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Chapter 10 – Foreign Exchange

Chapter 10

Foreign Exchange

Chapter Overview

This chapter provides an introduction to foreign exchange rates and exchange markets,

helping students to understand how they are determined and what accounts for their

fluctuation over days, months, years, and decades.

Learning Objectives: Establish an understanding of:

1. Nominal and real exchange rates

2. Relationship of exchange rates, the price level, and inflation

3. Currency supply and demand

4. Government intervention in foreign exchange

Important Points of the Chapter

Exchange rates are a key tool that makes international trade possible. Since buyers and

sellers both want to use their own currencies, which are likely to be different, there must

be an exchange of currencies. The exchange rate is the price of one currency in terms of

another. Exchange rates have implications for countries and individuals; long swings or

sudden spikes in exchange rates affect the costs of different goods in different countries.

Application of Core Principles

Principle #4: Markets. Arbitrage is the basis for the law of one price, the idea that

identical products should sell for the same price. If they did not, there would be an

opportunity for someone to profit by purchasing the item where it is cheap and reselling it

where its price is higher, but by doing that, the relative supplies would change and move

the two prices to equality.

Principle #4: Markets. The equilibrium exchange rate is determined by the supply and

demand for dollars. The values of all the major currencies of the world are determined by

market forces.

Principle #1: Time. The real interest rate is the nominal interest rate minus expected

inflation; an increase in real foreign interest rates when U.S. real rates are steady would

result in an increased demand for the foreign bonds and so an increase in the supply of

dollars on the foreign exchange market.

Principle #2: Risk. Changes in the riskiness of U.S. assets compared to foreign assets

will affect the supply of dollars and so the exchange rate.

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Principle #4: Markets. Government officials may intervene in foreign exchange markets

either to fix or to influence the value of the currency.

Teaching Tips/Student Stumbling Blocks

The discussion of the law of one price refers back to arbitrage, as discussed in

Chapter 9. You may wish to review this material to reinforce the concept.

When covering the calculation of the real exchange rate be aware that some

students may be puzzled by the example in the text, pointing out that there are

Starbuck’s coffee shops all over the world. Emphasize that, as used in the

example, Starbuck’s coffee represents “espresso sold in the United States.”

Have your students track the dollar against the yen and the euro by following (and

graphing) the daily movements for a week or two. Students can read the articles

that accompany the foreign exchange tables in The Wall Street Journal each day

and summarize the factors that have been important in the time period under

consideration. This is a good exercise to reinforce the idea presented in the

chapter about how exchange rates are recorded (i.e., in which currency unit) and

to illustrate how and why they fluctuate.

Features in this Chapter

Tools of the Trade: Following Exchange Rates in the News

This section explains how to read the foreign exchange table in The Wall Street Journal.

It points out that the table includes data on forward and spot rates.

Your Financial World: Investing Abroad

Investing abroad can increase diversification and so reduce risk without decreasing the

expected return. So long as the returns on stocks in other countries do not move in lock

step with the U.S. stock market, holding them will reduce the risk of your investment

portfolio. The data does indicate that the returns on other countries’ stock markets do

move independently of the U.S. stock market. The evidence shows that holding foreign

stocks reduces risk without sacrificing returns, despite the risk of exchange rate

fluctuations.

Applying the Concept: The Big Mac Index

The Economist magazine uses the McDonald’s Big Mac to provide a humorous

illustration of purchasing power parity. Twice a year the magazine publishes a table

showing the price of the Big Mac in about fifty countries and uses it to show which

currencies are overvalued or undervalued relative to the U.S. dollar. The Big Mac index

is a clever idea, and works surprisingly well considering that it is based only on one

commodity (that is not tradable), and whose local price depends on costs like wages,

rents and taxes.

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Your Financial World: Don’t Bet on Exchange Rates

Having a good sense of what will happen over the long run doesn’t help much in the short

run; what the experts can’t tell you is when exchange rate movements will occur.

Forward markets do provide forecasts of future exchange rates, but these rates are

typically very close to the current (spot) rates. In the short run, exchange rates are

inherently unpredictable, and betting on them is a bad idea.

