Money and Banking

1
Money and Banking

• Spring 2007
• Martin Andreas Wurm
• University of Wisconsin - Milwaukee

2
Exchange Rates

• Required Reading Mishkin, Chapter 19

3
Exchange Rates

• 1. Overview
• The largest market in the world in terms of the
  volumes traded is the so called foreign exchange
  market, with up to an estimated 1.9 trillion in
  April 2004 (according to the BIS). In this market
  currencies are traded for each other.
• The price of a currency in terms of another is
  the exchange rate.

4
Exchange Rates

• 1. Overview
• 1. There are two ways to define a (nominal)
  exchange rate. The first (and more common) one is
  to define an exchange rate E in terms of the
  foreign currency (for simplicity I will use
  Dollars as the domestic and Euro as the foreign
  currency in the following)
• E then indicates how many Dollars you have to
  pay/ how many dollars you get for one Euro (e.g.
  1.2 for 1) (Direct quotation)
• Alternatively, we can define 1/E as how many
  Euros you get for one dollar (e.g. 0.83 for 1)
  (Indirect quotation)

5
Exchange Rates

• 1. Overview
• 2. Foreign exchange markets are decentralized,
  over the counter markets and the major traders in
  these markets are banks.
• Primarily traded are deposits such as checking
  accounts denoted in a domestic currency with a
  domestic bank in exchange for deposits denoted in
  a foreign currency with a foreign bank (rather
  than exchanging bank notes for each other).

6
Exchange Rates

• 1. Overview
• 3. Two types of transactions are common in
  foreign exchange markets
• Spot transactions Two currencies are exchanged
  today at the prevailing interest rate (spot
  rates)
• Forward transactions An agreement is made today
  with a bank that two currencies are going to be
  exchanged some time in the future at an exchange
  rate, which is fixed today (forward rate). This
  serves to reduce risk in certain transactions.

7
Exchange Rates

• 1. Overview
• 4. A currency is said to appreciate in value
  compared to another currency if one unit of this
  currency buys more units of the second currency
  than previously. It is said to depreciate in
  value to another currency if one unit buys less
  units of the other currency.
• In terms of our notation this means that
• Appreciation (You have to pay/get less
  Dollars for one Euro)
• Depreciation(You have to pay/get more
  Dollars
• for one Euro)

8
Exchange Rates

• 1. Overview
• 5. In what context do exchange rates matter?
• 1. Trade in goods/services
• Exchange rates determine the price of imported
  and exported goods and services (the trade
  balance).
• In an open economy actual expenditure equals
  planned expenditure, such that YCIG(X-M).
  (X-M) indicate net exports or the trade balance.
  Domestic demand (and, thus, production) reacts to
  changes in the exchange rate.
• Trade is considered more of a long-run
  determinant of exchange rates.

9
Exchange Rates

• 1. Overview
• 5. In what context do exchange rates matter?
• 2. Trade of assets/ financial services
• Economies which have opened their financial
  markets to international capital flows can make
  use of the opportunity of international borrowing
  and lending (e.g. in buying foreign bonds, etc.)
• Trade in assets/ financial services determines
  most of trade in currencies and is used to
  explain short run fluctuations in nominal
  exchange rates.

10
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• Assumptions
• Two countries U.S., Canada
• One tradable good Milk
• Assume that there are no market imperfections
  such as transaction costs, trade barriers,
  information asymmetries, etc.
• Let the price of milk be 2 US-Dollars and 4
  Canadian Dollars per gallon of milk, respectively

11
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• We assume further that the equilibrium exchange
  rate is determined by the following equation
• Where indicates the domestic price in
  US-Dollars
• indicates the foreign price in Canadian
  Dollars

12
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• Using the numbers in our example, we find the
  equilibrium exchange rate between the U.S. and
  Canada to be
• In words You have to pay 50 US-Cent for 1
  Canadian Dollar in this example.

