Forex SFLS part 1

Introduction to Exchange Rates

(part 1)

Introduction to Exchange Rates:

3.) Change in Equilibrium – Appreciate vs Depreciate

1.) Classical Dichotomy - Nominal vs. Real

2.) Equilibrium - LoOP vs. PPP

4.) Change in Equilibrium – Reasons

5) Foreign Exchange regimes 制度

- the theoretical 理论 separation of nominal and real variables.

Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables.

If central bank doubles the money supply, Hume & classical thinkers contend:

all nominal variables – including prices –will double.

all real variables – including relative prices –will remain unchanged.

Classical Dichotomy

Classical Dichotomy 两分

are measured in monetary units. The day to day number in exchange rates

Nominal exchange rate is the price of a currency in terms of domestic dollars.

Nominal variables

Real variables

are measured in physical units. What you can actually buy with what you haveReal exchange rates are the price of goods in terms of domestic goods.

1.) Classical Dichotomy - Nominal vs. Real

- the rate at which one country’s currency trades for another.

Nominal exchange rate:( Nominal variables )

1.) Classical Dichotomy - Nominal vs. Real

Nominal exchange rate:

1.) Classical Dichotomy - Nominal vs. Real

( Real variables )

- the rate at which the good and service of one country trade for the goods and services of another.

Real exchange rate:

Equation:

P = domestic priceP* = foreign price (in foreign currency)

e = nominal exchange rate, i.e., foreign

currency per unit of domestic currency

e x P

P*

Real Exchange Rate Example with McDonalds

Example with one good…

A Big Mac costs $2.50 in U.S., 400 yen in Japan

e = 120 yen per $

e x P = price in yen of a U.S. Big Mac

= (120 yen per $) x ($2.50 per Big Mac)

= 300 yen per U.S. Big Mac

Compute the real exchange rate:

= 0.75 Japanese Big Macs per US Big Mac

300 yen per U.S. Big Mac

400 yen per Japanese Big Mac=

Real Exchange Rate

e x P

P*

The real exchange rate = 0.75 Japanese Big Macs per 1 U.S. Big Mac

Correct interpretation:

A Japanese citizen can buy0.75 Big Macs in Japan or 1 Big Mac in the U.S.

An American citizen can buy 1 Big Mac in the U.S. or 0.75 Big Macs in Japan

Interpretation…Real Exchange Rate

e = 10 pesos per $

price of a tall Starbucks coffee P = $3 in U.S., P* = 24 pesos in Mexico

A.) Calculate the price of a US coffee measured in pesos, the nominal exchange?

B.) Calculate the real exchange rate, measured as Mexican coffee per US latte.

Another example…Real Exchange Rate

Two steps:…

e x P = (10 pesos per $) x (3 $ per US latte)

= 30 pesos per US coffee

B.) Calculate the real exchange rate.

30 pesos per U.S. coffee

24 pesos per Mexican coffee=

e x P

P*

= 1.25 Mexican coffee per US coffee

e = 10 pesos per $

price of a tall Starbucks coffee P = $3 in U.S., P* = 24 pesos in Mexico

A.) What is the price of a US coffee in pesos?

Interpretation…Real Exchange Rate

1.) Classical Dichotomy - Nominal vs. Real

How many things can I buy with the exchange?

Summary so far…

Nominal exchange rate: Real exchange rate:

What is the amount of money do I need to exchange today?

Introduction to Exchange Rates:

3.) Change in Equilibrium – Appreciate vs Depreciate

1.) Classical Dichotomy - Nominal vs. Real

2.) Equilibrium - LoOP vs. PPP

4.) Change in Equilibrium – Reasons

5) Foreign Exchange regimes 制度

Law of One Price( LoOP)

- A good should sell for the same price in all markets.

Easy definition:

Ceteris Paribus

( Real = Nominal)

2.) Equilibrium - LoOP vs. PPP

Short run – things can worth different amounts.

Law of One Price( LoOP)

- A good should sell for the same price in all markets.

Easy definition:

Ceteris Paribus

( Real = Nominal)

2.) Equilibrium - LoOP & PPP

Long run – Everything should balance be worth the same

Law of One Price( LoOP)

- A good should sell for the same price in all markets.

