External

7 Linkages
How is the exchange
rate determined?

DAMIEN KING
University of the West Indies, Jamaica
Why does the exchange rate
?
keep rising?
What effect does that
?
depreciation have on all of us?

2
 Nominal and Real Exchange
Outline 1Rates
Balance of Payments & the
2Market for FX

3
Purchasing Power Parity

3
Nominal and Real
Exchange Rates

4
 Nominal
Exchange Rate
The price of one
countrys currency in
terms of another

5
Currency Depreciation

6
Real Exchange
Rate
The price of one
countrys products in
terms of another
countrys

7
Real Exchange Rate

How many local

chips does it
take to buy a
foreign
What beer?
is the real
price?
9
Real Exchange Rate

? ? ?
Price of a Exchange Price of a
M$1.5
chip in M$3
Rate: US$1
beer in
Malaysia Malay/US USA

10
 Real Exchange Rate
Foreign
Price
Increase

US$2
M$1.5 M$3 US$1

Relatively Relatively
less = more
valuable valuable 11
 Real Exchange Rate
Foreign
Price
Increase

US$2
M$1.5 M$3 US$1

Relatively Relatively
less = more
valuable valuable 112
 Real Exchange Rate
Nominal
Ringgit
Depreciatio
n

M$4.5
M$1.5 M$3 US$1

Relatively Relatively
less = more
valuable valuable 113
 Real Exchange Rate
Local
Price
Increas
e

M$2
M$1.5 M$3 US$1

Relatively Relatively
more = less
valuable valuable 114
Real Exchange Rate

compares
the relative
cost of local
and foreign
goods
115
 Foreign
Nominal
Price
Exch Rate
Level

Real E x P*
Exchang =
e Rate
P
Local
Price
Level
16
 Cost of
foreign goods,
locally
Real E x P*
Exchang =
e Rate
P Cost of
domestic
goods

17
 M$3 US$1
US$2

Real E x P* 4
Exchang = =2
e Rate
Depreciat P Foreign
goods more
ion expensive
M$1.
5
18
 M$3 US$1

Real E x P* 1
Exchang = =2
Foreign
e Rate
Appreciat P goods
ion cheaper
M$1.
M$2
5
19
 Real E x P*
Exchang = = Foreign
e Rate
Appreciat P goods
cheaper
ion

20
 More
expensi
ve

Cheaper

Imports

HOME FOREIGN
21
 More
expensi
ve

Cheaper

Exports

HOME FOREIGN
22
A rise in the real
exchange rate (a
real depreciation)
causes imports to
fall and exports to
23
24
160

140

120
Real
100

80
Exchan
60

40
ge Rate
20

25
The Balance of
Payments and the
Market for Foreign
Exchange

28
 External Links
Goods Services Transfers FDI Portfolio NIR

Manufacture Financial Fac. Income Buildings Stocks Official

s Shipping Profits Land Bonds
Crops Tourism Remittances Equipment Accounts
Minerals

29
 Balance of
Payments
An accounting of all
payments that cross a
countrys borders
Classified by direction and category

30
31
 Balance of Payments
Goods Services Transfers FDI Portfolio NIR

+ Exports + Exports + Remittances + FDI

Imports Imports K outflows
Trade Bal. Services Bal.

Goods & Svcs Bal + Remittances Foreign Investment + NIR

Current Account Capital Account

32
 FX Demand FX Supply

+ Exports + Exports + Remittance + FDI

Imports s K
Imports outflows

33
 FX Demand FX Supply
Imports Exports
K outflows Remittances
Real Exchange Rate FDI
The
Market
for
Foreign
Exchange
Foreign Exchange

34
 FX Demand FX Supply
Imports Exports
K outflows Remittances
Real Exchange Rate FDI
The
Market
for
Foreign
Exchange
Foreign Exchange

35
 FX Demand FX Supply
Imports Exports
K outflows Remittances
Real Exchange Rate FDI
The
Market
for
Foreign
Exchange
Foreign Exchange

36
 FX Demand FX Supply
Imports Exports
K outflows Remittances
Real Exchange Rate FDI An Increase
in
Remittance
s

Foreign Exchange

37
 Remittances
Exch
Rate
An Increase
Imports in
Remittance
=
Exports
s
K-outflows FDI

Outflows Inflows
38
 FX Demand FX Supply
Imports Exports
K outflows Remittances
Real Exchange Rate FDI
A Rise in
the Rate of
Interest

Foreign Exchange

39
 Loanable Funds Market Foreign Exchange Market
Real Rate of Interest
Lenders FX Demand FX Supply

Real Exchange Rate

Borrower
Desired
s Inv. Dom. Sav. Imports Exports
+ For. Sav. K outflows Remittances
Fiscal Def. FDI

Investment Funds Foreign Exchange

Fiscal More Lower Capital Exchange Trade

Depreciatio
Deficit Credit Interest Outflow n Deficit
40
Purchasing
Power Parity
The Nominal Exchange
Rate in the Long Run

41
150

Nominal
Exchange
15

2 Rate:
0
J$/US$

42
 Arbitrage
The practice of exploiting
price differences between
markets for profit

43
 $140
$120
$
$$

Ba na
$120

nas
$100

44
 Law of One Price
A commodity should sell for
the same price in all
accessible locations
taking account of real differences
in value in the two locations

45
Guess the exchange rate

L105 L7 = B$1 B$15

46
Purchasing Power
Parity
A given amount of money
should buy the same
quantity of commodities
in each country

47
Suppose PPP does not hold.

Suppose
L10
buy = B$1
@ L10 = B$1
105
LB$10.5 sell B$15
L B$
appreciate depreciate

48
 Real Exchange Rate
Demand for Supply of
Foreign Foreign
Exchange Exchange

Exchange
Rate in
L10
L7
PPP the Long
Run
Foreign Exchange (=B$)

49
How to Calculate PPP

L105

L7=B$1 E PPP
=
B$15

50
How to Calculate PPP

P252

P2.10 = TT$1 E
PPP
=
$120

51
 What is PPP good for?
P2.50
P2.40
P2.30 P252
P2.20
P2.10 = TT$1 E
PPP
=
P2.00
P1.90 $120
P1.80
P1.70 52
Jamaican dollar devalues

53
Why does the exchange rate keep rising?

high
inflation
E E PPP
=
Low
inflation
54
150

Actual
Exchange
Nominal
Exchange
15 Rate

PPP
2
Exchange
Rate Rate:
0
J$/US$

55
 The real exchange rate is the real price (in
1domestic goods) of foreign products
A real depreciation discourages imports
2and stimulates exports
Economies are linked through
3commodities, transfers, and assets
The real exchange rate adjusts to clear
4imbalances between inflows and outflows
Purchasing power parity explains the
5behaviour of the nominal exchange rate
56