Econ 162 3-18

# Econ 162 3-18 - Econ 162 Two models of exchange rate...

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Econ 162 3-18-09 Two models of exchange rate determination 1. Purchasing power parity (ppp) theory- long run trend 2. Supply and demand analysis – short run/day to day fluctuations 1. Ppp theory: P=pf* E Domestic price foreign price exchange rate ( units of home currency per unit of foreign currency) Example – US and japan Assumption: \$1 = 100 yen/ \$.01 = 1 yen Price of ton of wheat in us is \$50 P=pf * E = 50+ pf * .01 Pf + 50/.01 = 5000 yen Ppp as a theory- assume ppp doesn’t hold Assume: domestic price is \$50 Foreign price is 10000 yen Exchange rate : 1 yen is \$.01 It costs \$10 to ship one ton of wheat bet countries Is it possible to profit thru international arbitrage Activity : result of activity: Buy one ton of wheat in us -\$50 Ship one tone of wheat to japan -\$10 Sell in japan for 10000 yen +\$100 Exchange 10000 yen for \$100 Profit= +\$40 As wheat is shipped from us to japan: Supply of wheat in us goes down and price of wheat in us goes up Supply of wheat in japan goes up and price of wheat in japan goes down

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Prices get closer together until the only remaining price differential reflects shipping costs Lower ship costs= ppp more present If prices are fixed, then exchange rates must adjust P= 50 dollars Pf= 10000yen P=pf * E 50=10000*E E=50/10000=.005 We go from 1 yen =.01 dollars to 1 yen= .005 dollars Yen depreciates Depreciation- a fall in value of a currency We go from \$1 = 1000 yen to \$1 = 200 yen dollar has appreciated Appreciation is an increase in value of currency 2. Supply and demand analysis 2 markets: 1. market for yen in us 2. market for dollars in japan Demand for yen in us = supply of dollars in japan Demand for dollars in japan = supply of yen in us Market for yen in us market for dollars in japan (\$/yen)E s(yen) (yen/\$)1/E s\$ s’ Price of --- Price of - Yen in d d’ dollars in d\$ Dollars yen
Increase in us demand for japanese hybrid autos inc in us demand for yen inc in supply of dollars in japan yen appreciates ( 1 yen= \$.01 to 1 yen=\$.02) dollar depreciates (\$1=100 yen to \$1=50yen) 3.20.2009 Measuring international transactions Balance of payments- a record of one country’s trade in goods, services, income, and financial assets with the rest of the world Balance of payments consists of two separate accounts: -current account: flows of goods, services, Income, unilateral transfers

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