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Market for foreign exchange Introduction Nominal exchange rate Real exchange rate Trade and the real exchange rate

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Introduction

Suppose we wish to purchase more foreign assets and goods.

First, we need to obtain foreign currency to make this happen.

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Introduction

What if foreigners wish to purchase more of our assets and goods.

They need U.S. dollars to accomplish this.

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Introduction

Where do we obtain currency of another country?

In the market for foreign exchange (forex market).

Currencies are traded one for another in the forex market.

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Exchange rate

Like any market, the market for foreign exchange has a price, a demand, and a supply.

The nominal exchange rate is the price in this market.

The nominal exchange rate is the rate at which two currencies trade for each other.

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Current exchange rates

Currency

Units of foreign

currency per U.S. dollar

Japan yen 123Mexico peso 16.7United Kingdom

pound 0.658

France euro 0.937

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Exchange rate

A currency that gains exchange value relative to another currency has appreciated.

Example: one euro now trades for 0.93 U.S. dollars. One year ago, one euro exchanged for 0.8 dollars.

The dollar has appreciated relative to the euro.

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Exchange rate

A currency that loses value relative to other currencies has depreciated.

Example: currently16.7 Mexican pesos trades for one U.S. dollar.

One year ago, one dollar exchanged for 13.5 pesos. The peso has lost value, or depreciated, relative to the dollar.

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Foreign exchange market for dollars

Euros per

dollar

Quantity of dollars

Demand

e0

Q0

Supply

Forex market for dollars

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Demand for currency

Foreigners need U.S. currency to purchase domestic assets or domestic goods and services.

Changes in currency demand are caused by:1) a change in preferences for U.S. goods2) higher rate of growth of foreign

incomes

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Foreign exchange market for dollars

Euros per

dollar

Quantity of dollars

D0

e0

Q0

S0

D1

Q1

e1

Increase in the demand for dollars.

Dollar appreciates.Euro depreciates.

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Supply of currency

We need foreign currency to purchase foreign assets or foreign goods and services.

Changes in supply are caused by:1) a change in preferences for foreign

goods2) higher rate of growth of income in the

U.S.3) higher real interest rates overseas

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Foreign exchange market for dollars

Euros per

dollar

Quantity of dollars

D0

e0

Q0

S0

Q1

e1

Increase in the supply of dollars.

Dollar depreciates.Euro appreciates.

S1

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Euro/dollar exchange rate

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Trade weighted dollar index

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Real exchange rate

Nominal exchange rate – rate at which currencies trade

Real exchange rate – rate at which goods and services trade. Trade depends on the real exchange rate.

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Real exchange rate

Real exchange rate = nominal exchange rate x P / P*

P = domestic price levelP* = foreign price level

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Big Mac 1

A Big Mac sells for $4.50 in New York and £5.00 in London. The nominal exchange rate is 0.8 pounds per dollar.

What is the real exchange rate (in terms of Big Macs)?

In other words, if Big Macs were to trade between New York and London, what would be the exchange rate?

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Big Mac 1

Real exchange rate = 0.8 pounds per dollar * $4.50 / £5.00

Real exchange rate = 0.72 to one

0.72 Big Macs in London exchange for one big Mac in New York.

This means that the real price of a Big Mac in London is higher than in New York.

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Big Mac 2

A Big Mac sells for $4.50 in New York and Y654 in Tokyo. The nominal exchange rate is 123 yen per dollar.

What is the real exchange rate (in terms of Big Macs)?

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Big Mac 2

Real exchange rate = 123 yen per dollar * $4.50 / Y654

Real exchange rate = 0.85 to one

0.85 Big Macs in Tokyo exchange for one big Mac in New York.

This means that the real price of a Big Mac in Tokyo is higher than in New York.

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Big Mac 2

What is the dollar price of a Big Mac in Tokyo?

Dollar price = dollars per yen * number of yen

Dollar price = 1/ 123 * Y654 = $5.32 per Big Mac

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Example: Chanel hand bagsPrice for a Chanel classic 11.12 bagParis : $3,750China: $6,095

Real exchange rate = $3,750/$6,095 = 0.62

Bags are more valuable in China.

What incentive is created?

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Example: Chanel hand bags

Incentive: purchase bags in Paris, sell them in China on Taobao website at a price less than the local price

Suppose the cost of the transaction is $1,000 per bag.

What is the potential profit for trading 100 bags?

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Example: Chanel hand bags

Revenue: 100 * $6,095 = $609,500

Cost: 100 * ($3,750 + $1,000) = $475,000

Profit: $609,500 - $475,000 = $134,500 !

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Example: Chanel hand bags

Making profit by trading an identical item or asset at different prices is called arbitrage profit.

Idea: buy low in one location, sell high in a different location. Be the first or the fastest before no one else notices the profit opportunity.

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Example: Chanel hand bags

Chanel is aware of the practice.

What do you think Chanel did about it?

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Example: Chanel hand bags

Chanel raised its prices in Paris, and cut its prices in China.

By reducing the price differential, Chanel hopes to remove the incentive for arbitrage and capture more of the profits for itself.

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Real exchange rateWhy does the real exchange rate matter?

Exports and imports depend on the real exchange rate.

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Real exchange rate

When a company buys foreign goods, it will compare importing from Europe with purchasing the same goods in the U.S.

Which is lower, the price of the import or the domestic price?

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Real exchange rate and trade

So the U.S. buyer compares these two prices:

Domestic price in the U.S.

Dollar price of the import = exchange rate * foreign price

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Real exchange rate and trade

The import price depends on two things: the nominal exchange rate and the price of the good in Europe.

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Real exchange rate and trade

So, the U.S. buyer must take into account:the nominal exchange ratethe price of the good in the U.S. andthe price of the good in Europe.

These are the components of the real exchange rate.

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Real exchange rate and trade

When the real exchange rate declines, U.S. goods becomes relatively less expensive in Europe.

When the real exchange rate increases, U.S. goods become relatively more expensive in Europe.

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Real exchange rate and trade

Consequence: the quantity of exports and imports depend on the real exchange rate.

Exports and imports also depend on the rates of growth of incomes in the trading partners.

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Balance of trade

Trade deficit:Imports > Exports

Trade surplus:Imports < Exports

Trade balance:Imports = Exports

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Real exchange rate and trade

When the real exchange rate appreciates: Imports are less expensive for us Our exports are more expensive for our

trading partners Imports rise, exports decline The trade balance becomes more negative

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Real exchange rate and trade

When the real exchange rate depreciates: Imports are more expensive for us Our exports are less expensive for our trading

partners Imports decline, exports rise The trade balance becomes more positive

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Real interest rates

Euros per

dollar

Quantity of dollars

Demand

e0

Q0

Supply

Forex market for dollars Event: real interest rates rise in the U.S. relative to

Europe.

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Real interest rates rise in the U.S.

Euros per

dollar

Quantity of dollars

D0

e0

Q0

Supply

Forex market for dollars

Foreigners buy more dollars

D1

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Real interest rates rise in the U.S.

Euros per

dollar

Quantity of dollars

D0

e0

Q0

S0

Forex market for dollarsThe dollar

appreciates. Exports decline,

imports increase.

D1

S0

e1

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Summary

Nominal exchange rate – rate at which currencies trade

Demand for currency – to purchase domestic goods and assets

Supply of currency – to buy foreign goods and assets

Real exchange rate – nominal exchange rate adjusted for domestic and foreign prices

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Summary

Exports and imports are affected by the real exchange rate

Arbitrage – buying and selling the same good at different prices in different places