Understanding Exchange Rates

  • In general, stuff produced in a country will be paid for that country's currency

    • US pruducts will be paid in dollars

    • Japanese products will be paid in yen

    • European products will be paid in euros

    • British products will be paid in pounds

  • Foreign exchange markets

    • market in which currencies are exchanged for each other in which exchange rates are determined

The Foreign Exchange Market

  • When the Euro was first introduced, 1 Dollar = ~1 Euro. What has happened since?

  • Show using quantity of US Dollars on the x-axis, and euros per dollar on the y-axis

    • Dollar has depreciated

    • Bad for US travelers to Europe

    • Good for US business

    legro - = 0.8 euro

  • When the Euro was first introduced, 1 Euro = ~1 Dollar. What has happened since? Show using quantity of Euros on the x-axis, and Dollars per Euro on the y-axis

    • Euro has appreciated

    • Europeans travelers to the US can purchase more stuff

    • European business now will export less, because their products are more expensive, relative to US business


Inflation and Real Exchange Rates

  • In 1990, 1 US Dollar = 2.8 Mexican Pesos

  • In 2010, 1 US Dollar = 12.8 Mexican Pesos

  • Why?

  • Inflation in Mexico was much higher than US inflation

  • Real exchange rates take into account the impact of inflation in both countries

  • US Real exchange rate=Mexican pesos per U.S. dollar×PUSPMex \text{US Real exchange rate} = \text{Mexican pesos per U.S. dollar} \times \dfrac{\text{P}_{\text{US}}}{\text{P}_{\text{Mex}}}

  • The current account responds only to changes in the real exchange, not the nominal exchange rate!

  • It still makes sense, however, to hold onto the currency with lesser inflation

    Exchange rate (pesos per U.S. dollar) Pes014 12 10 8 6 4 2 Nominal
exchange rate Real exchange rate Year

Purchasing Power Parity (PPP)

  • Useful tool for analyzing interest rates is a concept known as purchasing power parity

  • The purchasing power parity or PPP between two countries' currencies is the nominal exchange rate at which a given baskets of goods and services would cost the same amount in each country

  • In theory, you "should" be able to buy $100 worth of stuff in any country

  • For example, if 1 pound = 2 dollar, then $100 in the US should buy the same amount of stuff that 50 pounds would get you in the UK

  • Over the long run, purchasing power parities do a good job of predicating the nominal exchange rates

Exchange rate (Canadian dollars per U.S. dollar) 51.60 Nominal
exchange rate 1.40 1.20 Purchasing power parity 1.00 Year


  • The Big Mac index was first published in 1986 as an example of PPP, using the Big Mac as the benchmark

  • Not the best measure, as Argentina is not included because it did not want to be part of the 100+ countries on the list

  • In India, the $1.54 Big Mac is a Big Mac made of chicken, so is it really a Big Mac?

  • In 2014, a Big Mac in the US sells for $4.62 which is remarkably close to what it costs in the United Kingdom at $4.63

  • Overvalued Big Macs: Norway, Sweden, Denmark, Brazil, Switzerland

  • Undervalued Big Macs: Chinese yuan, Russia ruble, South African rand, Mexican peso, Indian rupee


Floating vs. Fixed Exchange Rate Regime

  • Fixed exchange rate

    • When the government keeps the exchange rate against some other currency at or near a particular target

    • Hong Kong sets an exchange rate of 7.80 HK Dollars to 1 US Dollars

    • Through manipulation of supply and demand, countries can

    • If the equilibrium is lower than the target rate, the government will buy currency to prop it up

    • If the equilibrium is higher than the target rate, the government will sell the currency to keep it from rising

  • Floating exchange rate

    • The exchange rate goes where the market takes it (ie. United States, UK, Canada)

Exchange rate (U.S. dollars per geno) US$1.50 Target exchange rate (a)
Fixing an Exchange Rate Above Its Equilibrium Value s Surplus at
exchange rate of USS 1.50 per geno Quantity of genos Exchange rate (U.S.
dollars per geno) US$1.50 Target exchange rate 0 (b) Fixing an Exchange
Rate Below Its Equilibrium Value S Shortage at exchange rate of US$1.50
per geno Quantity of genos

Exchange Rate Dilemma

  • Fixed rate regimes give predictability to trade partners as business with the United States operates as such, as do European countries adopting the Euro (ie. Italy, France, Germany)

  • Every choice has a cost!

    • Countries keep large quantities of foreign currency on hand at low return

    • Monetary policy is diverted to maintaining exchange rates

    • You give up use of monetary policy (as European countries did in adopting the Euro)

Practice Questions

  • On a Foreign Exchange Market Graph, what happens if capital flows from Europe to the United States has increased? Has the dollar appreciated or depreciated?


  • On a Foreign Exchange Market Graph, what would happen if there was an increase in US demand for imports from Europe? Has the dollar appreciated or depreciated?

    Q o.nars

  • Which of the following is a benefit of a fixed exchange rate regime?

    a. Certainty about the value of domestic currency

    b. Commitment to inflationary policies

    c. No need for foreign exchange reserves

    d. Allows unrestricted use of monetary policy

    e. All of the above

    Answer: a

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