Exchange rate & international trade

University of KhartoumHigh graduate Faculty

Foreign Exchange Rate & International Trade

Prepared by : Elhadi Mustafa M. E. Tabar

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OUT LINE INTRODUCTION Exchange Rates and International Transactions Nominal vs. Real Exchange Equilibrium Exchange Rates International Trade, Exchange Rates, and AD The purchasing Power Parity Theory

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INTRODUCTION

Currencies are bought and sold in the foreign exchange market, the largest market in the world. The exchange of goods, services, and assets among consumers, firms, or governments in different countries requires an exchange of currencies. The FX market is involved when US tourists fly to Mexico, a Sudanese importer buys a million tons of US wheat ,or a California electronics firm buys components from Malaysia. There are billions of international transactions daily, all involving the FX market one way or another. Each transaction at some point involves trading one currency for another, exchanging one medium of exchange for another.

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Exchange Rates and International Transactions:

Each country has a currency in which the prices of goods and services are quoted the Sudanese pounds in Sudan , the dollar in the United States, the euro in Germany, the pound sterling in Britain, the yen in Japan, and the peso in Mexico, to name just a few. Exchange rates play a central role in international trade because they allow us to compare the prices of goods and services produced in different countries. A consumer deciding which of two American cars to buy must compare their dollar prices, for example, $39,000 (for a Lincoln Continental) or $19,000 (for a Ford Taurus). But how is the same consumer to compare either of these prices with the 3,000,000 yen (¥3,000,000) it costs to import a Subaru from Japan? To make this comparison, he or she must know the relative price of dollars and yen.

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Exchange Rates and International Transactions(cont…)

• Interbank trading Foreign currency trading among banks It accounts for most of the activity in the foreign exchange

market.

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The Foreign Exchange MarketJust as other prices in the economy are determined by the interaction of buyers and sellers, exchange rates are determined by the interaction of the households, firms, and financial institutions that buy and sell foreign currencies to make international payments. The market in which international currency trades take place is called the foreign exchange market.

The Actors• The major participants in the foreign exchange market are:

Commercial banks International corporations Nonbank financial institutions Central banks

Exchange Rates and International Transactions(cont…)

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Exchange Rates and International Transactions(Cont..)

Characteristics of the Market• The worldwide volume of foreign exchange trading is enormous,

and it has ballooned in recent years.• New technologies, such as Internet links, are used among the

major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

• The integration of financial centers implies that there can be no significant arbitrage.

The process of buying a currency cheap and selling it dear.

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• Vehicle currency A currency that is widely used to denominate international

contracts made by parties who do not reside in the country that issues the vehicle currency.

• Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.

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Spot Rates and Forward Rates• Spot exchange rates

Apply to exchange currencies “on the spot”• Forward exchange rates

Apply to exchange currencies on some future date at a renegotiated exchange rate

• Forward and spot exchange rates, while not necessarily equal, do move closely together.

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Foreign Exchange Swaps• Spot sales of a currency combined with a forward repurchase of

the currency.• They make up a significant proportion of all foreign exchange

trading.

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Futures and Options• Futures contract

The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.

• Foreign exchange option The owner has the right to buy or sell a specified

amount of foreign currency at a specified price at any time up to a specified expiration date.

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Nominal vs. Real Exchange Nominal Exchange Rates are value of one currency in terms of

another. however, measure purchasing power, or Real Exchange Rate. Example: Suppose you can exchange $1 for 5.9 Sudanese pounds (SDG).Though 5.9SDG seems a large number, but in Khartoum a burger may cost 10SDG.In other words, purchasing power of SDG is very less as compared to that of dollar.

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Nominal vs. Real Exchange(cont..) Let a burger cost $1 in U.S. and 10SDG in Sudan, $1 buys 5.9 SDG on foreign-exchange markets. We can find real exchange rate by comparing the cost of burgers in

dollar terms . Let EX = nominal exchange rate in foreign currency per dollar. Pf = foreign currency price of goods in foreign country. P = domestic-currency price of domestic goods. EXr = real exchange rate.

