Week 10

Open Economy Macroeconomics: Exchange Rates

Reference: Bernanke, Olekalns and Frank - Chapter 14

Key Issues
Nominal and real exchange rates
Purchasing Power Parity (PPP)
Supply and Demand Model of the Exchange Rate
Fixed Exchange Rates


2
Nominal Exchange Rate

Rate at which two currencies can be traded for each other:
bilateral exchange rate

Units of foreign currency per $A (RBA)
21/09 2010 23/09/2011

US dollar 0.9456 0.9760
Japanese yen 80.91 74.45
Euro 0.7223 0.7234
Chinese renminbi 6.3389 6.2411
3
4

Cross Rates

We can use the exchange rate between the
Australian and US dollars
Australian dollar and Euro
to infer the exchange rate between the Euro and the US
dollar.

$US/$A= 0.9456 Euro/$A= 0.7223

Euro/$US =
US
A
A
Euro
$
$
$
= 0.72231.0575 = 0.7638
5
Quoting the Bilateral Exchange Rate

Note that we expressed the exchange rate between US
and Australian currencies in 2 ways:
$US/$A = 0.9456 and as $A/$US = 1.0575

Exchange rates can be expressed as:

Units of foreign currency per (one) unit of domestic
currency; $US/$A = 0.9456, or

Units of domestic currency per (one) unit of foreign
currency; $A/$US = 1.0575
6
A Definition

Let e denote the nominal exchange rate, and define it as:

e = number of units of foreign currency that one unit of
the domestic currency will buy

If we treat Australia as the domestic (or home) country
then:
e = Yen/$A or $US/$A

A rise in e corresponds to an appreciation of the $A
A fall in e corresponds to a deprecation of the $A
7
Appreciation and Depreciation

Appreciation: an increase in the value of a currency
against other currencies

20 Sept 21 Sept
$US/$A 0.9644 0.9856

Depreciation: a decline in the value of a currency against
other currencies
17 Sept 20 Sept
$US/$A 0.9748 0.9644

8
Monthly $US/$A and Trade Weighted Index (84-10)
0
0.2
0.4
0.6
0.8
1
1.2
3
1
/
0
1
/
1
9
9
4
3
1
/
0
1
/
1
9
9
5
3
1
/
0
1
/
1
9
9
6
3
1
/
0
1
/
1
9
9
7
3
1
/
0
1
/
1
9
9
8
3
1
/
0
1
/
1
9
9
9
3
1
/
0
1
/
2
0
0
0
3
1
/
0
1
/
2
0
0
1
3
1
/
0
1
/
2
0
0
2
3
1
/
0
1
/
2
0
0
3
3
1
/
0
1
/
2
0
0
4
3
1
/
0
1
/
2
0
0
5
3
1
/
0
1
/
2
0
0
6
3
1
/
0
1
/
2
0
0
7
3
1
/
0
1
/
2
0
0
8
3
1
/
0
1
/
2
0
0
9
3
1
/
0
1
/
2
0
1
0
TWI $US/$A

TWI is the weighted average value of the Australian dollar in relation to the currencies of Australia's trading partners.
The base level was set at 100 in May 1970. (RMB 22%, JPY 15%, EUR 10%, USD 8%, KRW 6%, etc...)
9
Real Exchange Rate

Suppose we are interested in comparing the price of the
same (or a very similar) good in two countries.

Example

Australian-made computer costs $2,400
Japanese-made computer costs 242,000 yen

Which computer is cheaper?


NOMINAL EXCHANGE RATE : PRICE OF DOMESTIC CURRENCY IN TERMS OF FOREIGN CURRENCY
vs.
REAL EXCHANGE RATE : PRICE OF DOMESTIC GOODS (SERVICES) IN TERMS OF FOREIGN GOODS (SERVICES)
10
Convert to Common Currency

Need nominal yen-dollar exchange rate

e = Yen/$A = 110

Convert $A to Yen
Price in yen =
A
Yen
$
(price in dollars) 110 * 2400

Convert Yen to $A
Price in dollars =
Yen
A $
(price in yen) (1/110)*242,000

11
Convert to $A
Price in dollars =
Yen
A $
(price in yen)
e Yen
A 1 $

Price in dollars =
200 , 2 $
110
000 , 242

Japanese-made computer is cheaper by $200.

Relative price of the two computers is
09 . 1
200 , 2
400 , 2

Australian-made computer is more expensive by 9%.

(Q: What iI e100Y/AUD?)
12
Real Exchange Rate

Measures the price of domestic goods relative to the price
of foreign goods (when prices are expressed in a common
currency)
Real Exchange Rate =
e
P
P
f
1

P = price of domestic goods
e
P
f
1

= price of foreign goods, in domestic currency

Real Exchange Rate =
f
P
eP

13
Real Exchange Rate and International Competitiveness
Real Exchange Rate =
f
P
eP


A rise in the real exchange rate implies that domestic
goods are becoming more expensive relative to foreign
goods.

Other things equal, this tends to reduce exports and
encourage imports; with the overall effect of reducing the
level of net exports.


14
Real TWI and Net Exports (1984-2009)
0.0
20.0
40.0
60.0
80.0
100.0
120.0
140.0
160.0
-.06000 0 -.04000 0 -.02000 0 .00000 0 .02000 0 .04000 0 .06000 0 .08000 0 .10000 0
nx/y
R
e
a
l

T
W
I

15
Models of the Nominal Exchange Rate

1. Purchasing Power Parity (PPP)

2. Supply and Demand for Currencies








16
Purchasing Power Parity (PPP)

Law of One Price

If transportation costs are relatively small, the price of an
internationally traded good must be the same in all
locations.

If this is not the case, then there will be profitable
opportunities to buy the good in the relatively cheaper
location and sell it the more expensive location.

Simple idea yields a model of the exchange rate.
17
Purchasing Power Parity

Suppose the law of one price holds for all goods and
services in two countries.

If we know the domestic price level P and the foreign
price level
f
P
, then it must be the case that;
P
e
P
f

or
eP P
f

or
e
P
P
f

18
Implications of PPP

Exchange rate is determined by relative price levels
Exchange rate adjusts so that price levels in two
countries are equal (when measured in a common
currency)
Countries that experience relatively high inflation will
tend to have depreciating currencies
e
P
P
f

or
e P P
f



Suppose 5% 10% = -5% (depreciation)
19
Limitations of PPP

1. Empirical evidence provides stronger support for
PPP in the long-run (i.e. over decades or centuries),
than in the short-run.

2. Non-traded goods. Some types of goods are difficult
to trade internationally (classic example is a haircut).


3. Trade barriers such as tariffs and quotas. Tend to
raise costs of transporting goods internationally.

20
Supply and Demand Model of the Australia Dollar

Foreign exchange market: $A and Yen

Who supplies dollars?

Australian households and firms who want to
purchase foreign goods, services or financial assets

Such purchases require foreign currency so households
and firms supply Australian dollars in exchange for
foreign currency (e.g. Yen)

21
Supply of Dollars Curve

A
Yen
$
S$






Qty of $A
An increase in the number of Yen offered per $A, makes
Japanese goods and assets more attractive.


(MAKE SURE YOU CORRECTLY LABEL THE UNITS!)
22
Who demands dollars?

Japanese households and firms who want to purchase
Australian goods, services or financial assets

Such purchases require $A so Japanese households and
firms supply Yen in exchange for $A






23
Demand for Dollars Curve

A
Yen
$






D$
Qty of $A
The more Yen that must be offered per $A, the less
attractive are Australian goods to Japanese
24
Equilibrium in Foreign Exchange Market

A
Yen
$
S$


e*

D$


Qty of $A traded
e* is the fundamental value of the exchange rate
25
Shifts in the Supply Curve

Exogenous shifts in the desire of Australians to purchase
Japanese goods and assets

Increase in Supply Curve

Increased preference for Japanese goods

Increase in Australian GDP (income effect) M = m(Y T)

(Expected) increase in the real return on Japanese
assets (given no change in exchange rate)
26
Increase in Supply of $A will lead to a Depreciation of
the $A

A
Yen
$
S$


e*

D$


Qty of $A traded
27
Shifts in the Demand Curve

Exogenous shifts in the desire of Japanese to purchase
Australian goods and assets

Increase in Demand Curve

Increased preference for Australian goods

Increase in Japanese GDP (income effect)

(Expected) increase in the real return on Australian
assets (given no change in exchange rate)
28
Increase in Demand for $A will lead to an Appreciation
of the $A

A
Yen
$
S$


e*

D$


Qty of $A traded
29
Monetary Policy and the Exchange Rate

In open economies like Australia, the exchange rate
provides an additional channel by which monetary policy
can influence the level of aggregate demand and GDP.

If the RBA tightens monetary policy (by raising the real
interest rates), this will increase demand for the dollar
and produce an appreciation of the exchange rate. (See
the diagram in previous slide).

Supply curve may also shift (inwards) as Australians buy
less foreign assets.
30
A Real Appreciation and NX

Recall that:
Real Exchange Rate =
f
P
eP


Then if domestic and foreign prices are sticky in the
short-run, the nominal appreciation will lead to an
appreciation of the real exchange rate.

The higher value of the dollar will tend to reduce the
level of next exports, reducing aggregate demand and the
level of output.
31
Fixed Exchange Rates

Country might seek to fix the value of its currency
against some other currency (or a basket of currencies).

Hong Kong dollar: 1 $US = $HK 7.75 7.85

Under a fixed exchange rate a currencys value can differ
from its fundamental value.

Currency can be overvalued or undervalued.


Most recently Switzerland moved to Iixed ex. rate.


[QUESTION]
Tight monetary policy _____ interest rates,
which _____ the demand for a currency and
_____ the fundamental value of the exchange
rate.
A. increases; increases; increases
B. increases; increases; decreases
C. increases; decreases; increases
D. decreases; decreases; decreases



[QUESTION]
Other things being equal, a recession in the
United States combined with rapid economic
growth in J apan would be expected to cause:
A. the dollar to appreciate against the yen
B. the dollar to depreciate against the yen
C. the yen to appreciate against the dollar
D. no predictable change in the dollaryen
exchange rate


www.asb.unsw.edu.au

Last updated: 25/09/11 CRICOS Code: 00098G





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