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Published on April 17, 2008

Author: Breezy

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Exchange Rates :  Exchange Rates Monetary Fundamentals Foreign Currency Market is large and growing (Source: BIS Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004 http://www.bis.org/publ/rpfx04.htm) :  Foreign Currency Market is large and growing (Source: BIS Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004 http://www.bis.org/publ/rpfx04.htm) US $ is one side of 90% of foreign exchange trades. :  US $ is one side of 90% of foreign exchange trades. Bilateral Exchange Rate :  Bilateral Exchange Rate Typically, a bilateral exchange rate is reported as the # of units of the currency with the lower value per unit of the currency of the higher value. Examples HK$7.8 per 1 US$, ¥120.14 per 1 US$ US1.53 per 1 ₤ Define exchange rate, e, as number of units of domestic currency needed to buy 1 US $. Terminology:  Terminology An appreciation of a currency is an increase in the value of a currency. A depreciation is a decrease in value. A revaluation is the official increase in the value of a currency specified by fixed exchange rates A devaluation is the official decrease in the value of a currency specified under fixed exchange rates. Exchange Rates :  Exchange Rates HK has a fixed bilateral exchange rate with the US. HK Exchange Fund (the currency board operated by HKMA) will buy or sell HK$ at a fixed exchange rate. No one will ever buy for more or sell for less. Effective Exchange Rate is a weighted average of a country’s bilateral exchange rates [weights are by share of merchandise trade in 1999-2000]. HK effective exchange rate fluctuates since US dollar fluctuates relative to important HK trading partners such as Japan, Germany, etc. Import Weights HK: 1999-2000 Hong Dept. of Census & Statistics:  Import Weights HK: 1999-2000 Hong Dept. of Census & Statistics HK Effective Exchange Rate Hong Dept. of Census & Statistics:  HK Effective Exchange Rate Hong Dept. of Census & Statistics Bilateral Exchange Rates with major currencies are very volatile. IMF International Financial Statistics :  Bilateral Exchange Rates with major currencies are very volatile. IMF International Financial Statistics East Asia currencies very stable before 1997. Sharp depreciations in 1997 and greater floating afterwards. :  East Asia currencies very stable before 1997. Sharp depreciations in 1997 and greater floating afterwards. Nominal vs. Real Exchange Rate:  Nominal vs. Real Exchange Rate Nominal exchange rate e is the price of US currency in terms of domestic dollars Real exchange rates are the price of US goods in terms of domestic goods. Another way to write the real exchange rate re is as the price of US goods relative to the price of domestically produced goods. Real Exchange Rate:  Real Exchange Rate A domestic customer compares the price of US goods with the price of our home goods. To buy 1 US good, he must pay e domestic dollars per US dollar and PUS US dollars for each good) PUS ( PUS ≡ Foreign price level). Total domestic currency price of US goods is e∙PUS To buy 1 domestic good, he must pay P domestic currency units. HK: US Real Exchange Rate (Calculated with CPI’s from CEIC database):  HK: US Real Exchange Rate (Calculated with CPI’s from CEIC database) Law of One Price (LoOP):  Law of One Price (LoOP) Law of One Price states that arbitrage should insure that identical goods should sell for the same price in different markets. If prices differ in two markets, arbitrageurs should buy in the cheap market and sell in the cheap market until prices equalize. For easily transportable, standardized goods sold in highly competitive markets (such as gold), LoOP holds. Purchasing Power Parity theory assumes LoOP applies to all markets. Why doesn’t LoOP hold for most goods?:  Why doesn’t LoOP hold for most goods? Transport Costs – Large costs of moving goods may keep arbitrage from working. Non-traded Goods – Some goods, such as real estate, have near infinite transport prices. Pricing-to-Market – Firms with market power may find it optimizing to charge different prices in different markets. Tariffs & Taxes – Imported goods may face additional taxes Purchasing Power Parity (PPP):  Purchasing Power Parity (PPP) Define relative prices of foreign goods Absolute PPP says that the real exchange rate is always re = 1 or e = XP Relative PPP says that the growth rate of the real exchange rate is zero Does PPP Hold?:  Does PPP Hold? Does Absolute or Relative PPP hold? In short run, NO. Exchange rates are much more volatile than inflation rates. In long run for countries with similar levels of development, PPP roughly holds. Example. Twenty year averages for OECD countries. Long Run Relative PPP: Developed Economies:  Long Run Relative PPP: Developed Economies Exercise: Comparing Output Levels across countries:  Exercise: Comparing Output Levels across countries National GDP’s are measured in domestic currency units. To compare, we need to convert in뀀蕒 equivalent units. Two methods Exchange Rate Conversion PPP Conversion PPP Conversion Factor:  PPP Conversion Factor A number of international statistical agencies (including OECD {for developed economies} and World Bank {for developing economies}) calculate the prices of a fixed market basket of goods in a wide variety of economies. Define price ratios as Example: In 2002 in HK, e = 7.8 and the World Bank measures xp = 6.9 meaning a representative market basket that costs US$100 in US cost HK$690 in HK. Comparing Income Levels:  Comparing Income Levels An American is offered a salary of $40,000 per month to work in Hong Kong. Q: How much is that in US dollars Exchange rate conversion would suggest this is equal to a salary of US$5,128.20 PPP conversion would suggest this would by goods in HK whose cost in the US would be US$5,797.10. Which to