rate 71 euros 1 What is the real exchange rate between the Euro zone and the U S 240X 71 288 59 Purchasing Power Parity PPP E should be such that e 1 e P Dom X E P FOR e 1 E P For P Dom In our example P dom 100 P for SF300 so if e 1 it must be that E SF300 100 SF3 1 Zara Mahmood Oct 22 2013 EC102 PPP and the Big Mac index if E is at the PPP level e 1 if e 1m then E is too high i e the foreign currency is undervalued relative to the domestic currency Recently a Big Mac cost 15 4 yuan in Beijing 4 20 in U S if PPP held and e 1 then E would have to be P for P dom 15 4 4 20 3 67 instead E 6 32 yuan to the dollar so yuan is 41 9 of the dollor 4 20 X 6 32 15 4 1 83 Recently A Big Mac cost SF 6 5 in Switzerland 4 20 in U S if PPP held and e 1 then E would have to be P for P dom 6 5 4 20 1 55 instead E SF 96 to the dollar so the swiss frank is 41 9 overvalued Limitations of PPP theory across countries Two reasons why echange rates do not always adjust to equalize prices o Many goods cannot easily be traded o Examples haircuts going to the movies o Price differences on such goods cannot be arbitraged away o Foreign domestic goods not perfect substitutes Nonetheless PPP works well in many cases especially as an explanation of laog run trends PPP and its implications PPP implies that the nominal exchange rate between two countries should equal the ration of price levels If the two countries have different inflation rates then E ail change over time If inflation is higher in Mexico than in the US then P for rises faster than P dom so E rises the dollar appreciates against eh peso If inflation is higher in the US than in Japan then P dom rises faster than P for so E falls