Exchange Rates and Open-Economy Macroeconomics

Lecture 2
Chapter 14 from Paul R. Krugman, Maurice Obstfeld, Marc J. Melitz
31.10.22
 Exchange Rates and Open-Economy
Macroeconomics

• An exchange rate is the price of one country’s currency in terms of another country’s currency
• It is denoted by 𝐸𝐺𝐸𝐿/$ (number of GEL per dollar)
• 𝐸𝐺𝐸𝐿/$ = 3 means that one will need 3 GEL to purchase 1 $
• When currency depreciates/gets weaker it means that one would need more of that currency to
purchase the same amount of foreign currency
• For example, if exchange rate changes from 𝐸𝐺𝐸𝐿/$ = 3 𝐸𝐺𝐸𝐿/$ = 4 we would say that GEL has
depreciated
• But for example, if 𝐸𝐺𝐸𝐿/$ = 2 we would say that GEL has appreciated/got stronger, so now we
need less GEL to purchase the same amount of $ (is this good or bad for the economy)
 Exchange Rates and Open-Economy
Macroeconomics
• Exchange rates are determined in the foreign exchange (FoReX) market. The major participants in that
market are:
• Commercial Banks
• International Corporations,
• Nonbank Financial Institutions
• National Central Banks (How?)
• Commercial banks play a pivotal role in the market because they facilitate the exchange of interest-
bearing bank deposits
• Important category of foreign exchange rates is Forward and Spot exchange rates
• Forward exchange rate – When parties agree to exchange currencies on some future date at a
prenegotiated exchange rate
• Spot exchange rate– When trade is settled immediately at the current exchange rate; “on-the-spot”
 Exchange Rates and Open-Economy
Macroeconomics
• Arbitrage - the process of buying a currency cheap and selling it dear (Can it last for a
long period?)
• Imagine € 1 = $ 2 on Georgian market and $ 1.5 = € 1 on Turkish market. Thus, people will buy € 1
for only $ 1.5 in Turkey and sell euros for $ 2 on Georgian market. This way their profit will be $ 0.5

• Vehicle Currency - currency is one that is widely used to denominate international

contracts made by parties who do not reside in the country that issues the vehicle
currency; Dollar is the most common Vehicle Currency
• Example: A bank wishing to sell Swiss Francs and buy Israeli Shekels, for example, will usually sell
its francs for dollars and then use the dollars to buy shekels (Why?)
 Demand for Foreign Currency Assets

• To understand how exchange rates are determined we assuming for now that participants in the foreign
exchange market base their demands for foreign currency assets exclusively on a comparison of those assets’
expected rates of return.
• Rate of Return - The percentage increase in value it offers over some time period
• Example: If the stock pays you a dividend of $1 at the beginning of 2020, and if the stock’s price rises
from $100 to $109 per share over the year, then you have earned a rate of return of 10 percent
• Interest Rates – Helps compute the rate of return on different currency deposits:
• For example, when the interest rate on GEL is 10 percent per year, a GEL 100,000 deposit is worth
GEL 110,000 after a year
• But more important concept is The Real Rate of Return - that is, the rate of return corrected with expected
inflation (Khachapuri example) :
• Example: Rate return = 10% and expected Inflation = 12% How much will your deposit of 100 GEL
generate in real terms after a year?
 Exchange Rates and Open-Economy
Macroeconomics
• Two main characteristics of an asset: Risk and Liquidity
• Risk - An asset’s real return is usually unpredictable and may turn out to be quite
different from what savers expected when they purchased the asset
• Liquidity - speed at which savers can turn an asset into currency:
• A house is a less liquid asset (Why?); What is the most liquid asset?
• *Also Please have a look at the definitions of Foreign Exchange swaps, Futures
and Options (page #387 from the textbook)
 Exchange Rates and Open-Economy
Macroeconomics

