EC 340

Lecture 9 - What Determines Exchange Rates?

from last time
prices and exchange rates
purchasing power parity
factors affecting exchange rates
exchange rate overshooting
foreign exchange policies
European monetary union

From Last time

Prices and Exchange Rates

The U.S. economy is linked to the rest of the world through exchange rates. An exchange rate is the price of one national currency in terms of another.

Suppose an American buys a bottle of Kahlua for 85 pesos and that the exchange rate is $1 = 7.9060 pesos. Then, that bottle of Kahlua costs $10.75.

Suppose A Mexican buys a 6-pack if Yuengling Black and Tan for $5.75. At $1 = 7.9060 pesos, the beer costs 45.46 pesos.

Purchasing Power Parity

The law of one price says that identical goods should cost the same in all countries. Profit opportunities ensure that the price of a good is the same all over the world. For example, suppose a yard of cloth costs $10 in the U.S. and the same yard of cloth produced by a French firm sells for 50 francs. The exchange rate between dollars and francs should be 50 francs = $10 or 5 francs = $1. If, at the going exchange rate, U.S. cloth is cheaper, the demand for dollars would go up, raising the value of the dollar.

Purchasing power parity generalizes the law of one price to a group of goods. A basket of goods and services should cost the same in all countries after converting prices into the same currency.

absolute PPP: r = P/Pfor

relative PPP: % change in r = domestic inflation rate - foreign inflation rate

Big Mac PPP

The Big Mac is a collection of ingredients sold all over the world. Hence, it provides a good test of purchasing power parity. Big Mac PPP is the exchange rate that would leave burgers costing the same in America as abroad. Let Big Mac PPP be equal to the foreign price in foreign currency divided by the American price in dollars. The foreign currency is overvalued if Big Mac PPP is greater than the actual exchange rate.

Why does PPP fail?

  1. transportation costs
  2. barriers to trade
  3. non-traded goods - price of a Big Mac reflects more than just the price of its ingredients
  4. imperfect competition - able to engage in price discrimination
  5. current account imbalances - trade in assets affects supply and demand for currencies

Factors Affecting Exchange Rates

foreigners demand dollars to

Americans sell dollars to

  1. changes in real GDP
  2. expected future inflation
  3. interest rates
  4. shifts in demand
  5. change in U.S. money supply
  6. change in foreign money supply
  7. expected future spot exchange rate

Exchange Rate Overshooting

Exchange rate overshooting occurs when speculators rationally react to news of a change in economic policy by driving the exchange rate past what they know will be its ultimate equilibrium.

Suppose there is a 10% increase in the U.S. money supply. The value of the dollar will fall by 10% in the long run as the domestic price level rises by 10%. However, prices are sticky, so it takes time for prices to rise 10%.

exchange rate overshooting

rf/rs = (1 + i)/(1 + ifor)

A rise in the money supply will cause domestic interest rates to fall, making foreign investment more attractive. Now, covered interest parity does not hold. The left-hand side of the equation must also fall. If correct speculation makes rf go up by 10%, then rs must go up by more than 10% to keep CD = 0.

Speculators must have the prospect of seeing the value of the dollar rise in order to keep them invested in the U.S. This can only happen if the value of the dollar is bid below its ultimate value.

Foreign Exchange Policies

  1. intervene in the foreign exchange market
  2. impose direct restrictions on international transactions
  3. adopt tighter aggregate demand policies
  4. allow the exchange rate to adjust

exchange rate regimes
  1. gold standard
  2. Bretton Woods
  3. flexible exchange rates

European Monetary Union

A monetary union occurs when two or more independent countries agree to fix their exchange rates or to employ only one currency to carry out all transactions.


  1. reduces uncertainty
  2. promotes stability
  3. eliminates exchange rate management as a trade barrier
  4. saves resources that would have been employed in foreign exchange transactions
The European Currency Unit serves as the basis for determining exchange rate parities. It is a basket made up of fixed amount of all EC currencies. Each currency has an official rate against other EC currencies and against the ECU. Deviations of +/- 2.25% are permitted.

The European Central Bank comes into existence this summer. On January 1, 1999, the EMU will begin the move to a single currency, the euro. The European Central Bank will operate only in euros, as will the financial markets. At the retail level, national currencies will continue to circulate and remain sole legal tender until July 2002. The euro will be introduced for retail transactions in January 2002. Thereafter, national currencies will be redeemed for euros for periods set by national legislation.

European governments are giving up the ability to have an independent monetary policy. This would not be a problem if Europe is an optimal currency area (share the same currency without any adverse consequences).

optimal currency area: