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# ch13 - Chapter 13 Exchange Rates and the Foreign Exchange...

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Chapter 13: Exchange Rates and the Foreign Exchange Market Topics: Exchange Rates Foreign exchange market Asset approach to exchange rates Interest Rate Parity Conditions 1. Definitions a) Definition of exchange rate : price of one currency in terms of another. The conventional way of reporting this in economics is home currency per foreign. In the U.S. this is \$ per foreign currency. For example, it may take \$0.90 to buy one European euro (\$/euro). This is the convention in economics and will be used in this class. Sometimes you will hear quoted the other way around, often called European terms. i.e.: 1.11 euro/\$. b) Exchange rates are important for trade because they allow you to compare the cost of imports to that of domestic goods in common terms. Example: Consider the Mercedes: suppose the going price is 100 thou DM in Germany and 100 mil Italian Lira. Would Germans flock to Italy to buy Mercedes cars? It depends on the exchange rate - comparing DM and Lira is comparing apples and oranges. DM/Lira exchange rate yesterday was just about .001. 100 mil L * (.001 DM/L) = 100 thou DM. So 100 mil Lira is about the same as 100 thou DM, and so the auto price is about the same. We could also do this in reverse. How did I find the DM/L? The e-rate is often only given in terms of \$ /pound or \$/DM. You can divide one by other to find the e-rate you want. In this case: \$/L is .00065 and \$/DM is .64, so DM/L = (\$/L) / (\$/DM) = .001, where the \$s cancel out. Example pp. 325-7. c) The way we conventionally define the e-rate can also make it confusing to talk about changes in the rate, which we call appreciation or depreciation. A currency is considered to have appreciated relative to another currency if it has grown stronger relative to the other currency. A currency is considered to have depreciated relative to another currency if it has grown weaker relative to the other currency. Suppose the DM/L rate changed from .001 to .0009; we would say that the Lira had depreciated relative to the DM. Or we could say the DM appreciated relative to the L. Note that this can be confusing. Given how we define the German exchange rate as DM/L, if this gets lower, we call this an appreciation in the DM. It takes fewer DM to buy any given amount of lira, so the DM has grown stronger.

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Suppose the e-rate changed as described, but the domestic currency prices of a Mercedes didn’t change right away. Then while the German price of the Mercedes is 100,000 DM, the Italian price would be only 90,000 DM. Germans would go and buy Mercedes in Italy to resell them in Germany. A depreciation (appreciation) of a country’s currency makes its goods cheaper (more expensive) for foreigners, and makes foreign goods more expensive (cheaper) for domestic residents. 2. Features of the foreign exchange market. a) Actors 1) commercial banks: handle most of the exchange market transactions - involve a company having its commercial bank debit its account, change it into foreign currency and pay the business partner by depositing this currency in its foreign bank. Typically, electronic transactions for bank deposits, not a direct exchange of currency and coins.
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ch13 - Chapter 13 Exchange Rates and the Foreign Exchange...

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