Pf

pExEXr

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Nominal vs. Real Exchange(cont..) Countries produce many different goods. Real Exchange Rate computed from price indexes, which compare

price of basket of goods in one country with price of it in another. The relationship between nominal and real exchange rates depends

on rates of inflation in two countries. We can calculate % change in real exchange rate as % change in

numerator of previous equation minus the % change in denominator.

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Nominal vs. Real Exchange(cont..)

The equation shows % change in nominal exchange rate has two parts:• % change in real exchange rate.• Difference in foreign and domestic inflation rate.

If exchange rate rises:• Rise in real exchange rate.• Or higher foreign inflation rate, or maybe both.

If exchange rate falls:• Fall in real exchange rate.• Or higher domestic inflation rate, or maybe both.

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Equilibrium Exchange RatesI. SETTING THE EQUILIBRIUM

A. Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.

B. How Sudanese Purchase Chinese Goods1. Foreign Currency Demand-derived from the demand for foreign country’s goods, services, and financial assets. e.g. The demand for Chinese goods by Sudanese 2. Foreign Currency Supply:

a. derived from the foreign country’s demand for local goods.

b. They must convert their currency to purchase.

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Equilibrium Exchange Rates (cond..)

3. Equilibrium Exchange Rate:occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

C. How Exchange Rates Change1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.2. Home Currency Depreciation:

a. Foreign currency becomes more valuable than the home currency.b. Conversely, the foreign currency’s value has appreciated against the home currency.

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Equilibrium Exchange Rates (cond..)

3. Calculating a Depreciation:

Currency Depreciation

where e0 = old currency value

e1 = new currency value

Note: Resulting sign is always negative

Currency Appreciation

1

10

e

ee

0

01

e

ee

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Equilibrium Exchange Rates (cont…)

EXAMPLE: US$ AppreciationIf the dollar value of the dm goes from $0.64 (e0) to $0.68 (e1), then the dm has appreciated by

= (.68 - .64)/ .64 = 6.25%EXAMPLE: US$ Depreciation

We use the first formula,(e0 - e1)/ e1

substituting(.64 - .68)/ .68 = - 5.88%

which was the US$ depreciation.

0

01

e

ee

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Equilibrium Exchange Rates (cont…)D. FACTORS AFFECTING EXCHANGE RATES:

Inflation rates: Higher domestic inflation means less demand for local goods (decreased

supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

Interest rates: Higher domestic (real) interest rates attract investment funds causing a

decrease in demand for foreign currency and an increase in supply of foreign currency.

Economic growth: Stronger economic growth attracts investment funds causing a decrease

in demand for foreign currency and an increase in supply of foreign currency.

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Political & economic risk: Higher political or economic risk in the domestic country

results in increased demand and reduced supply of foreign currency.

Changes in future expectations: Any improvement in future expectations regarding the

domestic currency or economy will decrease the demand for foreign currency and increase the supply of foreign currency.

Government intervention: Maintain weak currency to improve export competitiveness.

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exports and imports multiplier effects on GDP.

Booms or recessions in one country affect other countries through international trade.

International Trade, Exchange Rates, and AD

International Trade, Exchange Rates, and AD (CONT..)

Relative Prices, Exports, and Imports• relative prices of a country’s exports

that country’s net exports its real GDP

The Effects of Higher Net Exports

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Pri

ce L

evel

Real GDP

D0

D0

S

S

D1

D1

A

B

International Trade, Exchange Rates, and AD

The Effects of Changes in Exchange Rates• A currency depreciation

relative prices of the country’s goods in international trade

its net exports and AD• A currency appreciation has the opposite effects.

Exchange Rates and Home Currency Prices

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

The Effects of Exchange Rate Changes on AD

D2

D2

D1

D1

S

S

E1

(depreciation)

(appreciation)

D0

D0

Pri

ce L

evel

Real GDP

E0

E2

Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets

Closed Economy: one that does not trade with other nations in either goods or assets

Aggregate Supply in an Open Economy

Aggregate Supply in an Open Economy(CONT..)

