Chapter 10: Foreign Exchange

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Financial markets do not stop at national borders: Funds flow to the best investment opportunities in and outside of the United States. Because of this we need to understand how exchanges rates respond to and impact other financial variables.
The big issue in exchange markets is the declining U.S. dollar. In November 2002 1 U.S. dollar traded for exactly 1 euro, but by September 2007 it takes a record 1.39 U.S. dollars to buy one euro.  What are the causes and consequences of this kind of exchange rate movement?
Foreign Exchange Rates
Let's start with some definitions and a look at the data on the exchange rates between the US. dollar and other major foreign currencies. Simply put, the exchange rate is the price of one country's currency in terms of another country's currency. Typically the exchange is quoted as the amount of foreign currency that can be purchased with $1, or:

If you read the front page of the Money & Investment section of the Wall Street Journal you will find that the exchange rate between the US. dollar and the Japanese yen are quoted this way. In figure 10.1 (229), the exchange rate between the South Korean Won and the U.S. Dollar is also quoted this way.
However, exchange rates may also be quoted by how many US. dollars it takes to buy a unit of foreign currency, also known as the US. dollar price of that currency:

This is the way the exchange rates are presented in figures 10.2 and 10.3. If you read front page of the Money & Investment section of theWall Street Journal you will find that the exchange rate between the US. dollar and the British Pound, Canadian dollar, or euro are quoted this way. (Why can't they be consistent? I honestly have no idea).
The rate at which one countries currency exchanges for another is the nominal exchange rate.
Even though you may buy everything in dollars, the exchange rate is important because it determines the price of the imported goods you buy, relative to domestic goods. Also, the exchange rate determines the price of US. goods overseas, relative to goods produced in those countries. Consider the following example (borrowed from my Eco 200 course):

Suppose as a U.S. car buyer we are deciding between a Toyota Corolla (made in Japan) and a Saturn SL2. Both are comparable compact sedans. Suppose also that
the Toyota Corolla costs 1.8 million  in Japan
the Saturn costs $13,500 in the US.
Case 1: Suppose the exchange rate is 120 /$
The price of the Corolla in the US. is
1,800,000  x $1/120 = 1,800,000/120 = $15,000
The price of the Saturn in Japan is
$13,500 x 120/$ = 1,620,000
Case 2: Now suppose the exchange rate changes to 110/$
In other words, each dollar gives you fewer yen than before. When this happens we say that

• the dollar has depreciated against the yen
• the dollar has fallen against the yen
• the dollar is weaker against the yen

or from the perspective of Japan

• the yen has appreciated against the dollar
• the yen has risen against the dollar
• the yen is stronger against the dollar

The six statements above all mean the same thing.
Now we recalculate the prices of the Corolla and the Saturn:
The price of the Corolla in the US. is
1,800,000  x $1/110 = $16,363.64
the price of the Saturn in Japan is
$13,500 x 110 /$ = 1,485,000 
When the $ depreciated, the Corolla got more expensive in the US. while the Saturn got cheaper in Japan.
So we can see that the exchange rate has an impact on the relative prices of imports vs. domestic goods
In fact, most Corollas sold in the U.S. are now made at plants in the U.S. One big reason Toyota did this was to avoid cost/price fluctuations stemming from exchange rate fluctuations.

To generalize the results from the example above:

• When the $ appreciates, imports are cheaper and our exports are more expensive abroad.
• When the $ depreciates, imports are more expensive and our exports are cheaper abroad.
• Exchange rates are a seesaw: If the dollar appreciates against the yen, then the yen MUST depreciate against the dollar.
• An exchange rate movement has both winners and losers: Corolla dealers are not happy about a depreciating $, but US. automakers are happy about it.

