Exchange rates

• For any country, the exchange rate, St, is the number of domestic dollars per US$.. • If you have a value of foreign currency that you will want to spend at home, convert using exchang

Exchange Rates

• Exchange Rate: S - # of domestic currency units

purchased for 1 US$

• An increase in S is a depreciation and a decrease in S

is an appreciation

Exchange Rates

International Comparisons Project

• Researchers at U of Pennsylvania periodically choose a representative world market basket and go to different countries to collect prices of that market basket of good.

• For a country, we calculate PPP = Purchasing

Power Parity as the price of the market basket relative to price of the market basket in US

• For any country, the exchange rate, St, is the number of domestic dollars per US$

Penn World Tables

Comparing GDP across

Countries

• When you compare income in two different countries,

each country’s GDP per capita is measured in local

currency You need to measure both with common

yardstick to compare

• Typically, the common yardstick will be US$ GDP can be

converted to US$ by Exchange Rate Method (divide

national GDP by the exchange rate) or PPP Method

(divide national GDP by PPP)

PPP vs Exchange Rate

Conversion

• Exchange rates are easily available so

exchange rate is a “quick and dirty” comparison

– Measures how many US dollars someone could buy with average income

• However, money goes farther in some countries

as many types of goods are relatively cheap

(especially developing countries).

– PPP conversion measures how much the goods

purchased by the average person would cost in the

US Better measure of living standards

Convert sums into another

economy’s currency

• Nj is a number

measured in country

j’s currency & you

want to convert it into

Which exchange rate conversion to

use?

• Depends on where the money will be spent

• If you have a value of foreign currency that you will want

to spend at home, convert using exchange rate because foreign prices are irrelevant

• If you want to spend the money in foreign country, then using PPP conversion may be more helpful

Exchange Rate Model

Exchange Rates are Volatile

Why do exchange rates change?

• Relative values of two currency determined by supply and demand by traders of the two currencies

• People trade currencies to engage in foreign trade and international investment

• Monetary policy is a prime driver of exchange rates

– And vice versa, Some economies structure monetary policy around exchange rate

Forex Market: Supply & Demand

Consider the spot foreign exchange market

• Price of US$: S is the price of US$ in terms of DCU.

• Supply of US$: Foreign people who want to acquire

DCU to buy domestic goods or assets.

– When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency

• Demand for US$: Domestic people who want to

acquire US$ for foreign purchases or overseas

investment.

– When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

Equilibrium in Forex Market

Supply Equals Demand

S

Supply Demand

S*

Increase in Desired Capital Outflows by

Increase in Desired Capital Inflows by

US Monetary Policy Causes

US$ Interest Rates Go Up

Relative Demand for US$ Goes Up

Domestic Monetary Policy Causes

D.C Interest Rates Go Up Relative Demand for US$ Goes Down

Monetary Policy & Exchange Rates

• The central impact of the foreign currency intervention is

on domestic interest rates.

• Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs

through currency intervention, OMO, or some other

change in quantity of bank reserves

• Monetary policy that does not shift interest rates will not shift exchange rates

Foreign Currency Intervention

• Foreign currency purchase:

– Central bank purchases foreign currency

– Credit reserve accounts of counterparty commercial bank– More reserves pushes down interest rates

– Increases demand for and reduces supply of US$ in forex market

• Foreign currency sale

– Central bank sells foreign currency

– Debit reserve accounts of purchasing bank

– Less reserves pushes up interest rates

– Reduces demand for and increases supply of US$ in

forex market

Excess Demand for Foreign Currency

maintaining Exchange Rate Stability

2 Shrinking money supply and higher

domestic interest rates

Forex Sale

Excess Supply of Foreign Currency

2 Growing money supply and lower

domestic interest rates

Iron Triangle of International

Fixed Exchange Rates

Pick 2 items from this menu

Learning Outcomes

• Students should be able to

• Convert series from one currency to another

using the exchange rate or the PPP rate.

• Use the Supply-Demand model of the forex