Lessons from the Crisis: Currency Risk and Rollover Risk

During the crisis of 2007-2009, banks faced currency risk and rollover risk. When

interbank markets dried up, banks found it difficult to borrow US dollars needed to fund

their dollar loans and securities. When a bank lends on a foreign currency, it typically

borrows in that currency, too. Banks face currency risk if they borrow in one currency

but loan in another. Banks also face rollover risk because loans usually have a longer

maturity than borrowings, and banks face a danger that funding liquidity in the foreign

currency will dry up. In the financial crisis of 2007-2009 the rollover risk facing

internationally active banks became acute and posed a threat to the financial system as a

whole. To limit its credit exposure, the Fed arranged a series of dollar swaps with ten

other countries.

In the News: Foreign Exchange: Neighbors Show Little Appetite for Brazil’s ‘War’

After years of arguing for a freely floating exchange rate ministers in Brazil are operating

a “dirty float” for the real at R$2.00 to R$2.10 per US$1. Loose monetary policy in the

world appreciated many currencies eating away competitiveness of exports and led to

aggressive, protectionist devaluations of the US dollar and other currencies.

Additional Teaching Tools

Almost any day’s issue of The Wall Street Journal is likely to provide an article that will

flesh out the material covered in this chapter. For example, in the June 14, 2010 online

issue, several articles discuss the recent drop in the value of the euro, subsequent

increases and predictions from experts that it will continue to increase.

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Lessons of the Article: Large flows of capital into a small economy can trigger a big

currency appreciation, which threatens its exports and makes it vulnerable to a sudden

reversal of the flows. After 2008, many emerging market economies complained

about capital inflows from advanced economies with low interest rates. As the article

notes, Brazil tried to manage its exchange rate through market interventions such as

taxing capital inflows, but few countries see that as an effective, long‐term strategy.

Chapter 10 – Foreign Exchange

Virtual Tools

Visit The Economist on line for the latest version of the Big Mac index. On January 15,

2004 the magazine also introduced “Lattenomics,” which does a similar analysis (but,

like this text chapter, uses coffee instead of burgers). It is interesting for students to

compare the two and, in particular, to see where they differ. The magazine’s web site is:

http://www.economist.com/

An excellent website which provides foreign exchange data, including graphs can be

found at http://www.x-rates.com. In particular, it allows the user to switch the units of

currency for the exchange rate to illustrate the point made in the chapter (i.e., dollars in

euro versus euro in dollars, etc.). The site also has some educational sections and

forecasts.

For More Discussion

Ask students, “Do exchange rates only matter if you travel?” and be surprised as to how

many of them will answer, “Yes.” How much of what you buy is actually imported?

Give students a sense of the role of imports in their lives by having them read labels

(particularly on clothing) or find out the origins of things they purchase. Discuss the

importance of the value of the dollar in terms of what they buy.

Chapter Outline

I. Foreign Exchange Basics

A. The Nominal Exchange Rate

1. The exchange rate is the price paid in one currency to obtain an amount of

another currency.

2. Exchange rates change every day.

3. A decline in the value of one currency relative to another is called a

depreciation (of the currency whose value is falling); an increase is called an

appreciation (of the currency whose value is rising).

4. When comparing two currencies, if one currency goes up in value relative to

the other, the value of the other currency must go down.

5. Exchange rates can be quoted in units of either currency; for example, as the

number of dollars needed to buy one euro or as the number of euro needed to

buy one dollar.

6. The two prices are equivalent (one is simply the reciprocal of the other) and

there is no rule for determining which way a particular exchange rate should

be quoted.

7. In practice, most rates tend to be quoted in the way that yields a number larger

than one.

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B. The Real Exchange Rate

1. The real exchange rate is the rate at which one can exchange the goods and

services from one country for the goods and services from another country.

2. The real exchange rate is the cost of a basket of goods in one country relative

to the cost of the same basket of goods in another country.

3. To compute the real exchange rate we take the dollar price of a good in the

United States divide it by the dollar price of the same good in another country

(the dollar price in the other country is found by taking the local price and

multiplying by the nominal exchange rate).

4. Whenever the real exchange rate as calculated above is greater than one (the

real exchange rate has no units), foreign products will seem cheap.

5. The real exchange rate is more important than the nominal exchange rate

because it measures the relative price of goods and services across countries,

telling us where things are cheap and where they are expensive.

