LECTURE XIII 30 July 2012
TOPIC 15 Exchange Rates
BIG PICTURE How do we evaluate currency across countries? How is the exchange rate determined? What is the relationship of the foreign exchange market and the foreign trade market? How is the exchange market related to domestic savings and investment?
Government Expenditure Consumption Expenditure Taxes Government Households Transfers Income Save Interest Loans Repayment Profits Output Market Economic Investment Factor Market Financial Market Repayment Loans Revenue Firms Costs Exports Imports Rest of the World Repayment Loans
BASICS OF EXCHANGE
WHY? EXCHANGE RATES Why do we need exchange rates? What are they representing? Think about Zimbabwe and money inflation, What if the cost of exports from Zimbabwe increased 1,000% with hyperinflation It would artificially inflate the value of goods in Zimbabwe because of their inflation; remember people in Zimbabwe got an enormous increase in money supply to pay for 1 billion dollar bread Why not have one currency? Independent currency is one valuable tool in managing a country s own monetary and fiscal policy Useful because the US does not always have a recession at the same time as other countries, etc.
NOMINAL EXCHANGE RATES Nominal exchange rate (e): The rate at which the currency of one nation can be exchanged for the currency of another nation Specifically, how much foreign currency can I buy for 1 USD (home currency) would be the US-Mexico exchange rate, e.g. e=10 pesos / USD So price of a foreign good is P = P*/e Why, say price of iphones in Japan in 10,000 yen and exchange rate is 120 yen / USD 10,000 yen / (120 yen / 1 USD) = 10,000 yen * 1 USD / 120 yen = 83.33 dollars Because 1 yen is not worth much in USD or 1 USD can buy a lot of yen, price should decrease from yen to USD
EXAMPLE: ZIMBABWE Suppose the exchange rate is 100 million ZD / 1 USD (makes sense? Zimbabwe dollars were worth close to nothing) Let s buy Zimbabwe bottled water The cost is 95 million ZD How much does it cost in USD? 95 million ZD * (1 USD / 100 million ZD) =.95 USD Very cheap!
CHANGING VALUE What if the exchange rate changes from 100 million ZD / USD to 120 million ZD / USD? It now takes more Zimbabwe dollars to buy US currency US currency is either more expensive or the Zimbabwe dollar is less valuable Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy So relative to US currency Zimbabwe dollar has depreciated; compared to others who knows Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy Here relative to Zimbabwe currency, US dollar has appreciated So when comparing two currencies, if one appreciates, the other must depreciate
GET REAL So what if 1 USD gets me 120 million Zimbabwe dollars; we are interested in goods 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 Real exchange rate formula (RER): ep/p* So the real exchange rate will tell us how many goods and services we can get in Zimbabwe in comparison to in America
EXAMPLE: GERMANY Suppose: Starbucks coffee costs 2 USD here, in germany 1 Euro, and the nominal exchange rate is. 5 Euros / USD What is the real exchange rate in terms of coffee? RER = (.5 Euros / 1 USD) * 2 USD per coffee / 1 Euro per coffee = 1 German coffee / 1 US Coffee Notice that we simply need units to cancel to ensure foreign goods / domestic goods
REAL EXCHANGE RATE In trade people care about the real exchange rate (remember we only care about what we can actually eat and money has no nutritional value) Now if the RER is 2 German coffee / US coffee, I can buy 2 German coffee for each US coffee So German coffee is cheaper Since German Starbucks coffee is cheaper, we expect the US would want to import
EXCHANGE AND TRADE If the RER is 1 German coffee / 2 US coffee US coffee is cheaper so the US would export to Germany In general, if the RER < 1, the domestic country exports (here US) If the RER > 1, the domestic country imports
PURCHASING POWER PARITY Purchasing power parity: a theory of nominal exchange rates so a unit of any given currency should be able to buy the same quantity of goods in all countries Equation: (1/P)=(e/P*) Originally, we had nominal e =.50 Euros / 1 USD Suppose there is a US expansionary monetary policy so prices double in the US, then e =.25 Euros / 1 USD (why..?) US dollar has depreciated Examine PPP, before 1 / 2 = (.5 / 1) so we are safe Now 1 / 4 = (. 25) / 1 so we are still safe Basically price changes here are reflected in the exchange rate and as nominal price increases in the US, nominal prices to buy German goods increases PPP implies RER = 1 Exercise: Recitation 9 Parts B through E
OTHER INDICES
DETERMINING EXCHANGE RATES
FOREIGN EXCHANGE MARKETS How do we actually determine the exchange rate? There is a market! (of course) The foreign exchange market trades domestic and foreign currency What is price? Exchange rate! This obviously indicates how much domestic currency I get for foreign currency and vice versa Specifically, RER. PPP assumption is very strict and in general RER 1
