Transcript Money, Banking, and Financial Markets 2e

Chapter 6
Foreign
Exchange
Markets
PowerPoint Presentation by Charlie Cook
Copyright © 2004 South-Western. All rights reserved.
Fundamental Issues
1. What are foreign exchange markets?
2. What determines exchange rates?
3. What distinguishes nominal and real
exchange rates?
4. What is purchasing power parity, and
is it useful as a guide to movements
in exchange rates?
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6–2
Exchange Rates and the Market for
Foreign Exchange
• Foreign exchange:
 Exchange of currencies issued by different
countries.
• Foreign exchange market:
 A system of private banks, foreign exchange
brokers and dealers, and central banks through
which households, businesses, and governments
purchase and sell currencies of various nations.
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6–3
Foreign Exchange Markets and Spot
Exchange Rates
• Spot market:
 A market for contracts requiring the immediate sale
or purchase of an asset.
• Spot exchange rate:
 The spot-market price of a currency indicating how
much of one country’s currency must be given up in
immediate exchange for a unit of another nation’s
currency.
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6–4
Exchange Rates
Monetary
Unit
U.S.Dollar
Equivalent
Currency per
U.S.Dollar
Euro
Dollar
Real
Dollar
Yuan
0.9653
0.5331
0.3419
0.6322
0.1208
1.0359
1.8758
2.9245
1.5818
8.2767
Denmark
Hong Kong
India
Japan
Krone
Dollar
Rupee
Yen
0.1299
0.1282
0.0205
0.0083
7.6975
7.8000
48.6800
121.0400
Malaysia
Mexico
Ringgit
Peso
0.2632
0.1026
3.8000
9.7475
Country
European Monetary Union
Australia
Brazil
Canada
China,People’s Republic of
SOURCE: :Federal Reserve Bank of New York,August 8,2002.
Table 6–1
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6–5
Demand for the Pound
Figure 6–1
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6–6
An Increase in Currency Demand
Figure 6–2
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6–7
The Currency Supply Schedule
Figure 6–3
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6–8
A Reduction in Currency Supply
Figure 1–4
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6–9
The Equilibrium Exchange Rate
• The equilibrium exchange rate:
 The rate at which the quantity of a currency
demanded is equal to the quantity supplied.
 At the equilibrium exchange rate, the foreign
exchange market clears, meaning that the quantity
of the currency demanded is exactly equal to the
quantity supplied.
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6–10
Foreign Exchange Market Equilibrium
Figure 6–5
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6–11
An Increase in the Equilibrium Exchange Rate
Figure 1–4
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6–12
Currency Valuations
• Overvalued currency:
 A currency whose present market-determined
value is higher than the value predicted by an
economic theory or model.
• Undervalued currency:
 A currency whose present market-determined
value is lower than that predicted by an economic
theory or model.
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6–13
Exchange Rates
• Nominal exchange rate:
 An exchange rate that is unadjusted for changes in
the two nations’ price levels.
• Real exchange rate:
 An exchange rate that has been adjusted for
differences between two nations’ price levels,
thereby yielding the implied rate of exchange of
goods and services between those nations.
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6–14
Purchasing Power Parity
• Purchasing power parity (PPP):
 A condition that states that if international arbitrage
is unhindered, the price of a good or service in one
nation should be the same as the exchange-rateadjusted price of the same good or service in
another nation.

For this reason, economists often refer to the concept
of purchasing power parity as the law of one price.
 Absolute purchasing power is defined as:
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6–15
Spot Exchange Rates
• Sport exchange rate:
 The absolute PPP relationship can rearranged to
solve for the spot exchange rate:
 If absolute PPP holds, however, then S = P/P*, so
the real exchange rate is equal to one:
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6–16
Relative Purchasing Power Parity
• Relative purchasing power parity:
 Relates proportionate changes in exchange rates
to relative changes in countries’ price levels:
 Relative PPP can also be expressed as the
difference between two countries’ inflation rates
(denoted as “”):
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6–17
The Big Mac Index
•Purchasing power parity; local price divided by price in the United States.
†Average of New York,Chicago,San Francisco,and Atlanta.
‡Dollars per pound. §Dollars per euro.
SOURCES:McDonald’s; The Economist.
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Table 6–2
6–18
Currency-per-U.S.-Dollar Exchange Rates and
Relative Values of Currencies of Major U.S.
Trading Partners
(a)
(b)
(c)
(d)
April 2001
April 2002
(a)÷(a) X 100
(b)÷(a) X100
Canadian dollar
1.47
1.57
100%
106.8%
EMU euro
1.08
1.12
100%
103.7%
117.00
105.00
100%
89.7%
Japanese yen
SOURCE: Federal Reserve Bank of New York.
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Table 6–3
6–19