Chapter 10: Foreign Exchange

Why would someone want to exchange currency?

(1) to purchase goods and services produced abroad, like a Japanese television set, dinner in Paris, or tuition at a foreign university; and (2) to invest in foreign assets, such as bonds issued by the German telecommunications company Deutsche Telekom, or shares in Honda, the Japanese manufacturer of cars and motorcycles.

A rise in the supply of dollars Americans use to purchase foreign goods and services can be caused by:

An increase in Americans' preference for foreign goods. An increase in the real interest rate on foreign bonds (relative to U.S. bonds) An increase in American wealth A decrease in the riskiness of foreign investments relative to U.S. investments. An expected depreciation of the dollar.

US Dollar Liquidity

Because of its liquidity, the U.S. dollar is one side of 88 percent of these currency transactions.2 That means that someone who wishes to exchange Thai baht for Japanese yen is likely to make two transactions, the first to convert the baht to dollars and the second to convert the dollars to yen. Most likely these transactions will take place in London, because the United Kingdom is home to 37 percent of foreign exchange trades—nearly twice the volume in New York. Other significant foreign exchange trading takes place in Hong Kong, Singapore, and Tokyo

US vs Japan Intervention

Between 1997 and early 2016, the United States intervened only twice; both times it was pressured to do so by its allies. Among the major industrialized countries, the Japanese are the most frequent participants in foreign exchange markets.

Government Policy and Foreign Exchange Intervention

Some countries adopt a fixed exchange rate and act to maintain it at a level of their choosing. Large industrialized countries and common currency zones like the United States, Europe, and Japan generally allow currency markets to determine their exchange rate. Even so, there are occasions when officials in these countries try to influence the currency values. Sometimes they make public statements in the hope of influencing currency traders. But talk is cheap, and such statements rarely have an impact on their own. At other times, policymakers will buy or sell currency in an attempt to affect demand or supply. This approach is called foreign exchange intervention.

Real Exchange Rate

The exchange rate at which one can exchange the goods and services from one country for goods and services from another country. Dollar Price of Domestic Goods/ Dollar price of foreign goods

Appreciation of a currency

The increase in the value of a countrys currency relative to the value of another country's currency

Law of One Price

The principal that two identical goods should sell for the same price regardless of location. Based on the idea of arbitrage. Law of one price fails almost all the time

Nominal Exchange Rate

The value of one unit of a country's currency in terms of another country's currency

Short Run Exchange Rates

To explain short-run changes in nominal exchange rates, we turn to an analysis of the supply of and demand for currencies. Because, in the short run, prices don't move much, these nominal exchange rate movements represent changes in the real exchange rate. That is, a 1 or 2 percent change in the nominal dollar-euro exchange rate over a day or week creates a roughly equivalent change in the real dollar-euro exchange rate.

Law of one price fails almost all the time

Why? Transportation costs can be significant, especially for heavy items like marble or slate. Tariffs—the taxes countries charge at their borders—are high sometimes, especially if a country is trying to protect a domestic industry. And technical specifications can differ. A television bought in Paris will not work inPage 250 St. Louis because it requires a different input signal

Exchange Rates and Imports/Exports

The more a country relies on exports and imports, the more important its exchange rate. Currency appreciation drives up the price foreigners pay for a country's exports as it reduces the price residents of the country pay for imports.

Purchasing Power Parity

The principle that a unit of currency will purchase the same basket of goods anywhere in the world. Thus, purchasing power parity implies that the real exchange rate is always equal to one. So purchasing power parity tells us that changes in exchange rates are tied to differences in inflation from one country to another. Specifically, the currency of a country with high inflation will depreciate.