• How to decide in which currency to save money? How int rate of 5% in USD and 10% on GEL
deposits compare? (For simplicity let`s take GEL perspective and denominate in GEL)
• For this first we need to know: 1 How their lari and dollar values will change over a year. 2
The other piece of information we need in order to compare the rates of return offered by
lari and Dollar deposits is the expected change in the GEL/$ exchange rate over the year
• Basically, to compare rate of return of two assets in different currencies you need to choose
one currency and denominate rate of returns (RoRs) in that currency
• So, in other words to see GEL or $ deposit offers you more, you need to calculating the GEL
rate of return of a dollar deposit and compare it to GEL rate of return.
 Exchange Rates and Open-Economy
Macroeconomics
• To make things clear let`s have an example:
𝑒
• 𝐸𝐺𝐸𝐿/$ = 3 , 𝐸𝐺𝐸𝐿/$ = 3.22
• Gel deposits offers 10% and $ deposit offers 5%. In Which currency is better to deposit money? For this we need to find
out what is lari rate of return of dollar deposit
1 How much USD will I get if I deposit 1$? This is the same to deposit 3 lari at the beginning of the period
1 + 1 * 5% = 1.05 $
2 How much have I earned in terms of lari from my dollar deposit in nominal terms?
1.05 * 3.22 = 3.381
3 What is the rate of return from dollar deposit in terms of lari?
(3.381 – 3) /3 = 0.127 ➔ 12.7 %
Since deposit in lari offers me only 10% and deposit in dollar offers me 12.7 percent, I would choose dollar deposit, because
offers me more (Why this calculations might be unrealistic?)
 Exchange Rates and Open-Economy
Macroeconomics
• But dollar deposits paying more than lari deposits cannot prevail for a long time (why?)
• Thus, the expected rates of return must be equal in the equilibrium
• Interest parity gives us the representation of equilibrium:
𝑹𝑮𝑬𝑳 = 𝑹$ + (𝑬𝒆𝑮𝑬𝑳/$ − 𝑬𝑮𝑬𝑳/$ )Τ𝑬𝑪𝑬𝑳/$

• 𝑅𝐺𝐸𝐿 - Rate of return on lari deposits; from our example = 10%

• 𝑅$ - Rate of return on USD deposits; from our example = 5%
𝑒
• 𝐸𝐺𝐸𝐿/$ - Expected exchange rate; from our example = 3.22
• 𝐸𝐺𝐸𝐿/$ - Current exchange rate; from our example = 3

• Note for now we assume that 𝑹𝑮𝑬𝑳 , 𝑹$ and 𝑬𝒆𝑮𝑬𝑳/$ are given and only variable is 𝑬𝑪𝑬𝑳/$
• How the formula is derived can be found in the textbook; Page # 393 - #395
 Case 1 : When 𝑹𝑮𝑬𝑳 > 𝑹$ + (𝑬𝒆𝑮𝑬𝑳/$ − 𝑬𝑮𝑬𝑳/$ )Τ𝑬𝑪𝑬𝑳/$

Exchange Rate
𝑬𝑮𝑬𝑳/$
• When lari rate of return is more that of dollar, we
lari Return have situation represented by the point 2
• Since the only variable is 𝑬𝑪𝑬𝑳/$ it is intuitive that
exchange rate will start to adjust
• We will have a situation when everyone would
𝟐
𝐸𝐺𝐸𝐿/$ want to purchase lari and sell dollar, thus, lari
𝟏
appreciates until rate of returns are not the same
𝐸𝐺𝐸𝐿/$ again
𝟑 • So, appreciation of lari (which is the same to say
𝐸𝐺𝐸𝐿/$
that 𝑬𝑪𝑬𝑳/$ decreases) prevails until the point 1
Expected dollar is not reached
Return in lari
Rates of return in
𝑹𝑮𝑬𝑳
lari
 Case 2 : When 𝑹𝑮𝑬𝑳 < 𝑹$ + (𝑬𝒆𝑮𝑬𝑳/$ − 𝑬𝑮𝑬𝑳/$ )Τ𝑬𝑪𝑬𝑳/$

Exchange Rate
𝑬𝑮𝑬𝑳/$ • When dollar rate of return is more that of lari, we
have situation represented by the point 3
lari Return
• Since the only variable is 𝑬𝑪𝑬𝑳/$ it is intuitive that
exchange rate will start to adjust
• We will have a situation when everyone would
𝟐
𝐸𝐺𝐸𝐿/$ want to purchase dollar and sell lari thus, lari
depreciates until rate of returns are the same
𝟏
𝐸𝐺𝐸𝐿/$ again
• So, depreciation of lari (which is the same to say
𝟑
𝐸𝐺𝐸𝐿/$ that 𝑬𝑪𝑬𝑳/$ increases ) prevails until the point 1
Expected dollar
is not reached
Return in lari
Rates of return in
𝑹𝑮𝑬𝑳
lari
 The effect of Changing Rate of Return