FOREIGN EXCHANGE MARKETS How about supply of dollars? Remember supply of dollars is determined by the Federal Reserve and government But WE use that money, only leftover money can be exchanged internationally So how much money is leaving the country? Net capital outflow: purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners So as we purchase more foreign assets we supply more dollars As foreigners purchase more of our assets, they take dollars and the supply of dollars decreases 2 components of Assets Foreign Direct Investment Foreign Portfolio investment - investment in financial assets
NET CAPITAL OUTFLOW United States Brazil Oil Refinery Need Dollars Sell Reals Petrobras + Apple Inc. Need Reals Sell Dollars = Factory Assets invested in foreign countries - US assets sold to foreigners
FOREIGN EXCHANGE MARKETS: FINANCIAL Net capital outflow is impacted by: Real interest rates paid on domestic and foreign assets (higher interest rates make the asset more attractive) Perceived risk of holding assets abroad (more risk is less attractive, all else equal) Government policy impacting foreign ownership of domestic assets Note that RER (our price in this market) does NOT impact the NCO so supply is vertical Real Exchange Rate Supply of dollars, NCO Net quantity of US exchanged
FOREIGN EXCHANGE MARKETS: CAPITAL For capital markets, where do we get the loanable funds for investment? From our own countries Interest Rates So increased interest rates here do not decrease the foreign desirability for capital investment in the US (remember higher interest rates do increase desirability for financial investment in the US) Supply = S Demand = NCO + I Loanable Funds Foreigners borrow money at home and buy capital for the States
FOREIGN EXCHANGE MARKETS: DEMAND Why would anyone demand dollars in exchange market? Wanted for exports from the US Foreign countries must have dollars to buy US goods So as RER increases, remember that US goods become more expensive so will export less So demand for dollars decreases as RER increases Likewise as RER decreases, demand for dollars increases
EQUILIBRIUM Now what if the supply of dollars shifts left because of an increase in interest rates (US assets more attractive) The RER increases, what happens to exports? Exports decrease because the US is more expensive How did the RER increase? Increased investment in US financial assets (will talk about connection with direct investment next class) Reduced net outflow of capital causes US currency to appreciate Real Exchange Rate Supply of dollars, NCO Demand for dollars Net quantity of US exchanged
CAPITAL FLOWS AND SAVINGS
Government Expenditure Consumption Expenditure Taxes Government Households Transfers Income Save Interest Loans Repayment Profits Output Market Economic Investment Factor Market Financial Market Repayment Loans Revenue Firms Costs Exports Imports NX Rest of the World Repayment Loans ~NCO
NCO AND NX Remember that our graph is closed so at each point, things coming in things going out Tells us NX = NCO (with some reinterpretation of repayment and loan ) Essentially demand for dollars in net exports and supply is NCO Suppose Japan exports a car to the US for $20000 so NX = -$20000 Then the US is basically sending $20000 to Japan to pay for the car Japan could then spend it on the US stock market or in some other asset so NCO = 0-20000 = -$20000 If Japan pays US employees with the 20K? Then US is exporting services with value of $20000 so NX = 0 and NCO = 0 Or company could give it to some other source, which then takes an option similar to above
INVESTMENT, SAVINGS, NCO Recall that the equation for national savings without taxes is income less spending (consumption and government) so S = Y - C - G Since GDP = Y = C + I + G + NX, we can rearrange terms so Y - C - G = I + NX Then S = I + NX or S = I + NCO since NX = NCO Before with S = I we assumed there was no trade, i.e. S = I + 0 So savings must equal investments plus net capital outflow
INVESTMENT, SAVINGS, NCO How do we solve a problem like low US savings? Borrow from abroad! S = I + NCO implies that if we save more than domestic investment we must send it abroad by buying foreign investment Here we save less than domestic investment so since S < I, NCO<0 If NCO< 0, foreigners are buying more US assets than US is buying foreign assets, which is what is the case with the US What about NX NX = NCO < 0, so the US is a net importer, which we know is true also
THE GOOD AND BAD OF BORROWING Is it bad to be a net importer? We can have higher level of investments with low savings Ultimately depends on investments made with foreign money E.g. foreigners could be investing in capital that will improve long-term growth
REVIEW Various exchanges rates are measures of the rate at which we convert domestic money / goods and services to foreign Exchange rates are set in the foreign exchange markets Demand in the market is set by net exports, while supply is set by the net outflow of capital, which can be positive or negative A negative NCO implies that the country is an importer and is borrowing from abroad; the opposite holds for a country with a positive NCO