Chapter 7 – Dealing with Foreign
Exchange
Foreign exchange rate is the price of one currency in terms of another
Appreciation is an increase in the value of the currency
Depreciation is a loss in the value of the currency
What determines the supply & demand of foreign exchange (foreign
exchange rates)?
o Relative price differences & PPP
Focuses on the long run
The law of one price
In the absence of trade barriers (such as tariffs), the price for
identical products sold in different countries must be the same
In the long run, exchange rates should move toward levels that
would equalize the prices of an identical basket of goods in any
two countries
Big mac index: should cost the same everywhere
o Interest rates & money supply
Focuses on the short run
If one country’s interest rate is high relative to other countries,
the country will attract foreign funds
Inflows of foreign currency need to be converted to the home
currency high interest rate increase demand
High inflation excess supply currency depreciation
o Productivity & balance of payments
Increase in relative productivity improve competitive
position better absolute and comparative advantage
more FDI increasing demand for the currency
A country highly productive in manufacturing may generate a
merchandise trade surplus in the balance of payments
Balance of payments is a country’s international transaction
statement, which includes merchandise trade, service trade,
and capital movement
o Exchange rate policies
There are two types: floating rate and fixed rate
Floating (flexible) exchange rate policy is a government policy
to let supply-and-demand conditions determine exchange rates
Clean (free) float is a pure market solution to determine
exchange rates
Dirty (managed) float is using selective government
intervention to determine exchange rates
Heavier intervention moves the country closer to a fixed
exchange rate policy and vice versa
Target exchange rate (crawling band) is specified upper or
lower bounds within which an exchange rate is allowed to
fluctuate
Exchange
Foreign exchange rate is the price of one currency in terms of another
Appreciation is an increase in the value of the currency
Depreciation is a loss in the value of the currency
What determines the supply & demand of foreign exchange (foreign
exchange rates)?
o Relative price differences & PPP
Focuses on the long run
The law of one price
In the absence of trade barriers (such as tariffs), the price for
identical products sold in different countries must be the same
In the long run, exchange rates should move toward levels that
would equalize the prices of an identical basket of goods in any
two countries
Big mac index: should cost the same everywhere
o Interest rates & money supply
Focuses on the short run
If one country’s interest rate is high relative to other countries,
the country will attract foreign funds
Inflows of foreign currency need to be converted to the home
currency high interest rate increase demand
High inflation excess supply currency depreciation
o Productivity & balance of payments
Increase in relative productivity improve competitive
position better absolute and comparative advantage
more FDI increasing demand for the currency
A country highly productive in manufacturing may generate a
merchandise trade surplus in the balance of payments
Balance of payments is a country’s international transaction
statement, which includes merchandise trade, service trade,
and capital movement
o Exchange rate policies
There are two types: floating rate and fixed rate
Floating (flexible) exchange rate policy is a government policy
to let supply-and-demand conditions determine exchange rates
Clean (free) float is a pure market solution to determine
exchange rates
Dirty (managed) float is using selective government
intervention to determine exchange rates
Heavier intervention moves the country closer to a fixed
exchange rate policy and vice versa
Target exchange rate (crawling band) is specified upper or
lower bounds within which an exchange rate is allowed to
fluctuate
