U.S. Dollar Exchange Rate Vs Gold Prices

Major Currency Index vs London AM Fix ($ per troy oz.)

65

70

75

80

85

90

95

100

105

110

115

120

125

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14$200

$300

$400

$500

$600

$700

$800

$900

$1,000

$1,100

$1,200

$1,300

$1,400

$1,500

$1,600

$1,700

$1,800

$1,900

$2,000

Nominal Exchange Rate (LHS)

Gold Price (RHS)

Chapter 17: The Foreign Exchange Market•Trade between countries involves the mutual exchange of different currencies (bank deposits denominated in different currencies)

•When American firms buy foreign goods, services and assets => U.S. $ exchanged for foreign currency

•Bank deposits denominated in U.S. $ bank deposits denominated in foreign currency

•This trade takes place in foreign exchange markets

Definitions:

•Exchange Rate - price of one currency in terms of another

•Spot exchange rate – exchange rate for the immediate (2-day) exchange of bank deposits

•Forward exchange rate – exchange rate for the exchange of bank deposits at some specified future date

•Appreciation – currency increases in value

•Depreciation – currency decreases in value

U.S. Dollar Versus Euro Exchange Rate

$0.50

$0.60

$0.70

$0.80

$0.90

$1.00

$1.10

$1.20

$1.30

$1.40

$1.50

$1.60

$1.70

99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

Euro/$

Euro/$$/Euro

$/Euro

Exchange rates are important because they affect the relative price of domestic and foreign goods.

Example:

The $ price of a German BMW to an American is a function of the interaction of 2 factors

1.The price of BMWs in Euros (50,000 euros)

2.The exchange rate E = $/euro,

If E = $1/1euro => 50,000 euro x ($1/1euro) = $50,000

If euro appreciates to ($1.20/1euro) => $ depreciates =>

50,000euro x ($1.20/1euro) = $60,000

Currency appreciates => country’s goods prices abroad and foreign goods prices in that country

1. Makes domestic businesses less competitive

2. Benefits domestic consumers

Import Prices (12-month Growth) Vs Exchange Rates Major Currency Index

Nominal & Real (1973 = 100)

-8

-6

-4

-2

0

2

4

6

8

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14Per

cen

t

60

65

70

75

80

85

90

95

100

105

110

115

120

Ind

ex

Import Prices (Excluding Petroleum)NominalReal

ePEU x ($/e) = $PMUS

U.S. Dollar Exchange Rate Major Currency Index

Nominal & Real (1973 = 100)

60

70

80

90

100

110

120

130

140

150

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 1460

70

80

90

100

110

120

130

140

150

Nominal RealSource: FRB: Exchange Rates G.5 (405)

U.S Exports (Year-Over-Year % Change)

-16

-11

-6

-1

4

9

14

19

1999 2000 2001 2002 2003 2004 2005 2006

(Per

cen

t)

80

85

90

95

100

105

110

115

Exc

han

ge

Rat

e

Export Growth Exchange RateSource: Bureau of Census

How Movements in the Exchange Rate Affect Exports

Law of One Price – if 2 countries produce an identical good and transaction costs and trade barriers are very low => the price of the good should be the same in both countriesExample: American computer chip costs $100, Canadian computer chip costs @200 (Canadian dollars = @) If E =$.50/@1, then prices are:

American Chips Canadian Chips

If E = $.75/@1 then prices are:

American Chips Canadian Chips

The demand for Canadian computer chips goes to zero, so either1. Price of Canadian chips must 2. Exchange rate must

Law of one price E = $.50/@1

Purchasing Power Parity (PPP)•Application of the law of one price to national price levels

•Theory of PPP => if foreign country price level increases relative to another => its currency depreciates relative to the other country

•Exchange rates between 2 countries will adjust to reflect changes in the price level of the 2 countries (relative price level determines exchange rate)

PPP assumptions1. Goods are identical

2. Transaction costs are low

3. Trade barriers are low

PPP: Foreign price level 10% => foreign currency 10%

1. Application of law of one price to price levels

2. Works in long run, not short run

Problems with PPP

1. All goods not identical in both countries: Toyota vs Chevy

2. Many goods and services are not traded across borders (e.g. land, housing, services)

So inflation in housing prices => higher price level,.. but will not have effect on E.

PPP: U.S. and U.K

Exchange Rates in the Short RunTheory of Asset Demand (we will use the asset market approach to determine exchange rates)

Exchange Rate – price of domestic bank deposits in terms of foreign bank deposits(the price of one asset in terms of another)

Assume Capital MobilityAmericans can buy European bank depositsEuropeans can buy American bank deposits

Deposits are perfect substitutes if:•American and European deposits have similar risk and liquidity characteristics•Few impediments to capital mobility

If Re$ > Re

@ => Europeans and Americans will want to hold $ deposits

If Re$ < Re

@ => Europeans and Americans will want to hold @ deposits

If Re$ = Re

@ => hold both

The Dollar and Interest Rates1. Value of $ and real rates rise and fall together, as theory predicts2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises

Econ 330 Chapter 17 Homework

Due Friday, April 11

Chapter 17Questions & Applied Problems 5, 8, 12, 15, 16, 17, 19,

20, 22, 23, 24