A currency depreciation • price of foreign goods• AS shifts inward

A currency appreciation has the opposite effects.

The Effects of Exchange Rate Changes on AS

(depreciation) S0

S0

(appreciation)

D

D S1

S1

S2

S2

E2

E0

E1

Pri

ce L

evel

Real GDP

Currency depreciation • AD and AS• Net result is inflation• Probably also expansionary

Impact on AD dominates impact on AS A currency appreciation has the opposite

effects.

The Macroeconomic Effects of Exchange Rates

The Effects of a Currency Depreciation

S0

S0 D0

D0

E

Pri

ce L

evel

Real GDP

S1

S1

D1

D1

A

The Effects of a Currency Appreciation

S0

S0

S2

S2

D2

D2

B

D0

D0

E

Pri

ce L

evel

Real GDP

The Macroeconomic Effects of Exchange Rates

Interest Rates and International Capital Flows• interest rates

Attracts foreign capital flows Appreciates the currency net exports GDP

• interest rates has the opposite effects

The purchasing Power Parity Theory

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Purchasing Power Parity (PPP)

When a country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the high-inflation country’s currency.

Purchasing power parity (PPP) theory attempts to quantify this inflation – exchange rate relationship.

Interpretations of PPPThe absolute form of PPP is an extension of

the law of one price. It suggests that the prices of the same products in different countries should be equal when measured in a common currency.

The relative form of PPP accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar.

Rationale behind PPP Theory

Suppose U.S. inflation > U.K. inflation.Þ U.S. imports from U.K. and

U.S. exports to U.K.Þ Upward pressure is placed on the £ .

This shift in consumption and the £’s appreciation will continue until

in the U.S.: price U.K. goods price U.S. goods

in the U.K.: price U.S. goods price U.K. goods

Derivation of PPPAssume that PPP holds. Over time, inflation occurs and the exchange rate adjusts to maintain PPP:Ph Ph (1 + I h )

where Ph = home country’s price indexI h = home country’s inflation rate

Pf Pf (1 + If ) (1 + e f )where Pf = foreign country’s price index

If = foreign country’s inflation ratee f = foreign currency’s % D in value

Derivation of PPP

Ih > If ef > 0 i.e. foreign currency appreciatesIh < If ef < 0 i.e. foreign currency depreciatesExample: Suppose IU.S. = 9% and IU.K. = 5% .

Then eU.K. = (1 + .09 ) – 1 = 3.81% (1 + .05 )

PPP holds Ph = Pf andPh (1 + I h ) = Pf (1 + If ) (1 + e f )

Solving for ef : ef = (1 + Ih ) – 1

(1 + If )

Simplified PPP RelationshipWhen the inflation differential is small, the PPP relationship can be simplified as

e f I h – If

Example: Suppose IU.S. = 9% and IU.K. = 5% .

Then e U.K. 9 – 5 = 4%

U.S. consumers: PU.S. = IU.S. = 9% PU.K. = IU.K. + e U.K. = 9%

U.K. consumers: PU.K. = IU.K. = 5% PU.S. = IU.S. – e U.K. = 5%

Graphic Analysis of Purchasing Power Parity

PPP line

Inflation Rate Differential (%)home inflation rate – foreign inflation rate

% D in the foreign currency’s spot rate- 2

- 4

2

4

1 3- 1- 3

Increased purchasing power of foreign goods

Decreased purchasing power of foreign goods

A

B

C

D

Why PPP Does Not Occur

PPP does not occur consistently due to: confounding effects

• Exchange rates are also affected by differences in inflation, interest rates, income levels, government controls and expectations of future rates.

a lack of substitutes for some traded goods

PPP in the Long Run PPP can be tested by assessing a “real”

exchange rate over time.• The real exchange rate is the actual exchange

rate adjusted for inflationary effects in the two countries of concern.

If the real exchange rate follows a random walk, it cannot be viewed as being a constant in the long run. Then PPP does not hold.

Exchange rate & international trade

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