Exchange Rates

Exchange rates

the price of one currency in terms of another currency.

Nominal exchange rate (bilateral)

The rate at which 2 currencies can be traded for each other.

Types of nominal exchange rate

direct quotes, indirect quotes

Direct quote

The amount of domestic currency needed to purchase 1 unit of foreign currency

Indirect quote

The amount of foreign currency needed to putchase 1 unit of domestic currency

Flexible (floating) exchange rate

An exchange rate whose value is not officially fixed, but varies according to the supply and demand for the currency in the foreign exchange market.

Fixed exchange rate

An exchange rate whose value is set by official government policy.

Real exchange rate

the relative price of the average domestic consumption basket relative to the price of the average foreign consumption basket, when prices are measured in the same currency.

Real exchange rate formula

E*(P/Pf)

What happens if RER increases

Domestic goods become more expensive relative to foreign goods —> exports fall, imports rise

• real appreciation

What happens if RER decreases

domestic goods cheaper relative to foreign goods —> exports rise —> imports fall

• real depreciation

Changes in real exchange rate formula

grer = ge+gp - gpf

ge = π - πf

• ge = change in nominal exchange rate

• π- πf = inflation differential

Law of One Price

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

pi = pif/E

domestic price = foreign price adjusted for inflation

Absolute PPP

Hypothesis is the idea that the law of one price holds for the whole consumption basket.

P = pf/e

If so real purchasing power is the same in both countries RER = 1

Relative PPP

Taking percentage changes of absolute PPP, which implies grer =0

If relative PPP holds, then if foreign inflation is greater than domestic inflation [long-run]

Domestic inflation is lower

Domestic prices rise slower than foreign

Domestic goods are relatively cheaper

Foreigners want to buy more domestic goods —> demand for domestic currency increase —> domestic currency appreciates

If relative PPP holds, then if foreign inflation is less than domestic inflation

Domestic inflation is higher

Domestic prices rise faster than foreign

Domestic goods become relatively more expensive

People buy more foreign, less domestically

Domestic consumers demand more foreign currency to buy cheaper foreign goods

Demand for foreign currency increases, supply of domestic currency increases

Domestic currency depreciates

What shifts when there is an increase in demand for foreign goods/services, and/or increase demand for foreign assets

Shift supply curve to the right

What shifts when there is an increase in demand for domestic goods/services and/or increased demand for domestic assets

Demand curve shifts right

How does changes in r (real interest rate) MONETARY POLICY affect the exchange rate

• increase in r makes domestic assets more attractive (greater returns) —> increased demand for domestic currency AUD

• increases in r makes foreign assets less attractive —> decreased supply of domestic currency AUD

• the exchange rate appreciates and net exports decrease

Exchange rate regimes

How a countries exchange rate is determined and maintained.

How is a fixed exchange rate maintained?

• policy makers must be willing to take the other side of the market

• Buy/sell foreign currency if currency standard

• Buy/sell commodity (gold) if commodity standard

• Exchange rate regime collapse if reserves are exhausted

What happens if exchange rate is undervalued (Epeg < Efun)

Excess demand for domestic currency CB sells its own currency and buys foreign currency, increasing reserves of foreign currency

What happens if exchange rate is overvalued (Epeg > Efun)

Excess supply of domestic currency, CB buys back its own currency using its reserves.

International reserves

The foreign assets a central bank holds.

Speculative attacks

Expectations of a future devaluation. investors may anticipate the peg failing and act preemptively.

• massive selling of domestic currency assets

Constraint of monetary policy on exchange rates

If r has to change to take pressure off the fixed exchange rate, it can no longer be used to stabilise the domestic economy.

Policy trilemma

States that a country cannot simultaneously achieve all three of the following goals:

1. Fixed exchange rate

2. Independent monetary policy

3. Free international capital flows (no capital controls)