Week 10&11 Flashcards
What is an exchange rate?
Exchange rate is the relative price of two currencies
What are two types exchange rate quotes?
-European quotes
-American quotes
What are European quotes?
- European quotes: units of a currency per $1
- INR (Indian Rupees) 54.84/$
What are American quotes?
- American quotes: units of $ per 1 foreign currency
- $ 0.018/INR (Indian Rupees)
What are direct quotes in terms of foreign exchange quotations?
- Direct quotes: The number of domestic currency per 1 unit of
foreign currency. (domestic currency/ foreign currency)
What are indirect quotes in terms of foreign exchange quotations?
- Indirect quotes: The number of foreign currency per 1 unit of
domestic currency. (foreign currency/domestic currency).
What are bid quotes?
exchange rate at which the dealer is willing to buy a currency
What are ask quotes?
exchange rate at which the dealer is willing to sell a currency
What are cross-rates?
- Cross rates: the exchange rate between two currencies
calculated using a third currency. - Alternatively, we can say cross rates are exchange rates
between 2 currencies that do not involve the currency of the
country in which they are quoted
What are vehicle currency?
Vehicle currency is a currency which is actively traded in many
international financial transactions.
Equation for direct quotes (Domestic / Foreign)?
change in = Spot exchange rate(1) - Spot exchange rate (0) / Spot exchange rate (0)
Equation for indirect quotes (Foreign / Domestic )?
change in = Spot exchange rate(0) - Spot exchange rate (1) / Spot exchange rate (1)
What is appreciation of a currency?
Appreciation of a currency refers to an increase in the value of one currency relative to another in the foreign exchange market. When a currency appreciates, it means that it can buy more of another currency than it could before.
What is depreciation of a currency?
Depreciation of a currency refers to the decline in the value of a currency relative to other currencies in the foreign exchange market. When a currency depreciates, it means that it takes more of that currency to buy the same amount of another currency.
Why Are Exchange Rates Important?
- Exchange rates are important because they affect the relative
price of domestic and foreign goods. - Say, the dollar price of French goods to an American is
determined by the interaction of two factors: the price of
French goods in euros and the euro–dollar exchange rate. - If euro appreciates against US dollar, and if the price of French
goods stay the same in France, the price of French goods
exported to US will increase - At the same time, the price of American goods exported to
France will decrease
How Is Foreign Exchange Traded?
- the foreign exchange market is organized as an
over-the-counter market in which several hundred dealers
(mostly banks) stand ready to buy and sell deposits
denominated in foreign currencies. Trades involve transactions
in excess of $1 million. - Because these dealers are in constant telephone and computer contact, the market is very competitive; in effect, it functions no differently from a centralized market.
- Typical consumers buy foreign currencies from retail dealers,
such as a commercial bank.
What is the law of one price?
-If two countries produce an identical good, and transportation costs and trade barriers are very low, the price of the good should be the same throughout the world, regardless of which country produces it.
What is the purchasing power parity theory?
Exchange rates between two currencies will adjust to reflect
changes in price levels. In other words, if one country’s price level rises relative to another’s, its currency should depreciate (the other country’s currency should appreciate)
Why PPP Cannot Fully Explain Exchange Rates?
- PPP does not work in the short run
- PPP is based on the assumptions that
- all goods are identical in both countries
- transportation costs and trade barriers are very low
- Not all goods are identical in both countries
- Many goods and services are not traded (e.g., haircuts, land,
etc.), but their prices are included in measuring the country’s price level
Equation for expected future exchange rate?
- s0: current spot exchange rate (indirect quotes foreign/domestic)
- E: expectation
- πd : domestic inflation rate
- πf : foreign inflation rate
= E(spot exchange rate(1))/ Spot exchange rate (0) = 1 +πf / 1 + πd
Equation for the change in the value of the domestic currency?
- s0: current spot exchange rate (indirect quotes foreign/domestic)
- E: expectation
- πd : domestic inflation rate
- πf : foreign inflation rate
= E(spot exchange rate(1) - E(spot exchange rate(0) / Spot exchange rate (0) = πf - πd / 1 + πd
Factors affecting exchange rates in the long run?
- relative price levels
- tariffs and quotas
- preferences for domestic versus foreign goods
- productivity
What is the basic principle of r factors affect the exchange rate?
- If a factor increases demand for domestic goods relative to foreign goods, the exchange rate ↑
- Because domestic goods will continue to sell well even when the value of the domestic currency is higher
What happens to relative price levels in the long run?
In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in
the country’s relative price level causes its currency to appreciate.
What happens to trade barriers in the long run?
- Barriers to free trade such as tariffs (taxes on imported goods) and quotas (restrictions on the quantity of foreign goods that can be imported) can affect the exchange rate.
- Increasing trade barriers causes a country’s currency to appreciate
in the long run.
What happens to Preferences for Domestic Versus Foreign Goods in the long run?
Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely, increased demand for
imports causes the domestic currency to depreciate
What happens to Productivity in the long run?
- When productivity in a country rises, it tends to rise in domestic sectors that produce traded goods rather than nontraded goods.
- Higher productivity → a decline in the price of domestically produced traded goods relative to foreign traded goods → the
demand for traded domestic goods rises, and the domestic currency tends to appreciate - In the long run, as a country becomes more productive relative to other countries, its currency appreciates
What is Exchange Rates in the Short Run?
- In the short run, an exchange rate is the price of domestic assets (bank deposits, bonds, equities, etc., denominated in the domestic currency) in terms of foreign assets (similar
assets denominated in the foreign currency). - Because the exchange rate is the price of one asset in terms of another, the natural way to investigate the short run determination of exchange rates is to use an asset market
approach that relies heavily on the theory of portfolio choice - the long-run determinants of the exchange rate we have just outlined also play an important part in the short-run asset
market approach
What is the Supply curve for domestic assets?
- Dollar assets supplied is primarily the quantity of bank deposits, bonds, and equities in the United States. This is fairly fixed in the short-run.
- The quantity supplied at any exchange rate does not change, so the supply curve is vertical
What is the Demand curve for domestic assets?
- The demand curve traces out the quantity demanded at each current exchange rate by holding everything else constant,
particularly the expected future value of the exchange rate. - The greater the expected rise (appreciation) of the dollar, the higher the relative expected return on dollar (domestic) assets
- The theory of portfolio choice then tells us that because dollar assets are now more desirable to hold, the quantity of dollar
assets demanded will rise - That is why the demand curve is downward sloping.
What happens to increase in the demand interest rate?
An increase in the domestic interest rate iD shifts the demand curve for domestic assets to the right and causes the domestic
currency to appreciate
What happens to decrease in the demand interest rate?
A decrease in the domestic interest rate iD shifts the demand curve for domestic assets to the left and causes the domestic
currency to depreciate
What happens to increase in the foreign interest rate?
an increase in the foreign interest rate iF shifts the demand curve for domestic assets to the left and causes the domestic currency to depreciate;
What happens to decrease in the foreign interest rate?
a fall in the foreign interest rate iF shifts the demand curve to the right and causes the domestic currency to appreciate
What happens to increase in the Expected Future Exchange Rate?
A rise in the expected future exchange rate shifts the demand curve to the right and causes an appreciation of the domestic currency;
What happens to decrease in the Expected Future Exchange Rate?
a fall in the expected future exchange rate shifts the demand curve to the left and causes a depreciation of the currency.
