Lecture 29 - Exchange Rates
from last time
exchange rates
what determines long-run exchange rates?
determining short-run exchange rates
From Last Time
- If the Fed keeps screwing up, why does Alan Greenspan get so much respect? (1) because he's so powerful and (2) the current expansion has lasted 7 years
- If the money supply is so hard to control, how do you effectively deal with a demand side problem? Although the money supply is hard to control, monetary policy does have a large impact on the economy.
- Are wars bad or good overall for our economy? Bad. They use up resources that could have been employed for something more productive. Although they can increase output and employment, they also lead to inflation which generally is followed by
a recession.
- In your explanation of free reserves targeting, interest rates increased, yet discount loans increased. Aren't interest rates and discount rates positively correlated? Given the discount rate, a rise in market interest rates makes discount
borrowing more attractive. Interest rates change much more frequently than does the discount rate.
Exchange Rates
Foreign exchange is the money of another country. The exchange rate is the
price of one country's currency in terms of another country's money. For example,
say, $1 = 5.6415 French francs.
Suppose the exchange rate becomes $1 = 5.7 French francs. Then the value of
the dollar has appreciated or gone up. The price in dollars of French goods has
fallen while the price of U.S. goods has increased for the French. So, our
exports will fall and imports will rise.
If the exchange rate, instead, became $1 = 5.4 French francs, the value of the
dollar has fallen or depreciated. Now, American goods are cheaper in terms of
the French franc while French products are more expensive for U.S. consumers.
Exports will rise and imports will fall.
The real exchange rate, R, takes price levels into account. It measures the price of foreign goods relative
to domestic goods, measured in the same currency.
What Determines Long-Run Exchange Rates?
The theory of purchasing power parity is used to explain long run exchange rates.
The idea is that the process of arbitrage ensures that goods sell for the same
price in different countries. So, for example, if a bushel of wheat costs $3 in
the U.S. and 1500 rubles in Russia, the exchange rate should be $1 = 500 rubles.
Why don't goods have the same price (adjusted for exchange rates) all over the
world?
- goods are not identical
- information is costly
- shipping costs
- barriers to trade
Purchasing power parity does well at explaining how inflation affects exchange
rates. Suppose there is 100% inflation in Russia and 0% inflation in the U.S.
Wheat now costs 3000 rubles a bushel in Russia. So, the exchange rate should be
$1 = 1000 rubles. Therefore, when the foreign inflation rate is greater than the
U.S. inflation rate, the dollar appreciates against the foreign currency.
Determining Short-Run Exchange Rates
Interest rates tell us something about short run exchange rates. Suppose you have
$10,000 to invest and you've narrowed your investment options to (1) a U.S.
government bond with an 8% interest rate or (2) a German government bond with a 6%
interest rate. Which bond is the better investment? It all depends on what you
expect to happen to the exchange rate between dollars and German marks.
If you invest in the U.S. bond, you will have $10,800 after one year.
If you invest in the German bond you must turn your dollars into marks now and
back again in one year. Suppose the exchange rate is now $1 = DM 2 and that the
mark is expected to appreciate 3% over the year so that the exchange rate next
year will be $1 = DM 1.94.
- $10,000 today = DM 20,000
- DM 20,000 + 6% = DM 21,200 after one year
- DM 21,200 next year = $10,928
So, the German bond is the better investment. This is because the German bond
provides two sources of return:
- interest rate
- appreciation in the value of the DM
The return on the foreign bond equals the foreign interest rate plus the percentage
change in the exchange rate value of the foreign currency.
Assets which have identical risk, taxation, and liquidity characteristics ought to
have the
same return. The U.S. bond and the German bond should have the same return.
return on U.S. bond = return on German bond
U.S. interest rate = foreign interest rate + percentage change in the exchange
rate value of the foreign currency
percentage change in the exchange rate = U.S. interest rate - foreign interest rate
- if the U.S. interest rate is greater than the foreign interest rate, the
dollar is expected to depreciate against the foreign currency
- if the U.S. interest rate is less than the foreign interest rate, the dollar
is expected to appreciate
the interest rate parity condition may not hold
- government controls on capital flows
- political risk
- differences in tax rates
EC 230, Money and
Banking Files 
