Exchange Rates

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 1 / 16
Key Questions

What are nominal and real exchange rates?

How are nominal and real exchange rates determined?

How are exchange rates related to net exports?

How are exchange rates linked to international asset markets?

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Nominal exchange rates and exchange rate systems

The nominal exchange rate, enom is the amount of foreign currency

which can be purchased with a unit of the domestic currency

Flexible (or oating) exchange-rate system

,! enom determined by supply & demand in foreign exchange markets
,! exchange rates adjust continuously

Fixed-exchange-rate system
,! enom set at o cially determined levels
,! maintained by the commitment of central bank to buy and sell their
own currency

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The real exchange rate
The real exchange rate is the amount of foreign goods one could
exchange for a given amount of domestic goods
,! tells us how cheap foreign goods are in terms of Canadian goods
,! or how expensive Canadian goods are in terms of foreign goods

It is based on price indices of baskets of goods and is given by

enom P
e=
PFor
where

PFor = price of foreign goods, in units of the foreign currency

P = price of domestic goods, in units of domestic currency

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Appreciation and depreciation

Nominal depreciation (enom falls)

,! a dollar buys less units of foreign currency, it becomes weaker

Nominal appreciation (enom rises)

,! a dollar buys more units of foreign currency, it becomes stronger

These terms are associated with exible exchange rates.

,! the xed-exchange rate equivalents are devaluation and revaluation

A real appreciation is an increase in the real exchange rate

,! the same quantity of domestic goods can be traded for more foreign
goods

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Purchasing power parity (PPP) hypothesis

PPP: the same basket of goods in each country should have the same
price in terms of the same currency:

e=1

,! ignores transportation and transaction costs

PPP implies that:

PFor
enom =
P

PPP holds only in the very long-run.

Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 6 / 16
Relative PPP (RPPP)
The growth in the real exchange rate is
e enom P PFor
= +
e enom P PFor
Re-arranging we get
enom e
= + For
enom e

e
Relative PPP implies that e = 0 so that

enom
= For
enom
,! a weaker implication than PPP that holds on average

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The real exchange rate and net exports

The real exchange rate:

,! the rate at which domestic goods can be traded for foreign goods
,! aects a countrys net exports

The higher is the real exchange rate

,! the cheaper are foreign goods in terms of Canadian goods
,! the lower are a countrys net exports.

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Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 9 / 16
How exchange rates are determined

People demand dollars (national currency) to buy Canadian goods,

real and nancial assets.
,! the demand curve is downward sloping

People supply dollars (national currency) to buy foreign goods, real

and nancial assets
,! the supply curve is upward sloping.

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Eects of changes in income and export quality

When domestic income rises, imports increase and NX falls.

,! the domestic currency depreciates, enom falls

When foreign income rises exports increase and NX rises.

,! the domestic currency appreciates, enom rises

When the quality of Canadian goods increases

,! foreigners demand more of our goods
,! the domestic currency appreciates, enom rises

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Eects of changes in real interest rates

If the domestic countrys real interest rate rises

,! its real and nancial assets are more attractive
,! the demand for domestic currency increases
,! the exchange rate appreciates (enom rises).
,! NX decline

If the foreign countrys real interest rate rises

,! the supply of domestic currency increases
,! the exchange rate depreciates (enom falls).
,! the domestic countrys NX rise.

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Exchange rates and international asset markets
Financial investment decisions depend on
,! foreign nominal interest rate, iFor , relative to the domestic rate, i
,! expected changes to the exchange rate

The gross nominal rate of return on a foreign bond is given by

enom
(1 + iFor ) f
enom
f
where enom = expected future value of enom

The nominal rate of return on a foreign bond is well-approximated by

enom
f
iFor
enom

where enom
f f
= enom enom is the expected nominal appreciation
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Macroeconomic Theory I (ECON222) Exchange Rates & Business Cycles Fall 2017 14 / 16
International asset market equilibrium

International arbitrage ) dierences in returns cannot persist for long

Equilibrium in international asset markets implies

enom
1+i = f
(1 + iFor )
enom

This can be well-approximated by

enom
f
i = iFor
enom

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Real interest rate parity

If RPPP is expected to hold on average, then

enom
f
= eFor e
enom
It follows that
i e = iFor eFor

Thus, asset market equilibrium and RPPP ) real interest parity

r = rFor

,! a simplifying assumption which ignores exchange rate risk,

transactions costs and taxes

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