week 7 (1) Flashcards
Foreign Exchange Rates
refer to the price at which one currency can be exchanged for another
Two kinds of exchange rate transactions that make up the foreign exchange market
- Spot Transactions: it involves the immediate exchange of bank deposits between currencies at the current exchange rate, called the spot rate.
- Forward Transactions:
it involves agreements to exchange currencies at a future date, but at a pre-determined exchange rate, known as the forward rate.
Why are Exchange rates important?
Because they affect the relative price of domestic and foreign goods
If the currency appreciates, exported goods become more expensive and imported good become cheaper. Vice versa, if the country’s currency depreciates
How is Foreign Exchange Traded?
- Most trades involve buying and selling bank deposits denominated in different currencies
- Trades in the foreign exchange market involve transactions in excess of $1 million
- Typical consumers buy foreign currencies from retail dealers, such as American Express
What determines the exchange rates in the long run?
Like the price of any good or assets in a free market, exchange rates are determined by the interaction of
supply and demand.
Law of one price
It is an important concept that drives the forces of supply and demand.
The Law of One Price states that the price of an identical good will be the same throughout the world,
regardless of which country produces it (elimination of price differences through arbitrage).
Theory of purchasing power parity
The theory states that in an efficient market, exchange rates between two currencies should adjust to reflect the relative price levels of the two countries
If the price of domestic good increases by 10%, then the currency depreciates by 10% relative to other currencies
Exchange rate in the long run: PPP and its disadvanatges in predicting exchange rates
Theory of PPP is only approximately valid in the long run, meanig it has a little predictive power in the short run. Thus, it is not a perfect predictor for exchange rates.
Also, there are problems which explain the failure of PPP in predicting failure:
- products are not identicial in both countries (different car manufacturer)
- many goods are not tradable (haircuts)
BIG MAC index
PPP implies that exchange rates are determined by the value of goods that currencies can buy. Thus, differnt in price of burgers can suggest what the exchange rate can be:
$5 vs 20 Yuan = 1:4 ratio
However, in essence, the real exchange rate is $1 : 6.4Yuan
(4-6.4)/6.4=0.375 meaning that Yuan is 38% undervalued
Factors that affect exchange rate in the long run
These are factors that affects the demand of domestic goods relative to foreign goods
- Relative price levels: a rise in relative price levels cause a country’s currency to depreciate.
- Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate in the long run.
- Preferences for domestic v. foreign goods: 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. - Productivity: if a country becomes more productive relative to other countries, its currency
appreciates.
Application: interest rate changes affecting exchange rates
- Real interest rate rises would lead to an appreciation because it attracts more foreign investors to investor in domestic assets-> higher demand for domestic currency
- Nominal interest rate rises due to inflation would lead to a depreciation because foreign investors find it unattractive to invest in assets that provide lower returns
What is flight to quality
a shift in investor behavior during times of economic uncertainty or financial crisis. In such periods, investors seek safer, more stable assets, such as government bonds from financially stable countries