Easy definition:

Ceteris Paribus

( Real = Nominal)

arbitrage 套利 should insure that identical goods should sell for the same price in different markets. (same Real values everywhere)

Arbitrage

- Taking advantage of different prices of the same thing by buying the item and then selling it somewhere else.

Hard definition

2.) Equilibrium - LoOP & PPP

There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in Boston.

Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are equal.

Arbitrage

Suppose coffee sells for $4/KGin Seattle…

and sells for $5/KGin Boston, and can be transported for free.

(LoOP) Law of One Price example…

So basically always moving towards this…

Law of One Price( LoOP)

- A good should sell for the same price in all markets.

Easy definition:

Ceteris Paribus

( Real = Nominal)

2.) Equilibrium - LoOP & PPP

arbitrage 套利 should insure that identical goods should sell for the same price in different markets. (same Real values everywhere)

Arbitrage

- Taking advantage of different prices of the same thing by buying the item and then selling it somewhere else.

Hard definition

- the number of goods or services that can be purchased with a unit of currency.

Purchasing Power

Law of One Price

Strong:Weak:

2.) Equilibrium - LoOP & PPP

Law of One Price

- A unit of any currency should be able to buy the same quantity of goods in all countries.(should end up with same.nominal values everywhere )

- based on the law of one price.

Purchasing Power Parity( PPP)

(Nominal = Real)

2.) Equilibrium - LoOP & PPP

Short run – things can worth different amounts.

Law of One Price

- A unit of any currency should be able to buy the same quantity of goods in all countries.(should end up with same.nominal values everywhere )

- based on the law of one price.

Purchasing Power Parity( PPP)

(Nominal = Real)

2.) Equilibrium - LoOP & PPP

Long run – Everything should balance be worth the same

A Big Mac costs $2.50 in U.S., 400 yen in Japan

e = 120 yen per $

e x P = price in yen of a U.S. Big Mac

= (120 yen per $) x ($2.50 per Big Mac)

= 300 yen per U.S. Big Mac

Compute the real exchange rate:

= 0.75 Japanese Big Macs per US Big Mac

300 yen per U.S. Big Mac

400 yen per Japanese Big Mac=

e x P

P*

Purchasing Power Parity Back to this example…

Example: a Big Mac P = price of US Big Mac (in dollars)

P* = price of Japanese Big Mac (in yen)

e = exchange rate, yen per dollar

According to PPP: e x P = P*

price of Japanese

Big Mac, in yen

Solve for e: P*

Pe =

price of US

Big Mac, in yen

PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels.

Purchasing Power Parity Back to this example…

Limitations:

- Many goods cannot easily be traded.Examples: haircuts, going to the movies.

Price differences on such goods cannot be arbitraged away

- Foreign, domestic goods not perfect substitutes.Example: some U.S. consumers prefer Toyotas over Chevys, or vice versa.

Price differences reflect taste differences.

2.) Equilibrium - LoOP & PPP

Purchasing Power Parity( PPP)

Limitations:

2.) Equilibrium - LoOP & PPP

Purchasing Power Parity( PPP)

- In the short run:Doesn’t hold, things are too volatile. 挥发物

- In the long run:- The theory seems to be mostly true.

So to summarize so far…

are measured in monetary units. The day to day number in exchange rates

Nominal exchange rate is the price of a currency in terms of domestic dollars.

Nominal variables

Real variables

are measured in physical units. What you can actually buy with what you haveReal exchange rates are the price of goods in terms of domestic goods.

1.) Classical Dichotomy - Nominal vs. Real

Law of One Price( LoOP)

- A good should sell for the same price in all markets.

Easy definition:

Ceteris Paribus

( Real = Nominal)

arbitrage 套利 should insure that identical goods should sell for the same price in different markets. (same Real values everywhere)

Arbitrage

- Taking advantage of different prices of the same thing by buying the item and then selling it somewhere else.

Hard definition

2.) Equilibrium - LoOP & PPP

Nominal

Summary…

- what is the amount of money do I need to exchange today?

Real

LoOP

PPP

- how many things can I buy with the exchange?

- Ceteris Paribus, Goods should sells for the same price in all markets. ( Real = Nominal)

- Ceteris Paribus, Prices should buy the same number of goods (Nominal = Real)

End of part 1

Thanks!