What determines the value of a dollar?
Nominal exchange rate: the rate at which you can exchange one currency for
“e” – how much foreign currency you can purchase with $1 Canadian dollar
“e” goes up - $CAD dollar appreciates (Canadian dollar is getting stronger, can
buy more) (when shopping abroad, can buy more units of the foreign currency, can
buy more stuff) (trying to export are worse off)
“e” goes down - $CAD dollar depreciates (Canadian dollar is getting weaker)
(trying to export are better off)
real exchange rate: the rate at which you can exchange goods and services between
e as the number of units per foreign dollar (us domestic here, 4 x 10 / 20 = 2) A.
2 Mexican bushels of wheat per US bushel of wheat
eP = 10 pesos/$ x $4/US bushel = 10 x 4 pesos x $ . = 2 mex bushels of wheat
P* 20 pesos/Mex bushel 20 $ us bushel US bushel of wheat
How are exchange rates determined?
Purchasing-power parity (PPP): a unit of currency should buy the same quantity
of goods in any country (law of one price (market prices adjusting to bring quantity
demanded in line with quantity supplied) even though there’s a national border
between the buyer and the seller)
People should buy where the price is low and sell where price is high until either
the prices of exchange rates change so that they are the same