im8 - Part 3 Financial Markets Chapter 8 The...

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Part 3 Financial Markets Chapter 8 The Foreign-Exchange Market and Exchange Rates Overview Most students are intrigued by questions of foreign exchange. One of the strengths of this text is that the determination of exchange rates is discussed in an early chapter. The chapter begins by defining nominal and real exchange rates and their determinants in the long and short runs. In a section that should be of particular interest to students, there is a discussion of the use of information about current and expected exchange rates to compare expected rates of return on assets from different countries. The chapter presents the purchasing power parity (PPP) theory as the main determinant of exchange rates in the long run. The author argues that, if the law of one price holds and real exchange rates are constant, changes in the nominal exchange rate between two countries should be accounted for by differences in inflation rates. The difficulties with PPP, particularly as an explanation of the determinants of exchange rates in the short run, are carefully discussed. The theory of short-run exchange rate determination presented draws on the model of asset demand from Chapter 5. The conditions for nominal and real interest rate parity are presented and illustrated with a number of real-world examples. Finally, explanations for exchange rate fluctuations are discussed. Many students will probably find the material in this chapter to be heavy going. Therefore, real-world applications should be emphasized. Students typically find issues such as comparing expected rates of return on domestic and foreign financial assets to be very interesting. Throughout the chapter examples of the methods by which investors can compare financial investments in different countries are presented; these examples should be used. Building on student interest in these types of questions in order to carry the student through the demanding material set forth in this chapter is vital. Outline I. Exchange Rates and Trade A) In the 2000s, many important markets are global, which requires individuals, businesses, and governments in one country to convert their currency into the currency of another country. B) The nominal exchange rate is the price of one country’s exchange rate in terms of another’s. 1. The nominal exchange rate is usually called the exchange rate . 2. An increase in the value of a country’s currency compared to the currencies of other countries is called appreciation . 3. A decrease in the value of a country’s currency compared to the currency of other countries is called depreciation .
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39 Hubbard • Money, the Financial System, and the Economy, Sixth Edition C) The real exchange rate is the purchasing power of a currency relative to the purchasing power of other currencies.
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