ECN 506 Chapter 6: Chapter 6-Money and Banking

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4 Aug 2016
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Chapter 6: Foreign Exchange Markets
The nominal exchange rate (e) is the price of one currency in terms of another.
As depicted in the following figure the South African currency, the rand, fluctuated a lot.
This chapter explores the factors that cause exchange rates to fluctuate.
6.1 Currency Markets and
People exchange currencies to purchase goods and services produced in foreign
countries.
People exchange currencies to purchase foreign assets, called capital outflows.
If they buy stocks in European, the European stock is sold for Euros, must trade dollars
for euros before buying the stock
The Trading Process
The Interbank Market
-large commercial banks that trade currencies for themselves and also act as brokers
-U.S currencies are traded for other currencies
-exchange bank deposits to help with trading
The Retail Market
-for small banks that trade currencies through large banks, transfers funds from your account to
its account
Your Week in Paris
-less expensive to get currency from ATMs
-dollars are deducted from your account based in the interbank rate, must pay a small fee
Measuring Exchange Rates
-exchange rate as the amount of foreign currency that buys one unit of local currency
Changes in Exchange Rates
-appreciation: rise in a currency’s price in terms of foreign currency
-depreciation: fall in a currency’s price in terms of foreign currency
6.2 Why Exchange Rates Matter
Effects of Appreciation
-dollar appreciates, exchange rate rises
Cheaper Imports
-European goods and services becomes less expensive for American consumers
Lower Sales for Domestic Firms
-hurts U.S firms, harder to sell goods and services
-firms whose products compete with imports are hurt
-exporters are hurt
Losses to Holders of Foreign Assets
-reduces the dollar value of these assets
Hedging Exchange Rate Risk
Currency Futures and Hedging
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-firms use currency futures to hedge exchange rate risk
-asset holders also hedge exchange rate risk
Limits to Hedging
-contracts rarely have delivery dates that are more than 6 months
-hedgers can protect themselves against short lived moments, but not changes that last more than
6 months
Real Versus Nominal Exchanges
-The real exchange rate (ε) measures the relative price of domestic and foreign goods.
Ε=eP/P*
-The real exchange rate measures relative prices in different countries and accounts for changes
in the nominal exchange rate and local prices.
-The nominal exchange rate e between the dollar and Europe is expressed in euros per dollar.
Defining the Real Exchange Rate
- The real exchange rate depends on the U.S. price level, P, and the foreign price level, P*.
-The cost of American goods in euros is the nominal exchange rate times the U.S. price
level:cost of American goods in euros = e P
-The cost of European goods in euros = P*.
-The real exchange rate is the ratio of the two costs:
ε = cost of U.S. goods/cost of European goods
ε = e P/ P*
-an economy’s price level is the average of prices of all goods and services
e.g. Assume:
e = 0.8, P = 150, and P* = 100
The real exchange rate is:
ε = (0.8)(150)/100 = 1.2
This means U.S. goods are 1.2 times as costly as European goods.
Which Exchange Rate Matters?
-higher the nominal rate, higher the real rate
-real rate determines the cost of imports, the cost of American goods in Europe and the real
exchange rate
The Trade-Weighted Real Exchange Rate
-twrer: weighted average of a country’s real exchange rate, with weights proportional to levels
of trade
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