6. The real exchange rate is the guiding force behind international transactions.

7. The competitiveness of U.S. exports depends on the real exchange rate; if it

appreciates, U.S. exports become less competitive and if it depreciates they

become more competitive

C. Foreign Exchange Markets

1. The daily volume of foreign exchange transactions is enormous.

2. Because of its liquidity, the U.S. dollar is one side of roughly 90 percent of the

currency transactions that occur.

3. The most important center for such transactions is London; other significant

foreign exchange trading occurs in New York, Tokyo, Singapore, Frankfurt,

and Zurich.

II. Exchange Rates in the Long Run

A. The Law of One Price

1. The law of one price is the starting point for understanding how long-run

exchange rates are determined.

2. The law is based on arbitrage, the idea that identical products should sell for

the same price.

3. If the same good did not sell for the same price in two places there would be

an opportunity for someone to profit by purchasing the item where it is cheap

and reselling it where its price is higher, but by doing that, the relative

supplies would change and move the two prices to equality.

4. The law of one price fails almost all the time; the same commodity or service

sells for vastly different prices in different countries as a result of

transportation costs, taxes, differences in technical specifications, differences

in tastes, and that fact that some things simply cannot be traded (like haircuts).

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B. Purchasing Power Parity

1. Even with its obvious flaws the law of one price is extremely useful in

explaining the behavior of exchange rates over long periods, like ten or twenty

years.

2. Extending the law from a single commodity to a basket of goods and services

results in the theory of purchasing power parity (PPP), which means that one

unit of U.S. domestic currency will buy the same basket of goods and services

anywhere in the world.

3. PPP implies that the real exchange rate is always equal to one.

4. PPP implies that when prices change in one country but not in another the

exchange rate should change as well.

5. Changes in exchange rates are therefore tied to differences in inflation from

one country to another; the currency of a country with high inflation will

depreciate.

6. Over weeks, months, and even years, nominal exchange rates can deviate

substantially from the levels implied by purchasing power parity. Such

short-term movements have other explanations

7. A current market rate that deviates from purchasing power parity results in a

currency being considered undervalued or overvalued.

III. Exchange Rates in the Short Run

A. The Supply of Dollars

1. Someone who wants to exchange dollars for another currency supplies them

to the foreign exchange markets.

2. The two reasons for such an exchange would be to purchase foreign goods

and services or to invest in foreign assets.

3. The more valuable the dollar, the cheaper foreign goods, services, and assets

are, and the higher will be the supply of dollars in the foreign exchange

market.

B. The Demand for Dollars

1. Foreigners who want to purchase American-made goods, assets, or services

need dollars to do so and so represent the demand for dollars.

2. The cheaper the dollar the more attractive such goods, assets, or services are

and the higher the demand for dollars with which to buy them.

C. Equilibrium in the Market for Dollars

1. Equilibrium in the market for dollars occurs where the supply and demand are

equal.

2. Fluctuations in the values of currencies are the result of shifts in supply or

demand.

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D. Shifts in the Supply and Demand for Dollars

1. Shifts in supply: the supply of dollars will increase (i.e., the supply curve

shifts right) the more Americans want to import goods and services from

abroad or the higher their preference for foreign stocks and bonds. These can

result from:

a. An increase in Americans’ preference for foreign goods.

b. An increase in the real interest rate on foreign bonds.

c. An increase in American wealth.

d. A decrease in the riskiness of foreign investments relative to U.S.

investments.

e. An expected depreciation of the dollar.

2. Demand: the demand will increase (i.e., the demand curve shifts right) if

there is an increased desire by foreigners to buy American-made goods and

services or to invest in U.S. assets. This can be the result of:

a. An increase in foreigners’ preference for American goods.

b. An increase in the real interest rate on U.S. bonds.

c. An increase in foreign wealth.

d. A decrease in the riskiness of U.S. investments relative to foreign

investments.

e. An expected appreciation of the dollar.

3. Explaining exchange rate movements: the supply and demand model helps to

explain short-run movements in currency values.

4. Shifts in supply and demand can both occur at the same time, and the

movement of the exchange rate will depend on which effect is stronger (i.e.,

which shift is bigger).

IV. Government Policy and Foreign Exchange Intervention

1. Government officials can intervene in foreign exchange markets in several

ways.

2. Some countries adopt a fixed exchange rate and act to maintain it at a level of

their choosing.

3. Large industrialized countries generally allow markets to determine the

exchange rate but may intervene at times to influence the value.

4. When policymakers buy or sell currency to affect demand or supply it is

called foreign exchange intervention.

