13 Exchange rates 1 (W10 L18)

Why do exchange rates matter?

They set the relative value of exports and imports, change GDP through the quantities of exports and imports, connect interest rates across countries through expected changes, and make monetary policy less effective at stabilising demand under fixed rates.

What is the nominal exchange rate and what are the two quoting conventions?

The relative price of one currency in terms of another. A direct quote is domestic currency per unit of foreign currency, and an indirect quote is foreign currency per unit of domestic currency (the one used in this course).

What does an increase in E (indirect quote) mean?

An appreciation of the domestic currency. For example E = 0.75 USD per AUD, and a rise in E is an appreciation of the AUD against the USD.

What is the real exchange rate?

The relative price of one consumption basket in terms of another. RER = EP/P^f, where P is the domestic price level and P^f is the foreign price level.

Why can the RER change even if the nominal exchange rate is fixed?

Because it also depends on relative price levels P/P^f, so differing inflation rates change it.

What is the growth rate of the real exchange rate?

g_RER = g_E + π − π^f, which is the change in the nominal exchange rate plus the inflation differential.

What does a real appreciation (RER rises) do?

Foreign goods become cheaper and domestic goods dearer, so imports rise and/or exports fall, and net exports fall.

What does a real depreciation (RER falls) do?

Foreign goods become dearer and domestic goods cheaper, so imports fall and/or exports rise, and net exports rise.

What is the law of one price?

Tradeable goods should sell for the same price everywhere once prices are in a common currency, p_i = p_i^f/E. If not, people buy low and sell high.

What is absolute PPP?

The law of one price holding for the whole consumption basket, P = P^f/E, which is equivalent to RER = 1.

What is relative PPP?

It requires g_RER = 0, which gives g_E = π^f − π. The change in the nominal exchange rate equals the inflation differential, so the real exchange rate stays constant.

What does relative PPP imply for the domestic currency?

It appreciates if foreign inflation is greater than domestic inflation and depreciates if foreign inflation is less than domestic inflation.

What is the relationship between absolute and relative PPP?

Absolute PPP implies relative PPP, but relative PPP does not imply absolute PPP.

How good is PPP in the long run and the short run?

A good guide in the long run (and for high-inflation countries), but a poor guide in the short run, where real exchange rate changes mostly come from changes in the nominal rate E.

What are the supply and demand for domestic currency in the forex market?

Supply comes from domestic households and firms wanting foreign currency to buy foreign goods, services and assets. Demand comes from foreigners wanting domestic currency to buy domestic goods, services and assets. The equilibrium E is where they are equal.

What increases the supply of domestic currency?

Higher demand for foreign goods (tastes, new goods, higher national GDP) or for foreign assets (higher real returns abroad, flight to safety).

What increases the demand for domestic currency?

Higher demand for domestic goods (tastes, new goods, higher GDP) or domestic assets (higher real returns locally, flight to safety).

How does monetary policy affect the exchange rate?

A higher r raises demand for and lowers supply of local currency assets, so the currency appreciates and net exports fall. A lower r does the reverse, causing depreciation and higher net exports.

Is monetary policy more effective in an open economy?

It is amplified by the exchange rate channel (the usual closed-economy effect plus the change in net exports), but only if the exchange rate is flexible.

What are the pros and cons of fixing the exchange rate?

It may reduce volatility from excessive exchange rate fluctuations, but it constrains monetary policy.