Exchange Rate
𝑬𝑮𝑬𝑳/$
lari Return • Strict monetary policy can induce change in
interest rates that will affect rate of returns as
well
• So now saving in lari gets more attractive and
market participants would want to sell their
𝟏
𝐸𝐺𝐸𝐿/$
dollars and purchase lari
• Since demand on lari increases lari appreciates
𝟏
𝟐 and exchange rates moves from 𝐸𝐺𝐸𝐿/$ to
𝐸𝐺𝐸𝐿/$
𝟐
𝐸𝐺𝐸𝐿/$ in other words 𝑬𝑪𝑬𝑳/$ decreases
Expected Dollar
Return in lari • Also, on the market there is a new equilibrium
𝑹𝟏𝐺𝐸𝐿 𝑹𝟐𝐺𝐸𝐿
Rates of return in which is indicated by the point 2
lari
Problem 1

• In Georgia a Khinkali costs 2 laris; a hot dog costs $0.5 in New York . At an
exchange rate of GEL 3/per dollar, what is the price of a Khinkali in terms of
hot dogs? All else equal, how does this relative price change if the lari
depreciates to $3.22 per dollar? Compared with the initial situation, has a hot
dog become more or less expensive relative to a Khinkali?
Answer to Problem 1

• At an exchange rate 𝑬𝑪𝑬𝑳/$ = 3, one Hotdog (which is 1.5 lari) buys only
1.5 / 2 = 0.75 Khinkali
• Relative price is - Hot dog = 0.75 Khinkali
• When lari depreciates i.e. 𝑬𝑪𝑬𝑳/$ = 3.22, one hotdog (which now is 1.61 lari) buys
1.61 / 2 = 0.805 Khinkali
• New Relative price is - Hot Dog = 0.805 Khinkali
• Now since lari became weaker foreigners can buy more of Georgian products by the
same amount of dollars
Problem 2

• A U.S. dollar costs 14.82 Turkish lira , the same dollar can be
purchased for 3.22 Georgian lari. What is the Turkich lira/Georian
lari exchange rate?
• Given: 𝐸𝐺 𝐸𝐿Τ$ = 3.22 ; 𝐸₺/$ = 14.82
• We need to calculate : 𝐸₺/𝐺𝐸𝐿 ? So, we are asked to calculate How
much lira is one lari?
Answer to Problem 2

• By writing a simple proportion we can calculate lira/lari exchange rate

• 14.82 ₺ - 3.22 GEL
X ₺ - 1 GEL ➔ 𝐸₺/𝐺𝐸𝐿 = 4.602
Problem 3

• Calculate the dollar rates of return on the following assets:

• a. A painting whose price rises from $200,000 to $250,000 in a year.
• b. A bottle of a rare Burgundy, Domaine de la Romanee-Conti 1978, whose
price rises from $180 to $216 between 1999 and 2000.
• c. A £10,000 deposit in a London bank in a year when the interest rate on
pounds is 10 percent and the $/£ exchange rate moves from $1.50 per
pound to $1.38 per pound
 Answer to Problem 3

a. (250 000 – 200 000) / 200 000 = 0.25 ➔ 25%

b. (216 – 180)/180 = 0.2 ➔ 20%
c. We have to take into account that we are asked to calculate dollar rate of return:
1. Step – Calculating the dollar amount of the initial deposit
10 000 * 1.50 = 15 000 $
2. Step – Calculating how much pounds will depositor get at the end of the period and what is its dollar
equivalent
10 000 + 10 000 * 10% =11 000 £ ➔ 11 000 * 1.38 = 15 180
3. Step – Calculate dollar rate of return on the deposit
(15 180 – 15 000)/15 000 = 0.012 ➔ 1.2%
Problem 4

• What would be the real rates of return on the assets in the preceding question
if the price changes described were accompanied by a simultaneous 10
percent increase in all dollar prices?
Answer to Problem 4

To answer this question, we need to remind ourselves that inflation reduces real
rate of return, because it eats up the purchasing power of the money.
a. 25 - 10 = 15%
b. 20 - 10 = 20%
c. 1.2 - 10 = -8.8%
Problem 5

• Petroleum is sold in a world market and tends to be priced in U.S. dollars. The
Phosphate Group of Morocco must import petroleum to produce fertilizer and
other chemicals. How are its profits affected when the Dirham (Moroccan
currency) depreciates against the dollar?
Answer to Problem 5

• When the Moroccan currency depreciates against the dollars and

all other variables stays unchanged one would expect that profits
of Moroccan firm will decline. Because now firm needs to pay more
Dirham to exchange to dollars and purchase the same amount of
petroleum.
Problem 6

