# OHCh20 - Chapter 20: The Foreign Exchange Market 1 Foreign...

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Chapter 20: The Foreign Exchange Market

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1 Foreign Exchange Market the exchange rate: the price of one cureency in terms of naother Figure 1 1.1 What Are Foreign Exchange Rates? spot transactions - the spot exchange rate forward transactions - the fowared exchange rate
appreciation of a curenncy depreciation of a currency 1.2 Why Are Exchange Rates Important? When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries. Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.

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2 Exchange Rates in the Long Run 2.1 Law of One Price Imagine that two counries prodcude an identical good (say steel) and that there are no transaction costs and trade barriers. Suppose that American steel costs \$100 per ton. Suppose that European steel costs 74 euro. Suppose that the exchange rate is 1.351 dollars per euro. Then the European steel costs \$100 (1 : 351 74 ± = 100).
2.2 Theory of Purchasing Power Parity The theory of purchasing power parity (PPP) applies the law of one price to national price levels. Suppose that the price level in the U.S. is P . Suppose that the price level in Eurpoe is P F : Suppose that the exchange rate is E (dollar/euro). Then the law of one price of the U.S. average good and the Eurpoean average good tells us that

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EP F = P (1) (after we adjust units of price levels in two countries to be comparable). Dividing both sides by P F , we obtain E = P P F (2) So the exchange rate should move with relative national price levels. If the European price level rises 10% relative to the U.S. price level, then the dollar will appreciate against the euro. See Figure 2.
2.3 Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates Some goods and services are not traded across borders: housing, land,

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## This note was uploaded on 07/17/2008 for the course ECON 520 taught by Professor Ogaki during the Spring '07 term at Ohio State.

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OHCh20 - Chapter 20: The Foreign Exchange Market 1 Foreign...

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