ch13notes - Basic Exchange Rate Concepts Nominal Exchange...

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Basic Exchange Rate Concepts Nominal Exchange Rate currency domestic of unit currency foreign of units = Nom e Real Exchange Rate goods domestic of unit goods foreign of units good foreign of price currency Foreign good domestic of price currency Foreign = = = For Nom P P e e Dollar Appreciation Nominal Appreciation: Dollar buys more units of foreign currency: Nom e Real Appreciation: Sale of domestic goods purchases more foreign goods: e Dollar Depreciation Nominal Depreciation: Dollar buys fewer units of foreign currency: Nom e Real Depreciation: Sale of domestic goods purchases less foreign goods: e Purchasing Power Parity Goods have equal values in each country: 1 = = For Nom P P e e Short-Run Real Exchange Rate Determination While Purchasing Power Parity offers a reasonably satisfactory explanation of long- run trends in nominal exchange rates, financial market conditions are more important for the determination of the equilibrium real exchange rate in the short run. Suppose that some domestic traders are interested in acquiring foreign assets, like foreign stocks or bonds. Such purchases (net of foreign traders' purchases of domestic assets) are referred to as Net Capital Outflow ( NCO ). Net Capital Outflow is the net amount of payments made to foreigners for the purchase of assets, so NCO is also identically equal to the Capital Account Deficit. That is: CA KA NCO = - = We also find it useful to identify NCO as the supply of dollars in the foreign exchange market. To engage in a positive amount of NCO , domestic residents must sell (supply) dollars to buy the foreign currency needed to buy the foreign assets.
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Currency transactions also result from trade in goods. In particular, when foreigners want to buy U.S. goods, they need to exchange their own currency for dollars to make their purchases. We therefore identify net exports ( NX ) as the demand for dollars in the foreign exchange market. The other current account items, net factor payments and net unilateral transfers, also result in a need to demand dollars, but we continue to assume that these two items are approximately zero. Equilibrium in the foreign exchange market occurs when the supply of dollars equals the demand for dollars. How does this equilibration take place? The supply of dollars due to Net capital outflow is determined primarily by financial conditions (factors like savings and investment flows, foreign and domestic real interest rates, and expected
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