Now the example about uses nominal exchange rates to illustrate the impact of a change in these rates. However of particular importance is the real exchange rate, which measures the relative cost of certain goods in two countries.
The real exchange rate can be written as

The exchange of foreign currencies is a huge market with of $1 trillion of transaction in any given day worldwide. At the hub of these transactions is London, although New York and Tokyo also deal with a large amount of this volume. Almost 90% of these transactions involve the U.S. dollar. This is due to the size of the U.S. economy, the popularity of U.S. currency as a store of value, and the worldwide pricing of oil in U.S. dollars. Exchange rate movement is determined by highly volatile responses to short-run factors and smoother long run factors.
Exchange Rates in the Long Run
The Law of One Price and Purchasing Power Parity (PPP)
A primary determinant of long-run exchange rates is the relative price levels between two countries. In other words, if one country has an inflation rate that is different from another country over long periods of time, we can expect the exchange rate to adjust.
Why? The adjustment centers on what is known as the law of one price, which states that an identical good should be the same price throughout the world (given that transportation costs are very low and that there are no trade barriers, like tariffs or quotas). Take, for example, a pack of chewing gum. If the exchange rate between US and Japan is 120 /US$ then gum that costs $1 in the US should cost 120  in Japan.
Now suppose prices in the US double, so now a pack of gum is $2. At the exchange rate above, a pack of gum in Japan, at 120  is now half the price of gum in the US. Everyone would buy cheaper Japanese gum. To equalize the prices, the exchange rate moves to $1 = 60 , or the dollar depreciates. Now gum is the same price in both the US and Japan.
The example above offers a theory of how exchange rates are related to the price level. Under purchasing power parity or PPP, exchanges rates adjust to changes in the relative price level between two countries:

• if U.S. prices rise faster than other countries (higher inflation) then the US dollar will depreciate
• if U.S. prices rise more slowly than other countries (lower inflation) then the US dollar will appreciate.

Nice theory, but how does it work? Take a look at figure 10.4 below:

Note how over a long period of time (over 25 years in this case), higher inflation relative to the U.S. is strongly associated with depreciation of the foreign currency relative to the U.S. dollar. This is exactly what PPP would predict.
Although the theory of PPP predicts the long-run trend in exchange rates it is a lousy predictor of short-run behavior. The evidence shows that PPP fails to hold quite frequently. One such piece of evidence is the Big Mac Index (pages 240-41) which compares the dollar price of the Big Mac across over 100 countries where it is sold.
Why the short-run failure? Keep in mind that the law of one price assumes that goods may be transported cheaply and are basically identical. That may be true for chewing gum, but it certainly is not true for cars or televisions. Both technical specifications and tastes will differ across countries. Furthermore, some goods, like an office building or restaurant meals, are not traded across borders.
Other factors affecting Exchange Rates in the Long Run
Anything that affects the demand for US goods relative to foreign goods will impact the flow of currency across borders and thus the exchange rate. These factors include:

• relative price levels according to the theory of PPP
• tariffs and quotas. In the US, as we impose trade barriers, we boost demand for domestically produced goods, causing the US$ to appreciate.
• productivity. If the US is relatively more productive than other countries, then they can make goods at a lower cost, making US goods more desirable and causing the US$ to appreciate.

Exchange Rates in the Short Run
To explain short-run movements in the exchange rate we turn to the (hopefully) familiar model of supply and demand. In applying this model to exchange rate markets, we need to specify the domestic country. Here we will use the U.S. Dollar. Let's suppose the foreign currency in question is the euro.
The Supply of Dollars
People who have dollars will supply them to the foreign exchange rate markets to either purchase foreign goods or services or to invest in foreign assets. As the dollar appreciates (more euros per dollar) people will be more likely to buy foreign goods as they become relatively cheaper, thus they will supply more dollars for exchange. So the supply curve for dollars slopes up:

What shifts the supply curve for dollars? Several factors, all relating to decisions in the U.S. to purchase foreign goods and services or foreign investments. Here are some factors that would INCREASE supply, causing the U.S. dollar to depreciate:

