III. Open economy macroeconomics

B. Foreign exchange markets

    Problem in practice: transactions aren't all in dollars. Instead, involve 2 currencies ordinarily.
    Here: assume 2 countries and currencies:
    U.S.: $
    EU: euro (eu)

    Imports: U.S. buyer starts with $ and EU seller wants to end up with euros.
    Exports: EU buyer starts with Euros and U.S. seller wants to end up with $.
    Either way, there is a derived demand for an intermediate transaction in foreign currency.
    These transactions occur in FX markets.

    Why FX matters: We've already seen that debt and credit situations hinge on trade balances.
    Trade balances in turn hinge on exchange rates

    Foreign exchange (FX) = foreign money
    Euros = F/E to U.S.
    $ = F/E to EU.

    Financial institutions serve as intermediaries in these transactions.
    Of course, they charge a fee for this service.
    Takes the form of buying foreign currency at a discount (bid price) and selling it at a premium (offer price).
    The spread is about 0.1 percent.

1. Exchange rates (ERs)

(1) Nominal exchange rates (E)
    What's printed daily in the paper: See current ERs handout
    Source: Daily Exchange Rates  

    Class: E = foreign exchange value of domestic money (euros per $)
    Text: e = domestic price of foreign money ($ per euro)
    E* = 1/E = $ per euro
    Foreign ERs are just the reciprocal of domestic ERs

    For some leading currencies, several values are given in the paper, depending on when you want to make your exchange

    Spot exchange rate (Esp): the ER for immediate transactions (actually, within 2 days, for $1M transaction).
    That's the rate you use as a tourist
    It's also the rate we plot when we diagram FX markets.
    Nearly 2/3 of transactions = spot transactions

    Forward exchange rate (Efwd): the ER for transactions contracted for a specified future date.
    Forward rates incorporate expectations about what will happen to the spot rate in the future.

    Under floating ERs:
    Appreciation = Currency value rises (higher ER value of domestic currency)
    Depreciation = Currency value falls (lower ER value of domestic currency)

    ? US expectations for next 6 months? (for countries with Efwd)
    use worksheet
    In practice, there is negligible bank risk in forward markets since rates keep changing until buy/sell contracts balance out (same as sports betting lines in Las Vegas)

    ? Pick a 3rd currency and predict how the two FXs moved against each other
    Currency arbitrage (buy cheap and sell dear) enforces globally compatible FX prices

    Countries with fixed ERs: Bahrain, China, Hong Kong, Kuwait, Lebanon, Saudi Arabia

    2009: $ appreciated 16.8% against Ghana's cedi.
    ? So would you say that this would make 2009 a better time than 2008 to be a tourist in Ghana?
    2009: Inflation in Ghana was 19.3% (prices fell 0.3% in the US in 2009)

    the point: you can't assess a country's competitiveness in the world money just from nominal exchange rates. You need price information too. -->

(2) Real exchange rates (R)

    ? What makes U.S. products look expensive compared to foreign products, $ appreciation or depreciation?
    $ appreciation --> strong dollar
    $ depreciation --> weak dollar

    ? What else makes US products look more expensive compared to foreign products? hPus,  iPfor

    A country's international competitiveness and therefore its net exports (NX) depends on the nominal exchange rate (E) and on relative price levels across countries (Pdom/Pfor)
    The real exchange rate incorporates these factors:
    Real exchange rate (R) = price level-adjusted ER

    +E, +Pdom, -Pfor all make US output more expensive compared to foreign output
    R compares the price level of US stuff to foreign stuff in a common currency.
    Ex: Jeans: $30 US / 25eu / eu/$=0.70

    You get the same answer regardless of which currency you use to value stuff:

    Example: Exchange rates worksheet

    Did the $ appreciate or depreciate...
        ? in nominal terms?
        ? in real terms?
    ? Are US goods more or less competitive than before?