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Appendix: Interest Rate Parity and Short-Run Exchange Rate Determination

1. Another way to think about the determinants of exchange rates over the short

term is to focus on them from an investor’s point of view.

2. If the bonds issued in different countries are perfect substitutes for each other,

then arbitrage will equalize their returns. Since investing abroad means

exchanging currencies, the result is a relationship among domestic interest

rates, foreign interest rates, and the exchange rate.

3. The interest parity condition (derived in this appendix) tells us that the U.S.

interest rate equals the rate on a foreign bond minus the dollar’s expected

appreciation.

4. If the interest parity condition did not hold, people would have an incentive to

shift their investments until it did.

5. Knowing current U.S. and foreign interest rates allows us to calculate what the

exchange rate should be.

6. The current value of the dollar will be higher the higher U.S. interest rates are,

the lower foreign interest rates are, and the higher the expected future value of

the dollar is.

Terms Introduced in Chapter 10

appreciation (of a currency)

Big Mac index

British pound

demand for dollars

depreciation (of a currency)

euro

law of one price

nominal exchange rate

overvalued currency

purchasing power parity (PPP)

real exchange rate

supply of dollars

undervalued currency

yen

yuan

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Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

U.S./euro foreign exchange rate EXUSEU

Japan/U.S. foreign exchange rate EXJPUS

U.S./U.K foreign exchange rate EXUSUK

Brazil/U.S. foreign exchange Rate EXBZUS

China/U.S. foreign exchange rate EXCHUS

Mexico/U.S. foreign exchange rate EXMXUS

South Korea/U.S. foreign exchange rate EXKOUS

Switzerland/U.S. Foreign Exchange Rate EXSZUS

Trade‐weighted U.S. dollar index: broad TWEXBMTH

Trade‐weighted U.S. dollar index: major currencies TXEXMMTH

Real trade‐weighted U.S. dollar index: broad TWEXBPA

Real trade‐weighted U.S. dollar index: major currencies TWEXMPA

Lessons of Chapter 10

1. Different areas and countries of the world use different currencies in their

transactions.

a. The nominal exchange rate is the rate at which the currency of one country can be

exchanged for the currency of another.

b. A decline in the value of one currency relative to another is called depreciation.

c. An increase in the value of one currency relative to another is called appreciation.

d. When the dollar appreciates relative to the euro, the euro will have depreciated

relative to the dollar.

e. The real exchange rate is the rate at which the goods and services of one country

can be exchanged for the goods and services of another.

f. Over $1 trillion is traded every day in markets run by brokers and foreign

exchange dealers.

2. In the long run, the value of a country’s currency is tied to the price of goods and

services in that country.

a. The law of one price states that two identical goods should sell for the same price,

regardless of location.

b. The law of one price fails because of transportation costs, differences in taxation

and technical specifications, and the fact that some goods cannot be moved.

c. The theory of purchasing power parity applies the law of one price to

international transactions; it states that the real exchange rate always equals one.

d. Purchasing power parity implies that countries with higher inflation than other

countries will experience exchange rate depreciation.

e. Over decades, exchange rate changes are approximately equal to differences in

inflation, implying that purchasing power parity holds.

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3. In the short run, the value of a country’s currency depends on supply and demand for

the currency in foreign exchange markets.

a. When people in the United States wish to purchase foreign goods and services or

invest in foreign assets, they must supply dollars to the foreign exchange market.

b. The more foreign currency that can be exchanged for one dollar, the greater will

be the supply of dollars. That is, the supply curve for dollars slopes upward.

c. Foreigners who wish to purchase American-made goods and services or invest in

U.S. assets will demand dollars in the foreign exchange market.

d. The fewer units of foreign currency needed to buy one dollar, the higher the

demand for dollars. That is, the demand curve for dollars slopes downward.

e. Anything that increases the desire of Americans to buy foreign-made goods and

services or invest in foreign assets will increase the supply of dollars (shift the

supply curve for dollars to the right), causing the dollar to depreciate.

f. Anything that increases the desire of foreigners to buy American-made goods and

services or invest in U.S. assets will increase the demand for dollars (shift the

demand curve of dollars to the right), causing the dollar to appreciate.

4. Some governments buy and sell their own currency in an effort to affect the exchange

rate. Such foreign exchange interventions are usually ineffective.

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