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Exchange Rates and

The Open Economy

SHARAVANAN A\L RAVECHENDRAN

ID -22610101
Open and Closed Economies

⚫A closed economy is one that

does not interact with other
economies in the world.
⚫ There are no exports, no imports, and
no capital flows.
Open and Closed Economies

⚫An open economy is one that

interacts freely with other
economies around the world.
An Open Economy

⚫An open economy interacts with

other countries in two ways.
⚫ It buys and sells goods and services in
world product markets.
⚫ It buys and sells capital assets in world
financial markets.
Exchange Rates

⚫The value of one currency relative

to another currency as the number
of units of one currency required
to purchase one unit of the other
currency.
Foreign Exchange

⚫All currencies other than the

domestic currency of a given
country.
Foreign Exchange Market

⚫The market on which currencies of

various nations are traded for one
another.
⚫Has no central trading floor where
buyers and sellers meet.
Nominal Exchange Rates

⚫The rate at which two currencies

can be traded for each other.
Nominal Exchange Rates for the U.S. Dollar
Country Foreign Dollar/Foreign
currency/dollar Currency
United Kingdom (pound) 0.645481 1.54923
Canada (Canadian dollar) 1.06088 0.942614
Mexico (peso) 13.0948 0.0763662
Japan (yen) 84.7479 0.0117997
Switzerland (Swiss Franc) 1.02289 0.977622
South Korea (won) 1196.82 0.000835548
Source: www.x-rates.com/d/USD/table.html, August 27,2010
Nominal Exchange Rates

⚫Currency Appreciation – an
increase in the value of a currency
relative to other currencies.
⚫Currency Depreciation – a
decrease in the value of a
currency relative to other
currencies.
Flexible VS Fixed Exchange Rates

⚫Flexible Exchange Rate - an

exchange rate whose value is not
officially fixed but varies according
to the supply and demand for the
currency in the foreign exchange
market.
⚫Fixed Exchange Rate – an
exchange rate whose values is set
by official government policy.
The Real Exchange Rate
⚫If the nominal exchange rate tells
us the price of the domestic
currency in terms of a foreign
currency, the real exchange rate
tells us the price of the average
domestic good or service in terms
of the average foreign good or
service.
The Real Exchange Rate
⚫The price of the average foreign
good or service relative to the
price of the average foreign good
or service, when prices are
expressed in terms of a common
currency.
⚫Real Exchange Rate = eP
Pf
Strong Currency = Strong Economy?
⚫Contrary to popular impression,
there is no simple connection
between the strength of country’s
currency and the strength of its
economy.
⚫One reason is that an appreciating
currency tends to raise the real
exchange rate, which may hurt a
country’s net exports.
Strong Currency = Strong Economy?
⚫An increase in the real exchange
rate implies that domestic goods
are becoming more expensive
relative to foreign goods, which
tends to reduce exports and
stimulate imports. Conversely, a
decline in the real exchange rate
tends to increase in net exports.
Determination of Exchange Rate
⚫Purchasing-Power Parity theory is
the simplest and most widely
accepted theory explaining the
variation of currency exchange
rates or how nominal exchange
rates are determined.
Purchasing-Power Parity

⚫The theory of purchasing-power

parity is based on a principle
called the law of one price.
⚫According to the law of one price,
a good must sell for the same
price in all locations.
Purchasing-Power Parity

⚫If the law of one price were not

true, unexploited profit
opportunities would exist.
⚫The process of taking advantage
of differences in prices in different
markets is called arbitrage.
Purchasing-Power Parity

⚫If arbitrage occurs, eventually

prices that differed in two markets
would necessarily converge.
⚫According to the theory of
purchasing-power parity, a
currency must have the same
purchasing power in all countries
and exchange rates move to
ensure that.
Limitations of PPP

⚫Many goods are not easily traded

or shipped from one country to
another.
⚫Tradable goods are not always
perfect substitutes when they are
produced in different countries.
The Supply of Dollars

⚫Anyone who holds dollars, from an

international bank to a Russian
citizen, is a potential supplier of
dollars to the foreign exchange
market.
⚫There are two major reasons why
would a U.S. household or firm
want to supply dollars in exchange
for foreign currency.
The Supply and Demand of Dollars

Supply of Dollars

Yen/Dollar Exchange Rate

e*

Demand of Dollars
Quantity of dollars traded
The Demand of Dollars

⚫In the yen-dollar foreign exchange

market, demanders of dollars are
those who wish to acquire dollars
in exchange for yen.
⚫There are two major reasons why
demand dollars.
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