use?:  Which to use? Advantages of XRate Conversion More expensive to calculate xp than e. Maybe a better measure of how much foreign goods a country can afford to buy. Advantage PPP Conversion Better measure of how many overall goods a country’s residents can afford to buy. Big Mac Conversion:  Big Mac Conversion Economist magazine puts forward the relative price of McDonald’s Big Macs as a good, fast substitute for PPP conversion. Big Mac includes broad range of inputs which can be representative to national goods. Calculate bm = Hong Kong Big Mac Converter vs. Starbucks Converter:  Hong Kong Big Mac Converter vs. Starbucks Converter Price of Big Mac in Hong Kong HK$12. Price of Big Mac in US$2.90. The Bigmac conversion factor is bm = 12/2.90 = 4.41. Price of Starbucks Tall Latte in Hong Kong HK$25; in US, US$2.80. Starbucks conversion factor is sb = 25/2.8 = 8.95. Poor countries have cheaper prices. (Source: Penn World Tables):  Poor countries have cheaper prices. (Source: Penn World Tables) Real Exchange Rates and the relative price of Non-traded Goods:  Real Exchange Rates and the relative price of Non-traded Goods Two types of goods. Good T can be freely traded across countries and always has the same relative price in each country. Good NT cannot be traded across countries. The price of non-traded goods relative to traded goods is A. Real Exchange Rate:  Real Exchange Rate The real exchange rate is written as Technology:  Technology In the long run, the relative cost of non-traded goods, A, is a function of the relative technology/efficiency level in the traded sector (manufacturing) and the non-traded sector (services). When the efficiency of the traded sector is high, the price of traded goods relative to non-traded goods will be low and A will be high. Rich Countries are more expensive than poor countries.:  Rich Countries are more expensive than poor countries. Many types of services have unchanging technology (like haircuts) or inherently limited supply (like real estate). Most technology advances occur in traded goods sector. As a country grows wealthier and more technologically advanced, the countries residents will pay more for real estate or services. If traded goods have roughly equal prices across countries, but a countries non-traded goods start to become more expensive as it develops, the overall relative price of its goods will increase. Balassa-Samuelson Effect:  Balassa-Samuelson Effect If rich countries have lower real exchange rates than rich countries, as a country develops, it should experience real appreciation. If growth increases productivity mostly in the traded sector, inflation should be highest in non-traded sector. Experience of East Asia tends to support this argument. Balassa Samuelson Effect 1960-2000 (source: Penn World Tables):  Balassa Samuelson Effect 1960-2000 (source: Penn World Tables) Inflation and Fixed Exchange Rates:  Inflation and Fixed Exchange Rates Exchange Rate Regimes and Monetary Policy:  Exchange Rate Regimes and Monetary Policy Many economies have monetary policies which are oriented to some degree around the stability of the exchange rates. Many large, developed economies such as the US, UK, Euro zone, and Japan explicitly state their focus on domestic economy considerations Focusing monetary policy on domestic considerations is called a floating exchange rates Some argue that Bank of Japan puts a first-order emphasis on exchange rates. Fixed Exchange Rates:  Fixed Exchange Rates Some small economies have exchange rates that specifically fix the exchange rate relative to one currency. In Asia, this includes Hong Kong and Malaysia which have a constant currency exchange rate with the US dollar. In Europe, many countries fixed their exchange rates to the Deutschemark before uniting to a single currency called the European Currency Unit or the Euro. Denmark currently has a fixed exchange rate with the Euro though it has not adopted the common currency. Fixing Exchange Rates:  Fixing Exchange Rates Monetary policy fixes the exchange rate by providing international markets the exact amount of domestic currency that it demands at that exchange rates. When financial markets will pay more for domestic currency, sell more domestic currency. When financial markets will pay less for domestic currency, buy more domestic currency with financial reserves. Hong Kong currency board will buy as many HK dollars as banking sector wants to sell for US dollars at e = 7.8. To print more HK dollars, banks must pay US dollars for licenses. Intermediate Regimes:  Intermediate Regimes Most economies have a monetary policy which takes into account both domestic considerations and exchange rate stabilization considerations. Regimes in which the currency at any point in time is a function of monetary policy but in which the exchange rate evolves over time at pre-determined rate of change. Regimes in which the exchange rate is allowed to fluctuate freely as long as it stays within some pre-announced price range but to intervene in Economies in which the central bank will upon occasion buy or sell foreign currency for reasons that are not pre-determined are called managed floats. Slide37:  International Monetary Fund Exchange Rate Classifications History of Exchange Rate Regimes:  History of Exchange Rate Regimes 1890-1913: Metallic Standard: Gold in Atlantic, Silver in Pacific 1919-1939: Attempts to Return to Gold Standard, Competitive Devaluations 1946-1971: Bretton Woods Agreement: US Dollar fixes to Gold: Other Currencies Fixed to US Dollars. Currency Adjustments managed by IMF 1971-2004: Floating Exchange Rates for Major Currencies but Concerted Efforts by G7 to manipulate exchange rates called the Plaza Accord and the Louvre Accord. US Gold Reserves Under Bretton Woods:  US Gold Reserves Under Bretton Woods Plaza Accords:  Plaza Accords

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