13
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• Why does this result occur?
• The best way to interpret the above equation is
  the following
• In equilibrium the prices of milk in both
  countries have to be equal to each other when the
  are expressed in the same currency.
• To see, why this must be the case consider the
  following example

14
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• Assume that the exchange rate initially was 1
  Canadian Dollar for 1 US-Dollar. In this case
  all Canadians would only buy American milk, since
  it would only cost them the equivalent of 2
  Canadian Dollars, which is cheaper than domestic
  milk.
• This increased demand, however, would in turn
  lead to an increase in the relative demand for
  US-Dollars, leading to an appreciation of the
  US-Dollar compared to the Canadian Dollar. As a
  consequence American milk becomes more expensive
  for Canadians. Once the exchange rate drops to
  0.5, Canadians are indifferent between American
  and Canadian milk and the market is in
  equilibrium again. This process is another
  example of arbitrage.

15
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• The equilibrium condition stated in the equation
  above is known as the law of one price (loop).
• Now, the central underlying assumption producing
  this result is that only one good is traded.
• Apparently, this is not true. In order to extend
  the law of one price to an aggregate level for
  all traded goods, we use price indices (such as
  the CPI or GDP deflator) in both countries as
  average price levels for all goods.

16
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• If we extend this relationship to the aggregate,
  we dont use the terminology law of one price.
  Instead we speak of (strong) purchasing power
  parity indicating that both currencies have the
  same real purchasing power in both countries in
  equilibrium.
• Empirically strong purchasing power parity has
  been challenged for a variety of reasons.

17
Exchange Rates

• 2. The long run Trade and Exchange Rates
• A simple model of exchange rate determination
• First, goods of the same type (such as cars) are
  not necessarily of the same quality in two
  countries (A Hyundai is not a BMW, a Relox is not
  a Rolex watch, etc.)
• Second, not all goods are traded. In particular
  services, such as haircuts, tend not to be
  traded.
• Both features prevent arbitrage from equalizing
  prices across both countries.

18
Exchange Rates

• 2. The long run Trade and Exchange Rates
• Factors determining exchange rates in the long
  run
• 1. Relative price levels in both countries
• 2. Trade barriers
• 3. Preferences
• 4. Productivity differences

19
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 1. Relative price levels
• Assume that in our previous example the price of
  milk in the U.S. drops to 1, while the price in
  Canada remains unchanged.
• At the old exchange rate of 0.5 the Dollar is
  undervalued. Canadians will want to be more
  Dollars since American milk has become cheaper in
  terms of Canadian Dollars. As a consequence, the
  Dollar will appreciate and E will drop.

20
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 1. Relative price levels
• We can extend the same argument to the aggregate
  price level As the price level in the home
  country decreases, E will decrease leading to an
  appreciation of the domestic currency, et v.v.
• Thus, we can make a statement about inflation. If
  a country has lower inflation than another one,
  its currency will appreciate. If it has higher
  inflation than another one, its currency will
  depreciate.

21
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 2. Trade barriers
• The most common forms of trade barriers are taxes
  and quotas on imports, but other forms (such as
  quality standards) exist as well.
• Trade barriers serve but one purpose To increase
  the price of imports.

22
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 2. Trade barriers
• Assume that in our previous example the domestic
  country imposes a tariff of 1 Canadian Dollar
  per gallon of milk imported from Canada.
• The law of one price then predicts, that in
  equilibrium
• It follows that E 0.4, leading to an
  appreciation of the US-Dollar over the Canadian
  Dollar (since Canadian milk has effectively
  become more expensive in the U.S.)

23
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 3. Preferences for domestic vs. foreign goods
• E.G. Italian wines just not the same as
  Californian, etc.
• If demand for the for the domestic good increases
  and demand for the foreign good decreases the
  price of the domestic good will increase and the
  price of the foreign good will decreases.
• As a consequence individuals have an incentive to
  buy the foreign good leading to a depreciation of
  the domestic currency and an increase in E.

24
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 4. Productivity
• Productivity increases matter for exchange rates,
  since the price of a good is ultimately
  determined by its production cost.
• E.g. if productivity in China increases and
  prices subsequently fall, this will lead to a
  higher demand for Chinese goods, and thus, the
  Dollar will depreciate compared to the Yuan, et
  v.v.

25
Exchange Rates

• 2. The long run Trade and Exchange Rates
• 5. Conclusion
• The easiest way to remember how exchange rates
  change under purchasing power parity react, is
  the following
• Everything that leads to an increase in the
  relative demand for the domestic good compared to
  the foreign good will lead to an appreciation of
  the domestic currency over the foreign one.
• Everything that leads to a decrease in the
  relative demand for the domestic good will lead
  to a depreciation of the domestic currency
  compared to the foreign one.