• An increase in the preference of Americans for foreign goods. When Americans desire more imports--French wine or German cars--then they supply more dollars to exchange for foreign currency, and supply increases or shifts right (see figure 10.7).
• An increase in U.S. GDP and income. With more income, U.S. consumers will buy more of all types of goods and services, both foreign and domestic. .
• An increase in the real interest rate on foreign bonds relative to U.S. bonds. The higher real interest rate makes the foreign bonds more attractive and investors supply more dollars to exchange for foreign currency and purchase the foreign bonds.
• A decrease in the riskiness of foreign investments relative to U.S. investments. Again, the foreign investments become more attractive.
• An expected depreciation of the dollar. People will supply dollars now to avoid holding dollars while they lose value against the foreign currency.

The Demand for Dollars
The demand for dollars comes from those wanting to purchase U.S. goods and serves or investors wanting to purchase dollar-denominated assets. These become more attractive (cheaper) when the dollar depreciates, so the demand curve slopes down:

What shifts the demand for dollars? Several factors, all relating to decisions of foreign countries to purchase U.S. goods and services or U.S. investments. Note that this is similar to the list of supply factors, only now we take of point-of-view of the foreign interests that demand dollars.
Here are some factors that would INCREASE demand, causing the U.S. dollar to appreciate:

• An increase in the preference of foreign countries for U.S. goods. These foreign countries demand dollars to purchase these goods and services, and demand increases or shifts right (see figure 10.8).
• An increase in foreign GDP and income. With more income, foreign consumers will buy more of all types of goods and services, both foreign and domestic.
• An increase in the real interest rate on U.S. bonds relative to foreign bonds. The higher real interest rate makes the U.S. bonds more attractive and investors demand more dollars to purchase the U.S. bonds.
• A decrease in the riskiness of U.S. investments relative to foreign investments. Again, the U.S. investments become more attractive.
• An expected appreciation of the dollar. People will demand dollars now to benefit when they gain value against the foreign currency.

Exchange Rate Movements
Anything shifting supply and/or demand for $ will imply a new exchange rate. For example, If the U.S. is experiencing faster growth the U.S. (i.e. U.S GDP is rising faster than Europe's GDP, this will increase the supply of dollars:

As a result, the U.S. dollar will depreciate, from E1 euros per dollar to E0 euros per dollar.
We can summarize all of the long-run and short-run factors that affect exchange rates in a table (holding other factors constant):

Factor			Change in Factor			Change in US $
US real interest rate			increase			appreciate
Foreign real interest rate			increase			depreciate
expected US price level/inflation			increase			depreciate
US investment risk			increase			depreciate
US relative tariffs and quotas			increase			appreciate
demand for US goods			increase			appreciate
demand for foreign goods			increase			depreciate
US relative productivity			increase			appreciate

Looking at all of these factors, it is easy to see why exchange rates are so volatile. If expectations about any of these factors changes, global financial markets will respond immediately with exchange rate adjustments. As these expectations change frequency, exchange rates will change frequently as well.
Government Intervention in Exchange Rate Markets
Given the importance of the exchange rate for imports and exports we might expect governments to intervene in exchange rate markets to control the relative values of their currencies. For major industrialized countries and area such as the U.S., Europe and Japan such interventions are rare. Most of the time, supply and demand are allowed to work freely to determine exchange rates. In cases of extreme depreciation or appreciation, governments may intervene to stabilize movements. These interventions are only effective if there is cooperation across countries and are large enough in scale. Most economists believe these interventions are at best effective in the short-run.
FYI Related Links
Multiple Choice Quiz for Chapter 10 An interactive quiz from the textbook website.
The European Central Bank Learn more about the euro.
Policy Debate: Will the European Monetary Union Succeed? One of many economic debates written by John Kane on the Southwest College Publishing web site.
The Universal Currency Converter Use live exchange rates to figure out the conversion rate between any two currencies.
Strong Dollar/Weak Dollar A Federal Reserve Publication about foreign exchange rates and the US economy. You must have Adobe Acrobat Reader to view this or any PDF file. It is free to download at the link I have provided.