ECN 211 Macroeconomic Principles L25: Theories of Exchange Rates Recap: Exchange rates ??..The price of one currency in terms of another. ? Example: ?1 sells for $1.4 ? Define: ?E? is the number of domestic units (dollars) required to purchase one unit of a foreign currency (Euro). ?In the example above E is 1.4 Recap: Appreciation and Depreciation. ? If the exchange rate last year was $2.0:?1. But this year the exchange rate was $1.5: ? 1. ? What has happened to the dollar over the year? ? The dollar has appreciated against the euro. ? ?E? decrease from 2 to 1.5 ? Of course this must mean the euro has depreciated against the dollar over same time period!! ? Remember changing exchange rates affect the domestic price of foreign goods. Recap: Price of goods and services. Domestic price of a foreign good = foreign currency price x exchange rate (E) Q) Suppose the exchange rate is $1.50: ?1. If a bottle of French wine is 25 euros what is the dollar price for the wine? A) dollar price = 25 x 1.50 = $37.50 ? So far we have simply converted the price of a foreign good into its dollar amount. ? Dollar appreciates: Imports increase and Exports decrease ? (every time $ up foreigners must pay more for our goods) What about if the good was the same in both countries? ? If a US citizen finds that goods sell for the same price in the US and UK (when converted into a common currency) then we have PPP Purchasing Power Parity : the dollar has same p.p. in US as does abroad. Test through the Big Mac index? how much are big macs around the world? ? the condition under which currencies have the same purchasing power in different markets. ? When people talk about a currency being ?over valued? they are talking about the nominal exchange rate relative to its PPP level. 04/15/09 5 04/15/09 6 The PPP Condition ? The condition for (absolute) PPP is: P= EF ? P = domestic price (US price ($)) of g/s ? E = [nominal] exchange rate (number of dollars to purchase one unit of a foreign currency) ? F = foreign price (UK price (?)). ? Ex. P of barrel of oil in US is $60 and converted to 40 lb in london, buy in london & sell in NY 04/15/09 7 The Big Mac Price Index Price of a Big Mac (local currency) Actual nominal exchange rate ($?s per one unit of foreign currency) [PPP does not hold-all should be $3.22] $ price of a Big Mac US 3.22 1 3.22 Britain 1.99 1.96 3.9 dollar undervalued against the lb. Canada 3.63 0.847457627 3.08 dollar overvalued against canada Euro Area 2.94 0.769230769 2.26 China 11 0.128700129 1.42 Japan 280 0.008264463 2.31 Switzerland 6.3 0.8 5.04 04/15/09 8 Why doesn?t PPP always hold? ? Goods are not always homogenous ? Expect it to hold better for gold/oil than for cars (don?t care where they come from). ? Gathering information is costly ? Consumers do not know prices are lower in other countries. ? Big reason put forward for joining the Euro?. ? Transportation costs alter prices ? Creates a ?price wedge? ? Kiwi fruit from New Zealand to the UK ? Taxation and/or legal restrictions ? Gas is $9 a gallon in the UK?. (higher sales taxes) ? Tariffs and Quotas can alter the domestic price of goods. ? Non-tradable goods ? Some goods are not tradable or have some non-tradable component. ? No arbitrage opportunities. (labor to produce big mac might vary in costs, ingredients virtually identical) ? Nevertheless exchange rates tend to move in the direction suggested by PPP ? Over time the nominal exchange rate converges to its PPP level. 04/15/09 9 Why doesn?t PPP always hold? 04/15/09 10 Relative PPP Inflation and Exchange Rates ? Changes in the nominal exchange rate can reflect differences in inflation rates. %?E = n (US) - n (foreign) N = inflation rate ? Suppose inflation in the US is 7% and in the UK it is 5% then the dollar will depreciate by 2% (E has gone to a higher number so dollar has gone down and dollar prices have gone up- lb. appreciates by 2%) 04/15/09 11 Interest Rates and Exchange Rates ? Exchange rates are also important in evaluating foreign financial assets ? Three variables are important in determining whether to invest in a foreign or domestic financial asset: ? The domestic interest rate ? The foreign interest rate ? The exchange rate Choices When investing ? Invest at home: ? Place money in bank. ? Receive domestic interest rate i^d 04/15/09 12 ? Invest abroad: ? First have to convert dollars into pounds. ? Then receive foreign interest rate i sub f ? Then have to convert back into dollars. ? So the dollar return on the foreign asset is: Dollar ret. = i (interest rate receive abroad) + % change in e.r. = if + (Enew- Eold )/Eold ? Note if Enew___>_ Eold then over the year the dollar has depreciate which is an additional return (because you had your investment denominated in pounds) 04/15/09 13 Example ? Suppose the UK rate of interest is 20% and at the start of the year the exchange rate is $2:?1 however at the end of the year it is $1.75: ?1. ? What is the dollar return from investing in the UK? Dollar ret. = if + (Enew- Eold )/Eold =.2 + (0.75 - 2)/2 .2-.125 .075 or 7.5% 04/15/09 14 04/15/09 15 Interest Rate Parity (IRP) ? This is the interest rate equivalent of PPP Interest Rate Parity ? the condition under which similar financial assets in different countries have the same interest rate return when measured in the same currency 04/15/09 16 IRP Condition Domestic interest rate = foreign interest rate + expected change in exchange rate id = if + expected [(E new- E old)/E old] Don?t know E new so that investment is always risky. ? So if the US interest rate is 10% and the UK interest rate is 6% then it is expected that the pound will appreciate (Enew > Eold) by 4% over the year. 04/15/09 17 Why IRP sometimes does not hold ? Government controls on the free movement of capital ? Attitude to risk ? Political risk - introduces a risk premium ? Taxes on the returns from financial assets differ in different countries ? We assumed zero taxation on returns. Matt PowerPoint Presentation
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