• Suppose the dollar interest rate and the euro interest rate are the same,
5 percent per year.
a) What is the relation between the current equilibrium $/€ exchange
rate and its expected future level?
b) Suppose the expected future $/€ exchange rate, $1.52 per euro,
remains constant as euro interest rate rises to 10 percent per year. If
the U.S. interest rate also remains constant, what is the new
equilibrium $/ € exchange rate? (Make all the calculations from the
dollar perspective)
 Answer to Problem 6

a) Let me remind you interest parity condition:

𝑹$ = 𝑹€ + (𝑬𝒆$/€ − 𝑬$/€ )Τ𝑬$/€
The problem tells us that: 𝑹$ = 5 and 𝑹€ = 5 and under this condition, only time the interest parity will
hold is when 𝑬𝒆$/€ = 𝑬$/€
b) 𝑹$ = 5 𝑹€ = 10 , 𝑬𝒆$/€ = $1.52 . We should calculate what will be current 𝑬$/€ ?
For this we can rearrange things and substitute all the known terms:
0.05 = 0.1 + (1.52 - 𝑬$/€ ) / 𝑬$/€ ➔ -0.05 = (1.52 - 𝑬$/€ ) / 𝑬$/€ ➔ 𝑬$/€ = 1.6
Problem 7

• Suppose 𝑹𝑮𝑬𝑳 increases but 𝑹$ stays the same .

a) What will happen to the value of GEL and why?
b) Show the old and the new equilibrium on the graph.
c) Describe the mechanism of adjustment in words.
 Answer to Problem 7

Exchange Rate
𝑬𝑮𝑬𝑳/$ a. Since now deposit in lari offers more RoR, market
participants would want to hold more deposits in
lari Return
lari, thus demand on lari increases. This way GEL
appreciates
b. The old equilibria is shown by the point 1. But when
RoR of GEL increases, which is shown on the graph
by moving from 𝑹𝟏𝐺𝐸𝐿 to 𝑹𝟐𝐺𝐸𝐿 the exchnge rates
𝟏
𝐸𝐺𝐸𝐿/$ starts to adjust. Because at the old exchange rate
GEL RoR is more than RoR dollars ( the difference is
𝟐
represented by the distance between 1 and 1`)
𝐸𝐺𝐸𝐿/$
c. After RoR in GEL increases everybody is willin to
Expected dollar hold GEL deposit and lari apreciates and exchange
𝟏 𝟏
Return in lari rate moves from 𝐸𝐺𝐸𝐿/$ to 𝐸𝐺𝐸𝐿/$
Rates of return in
𝑹𝟏𝐺𝐸𝐿 𝑹𝟐𝐺𝐸𝐿 lari terms
Problem 8

• The central bank of a country announces it would play a less active role in
limiting fluctuations in its currency interest rates. Do you think that the
exchange rate of its currency will become more volatile? Why?
Answer to Problem 8

• Greater fluctuations in the dollar interest rate lead directly to greater

fluctuations in the exchange rate using the model described here. The
movements in the interest rate can be investigated by shifting the vertical
interest rate curve. These movements lead directly to movements in the
exchange rate. So, there is a direct link between interest rate volatility and
exchange rate volatility, given that the expected future exchange rate does not
change.
Problem 9

• Multinationals generally have production plants in a number of countries.

Consequently, they can move production from expensive locations to cheaper
ones in response to various economic developments—a phenomenon called
outsourcing when a domestically based firm moves part of its production
abroad. If the dollar depreciates, what would you expect to happen to
outsourcing by American companies? Explain and provide an example.
 Answer to Problem 9

• If the dollar depreciated, all else equal, we would expect outsourcing to diminish. If, as the
problem states, much of the outsourcing is an attempt to move production to locations that are
relatively cheaper, then the U.S. becomes relatively cheap when the dollar depreciates. While it
may not be as cheap a destination as some other locations, at the margin, labor costs in the U.S.
will have become relatively cheaper, making some firms choose to retain production at home.
For example, we could say that the labor costs of producing a computer in Malaysia is 220$ and
the extra transport cost is 50$, but the U.S. costs were 300$, then we would expect the firm to
outsource. On the other hand, if the dollar depreciated 20% against the Malaysian ringitt, the
labor costs in Malaysia would now be 264$ (that is, 20% higher in dollar terms, but unchanged
in local currency). This, plus the transport costs makes production in Malaysia more expensive
than in the U.S., making outsourcing a less attractive option.