15' The Exchange Rate

1
15. The Exchange Rate

• Fixed versus floating exchange rates
• The real effective exchange rate
• The effects of exchange rate devaluations

2
The Market for Foreign Exchange

• In the foreign exchange market, one currency can
  be traded and converted for another currency
• The price at which one can exchange two
  currencies is the exchange rate
• This measures the number of units of foreign
  currency (e.g. US dollars, ) that are needed to
  exchange for one unit of the domestic currency
  (e.g. UK pounds, )

3

• An exchange rate of 1.8 to the measures the
  international value of sterling
• If there is a rise in the external value of the
  pound, say to 3 to the , there is an
  appreciation gt is stronger than the
• If there is a fall in the external value of the
  pound, say to 1 to the pound, there is a
  depreciation gt is stronger than the

4

• The demand for pounds comes from
• British exporters, who want to be paid in pounds
• US residents, who must convert their dollars into
  pounds to purchase British assets
• If the pound appreciates, then US residents must
  pay more dollars to buy each pound
• gt UK exports become more expensive and US
  imports become cheaper
• If the pound depreciates then US residents pay
  less dollars for each pound
• gt UK exports become cheaper and US imports
  become more expensive

5
Figure 15.1a The market for Foreign Exchange
Price of Pounds in dollars (/)
D
Quantity of Pounds
6
Figure 15.2b The market for Foreign Exchange
Price of Pounds in dollars (/)
S
Quantity of Pounds
7
Figure 15.1c Flexible Exchange Rates
Price of Pounds in dollars (/)
S

• With an exchange rate at e1 demand for gt supply
  of
• price of sterling ?
• demand of pounds ?
• supply of pounds ?

e
e1
D
Quantity of Pounds
8
Figure 15.2 Fixed Exchange Rates
Price of Pounds in dollars (/)
S
e2

• With an exchange rate at e1 demand for gt supply
  of . Central Bank is committed to sell (i.e.
  buy ) in order to maintain that exchange rate
• addition to the foreign exchange reserves

e1
D
Quantity of Pounds
9
The Purchasing Power Parity (PPP) Exchange Rate

• Purchasing Power Parity (PPP) theory a currency
  will tend to have the same purchasing power when
  it is spent in its home country as it would have
  if it were converted to foreign exchange and
  spent in the foreign country
• The PPP exchange rate is determined by the
  relative price levels in the two countries
• PPP is taken to govern exchange rates over the
  long-term
• There could be large deviations from PPP in the
  short and medium term
• The Big Mac Index

10

• Real exchange rate index how much does the
  exchange rate actually deviates from its PPP
  level?
• Real Effective Exchange Rate

• In the UK the evidence suggests that in
  1979-1995 the nominal exchange rate was away from
  its PPP level, but more recently it has
  converged, what about another examples? See The
  Economist!

11

• The Economist's Big Mac index (1994) is based on
  the theory of purchasing-power parity (PPP)
• The idea that exchange rates should move to
  equalise the prices of a basket of goods and
  services across different countries.
• Our basket is the Big Mac.
• For example, the cheapest burger in the chart is
  in China, at 1.26, compared with an average
  American price of 3.
• the Yuan is 58 undervalued relative to its Big
  Mac dollar-PPP.
• the euro is 25 overvalued, the yen 17
  undervalued.
• The Economist. London (UK) Dec 18, 2004,
  vol. 373, Iss. 8406, p.194.

12
For example

• Are the Italians right to moan about Europe's
  single currency?
• Is the euro overvalued?
• The annual Big Mac index suggests they have a
  case the euro is overvalued by 17 against the
  dollar.
• The euro is worth about 1.22 on the
  foreign-exchange markets.
• A Big Mac costs 2.92, on average, in the euro
  zone and 3.06 in the US.
• The rate needed to equalise the burger's price in
  the two regions is just 1.05.
• To patrons of McDonald's, at least, the single
  currency is overpriced.
• The Economist. London (UK) Jun 11,
  2005,vol. 375, Iss. 8430, p.76.

13
Ikea Index

• Swedish consultancy Hallvarsson Halvarsson
  produced in 2003 a European-sounding Ikea index
• Compares prices in 15 countries where the Swedish
  home furnishings giant has stores
• And where is it cheapest to buy Billy shelving
  and Klippan sofas?
• The US, then the Netherlands, Sweden, Germany,
  Canada and the UK
• The US supremacy owes much to the current
  weakness of the dollar, says Gabriel Thulin, the
  report's author
• gt Ikea bases its prices less on the purchasing
  power of a particular country than the local
  competition, which means that even among eurozone
  countries there are some big differences.
• Financial Times. London (UK) Nov 18, 2003, p.14.