An exchange rate is the price of one currency in terms of another currency.
Exchange rates fluctuate considerably and changes in the exchange rate are referred to as an appreciation or a depreciation. An increase in the value of a currency is referred to as appreciation. Analogously, a decline in the value of the currency is referred to as depreciation.
The US dollar has depreciated by 50 percent.
The demand for foreign exchange is a result of domestic residents demanding foreign goods and services, and that the exchange rate is simply the price of foreign exchange. Let us examine the demand for foreign exchange in more detail in order to learn what factors specifically affect this demand. Suppose that a US importer wants to buy Jaguars, and suppose that a Jaguar costs 30,000 British pounds. The dollar price of the Jaguars depends on the exchange rate. If the exchange rate were $3 per pound, the Jaguar would cost the importer $90,000. While there might be some demand for Jaguars in the US at this price, the quantity demanded would be fairly small. If the exchange rate fell to $2 per pound, the dollar price of the Jaguar would fall to $60,000 and the quantity demanded would be somewhat higher. If the exchange rate were $1 per pound, the car in question would cost only $30,000 and the quantity demanded in the US would be even larger.
As with most goods and services, changes in the demand for foreign exchange are related to a country’s income and relative price levels. The two most important factors that shift the demand for foreign exchange are changes in domestic income and domestic prices relative to prices in the foreign country.
If the US economy enters a recession then the demand for goods and services by Americans will fall in general. Along with this overall fall, there would be a fall in the demand for foreign goods and services. This would reduce the demand for foreign exchange and cause the demand for foreign exchange to shift to the left. Everything else equal, this would cause the US dollar to appreciate.
The supply of foreign exchange occurs as a result of the foreign demand for domestically produced products. For example, consider a British importer who wishes to buy a US computer network system priced at $100,000. In order to purchase this product, the British importer needs to obtain the requisite dollars from a British bank by exchanging pounds for dollars at the current exchange rate. If the exchange rate were two dollars per pound, then the importer would have to exchange (supply) £50,000 in order to obtain the computer network system. If the exchange rate were one dollar per pound, the computer network system costing $100,000 would now cost the British importer £100,000. At the exchange rate of one dollar per pound, there would be fewer computer network systems sold to the British. As a result, there would be fewer pounds supplied in the foreign exchange market. If the exchange rate was three dollars per pound, the computer network system would cost £33,333. At this price, the demand for network systems would be higher and the quantity of pounds supplied to the foreign-exchange market would also be higher. This supply of pounds, like any other supply curve, slopes upward and to the right. As the dollar depreciates, US goods become less expensive. The British buy more US goods and the quantity of pounds the British supply to the foreign exchange market increases. The supply of pounds to the foreign exchange market is dependent on the British demand for imports.
As with most goods and services, changes in the supply of foreign exchange are related to the foreign country’s income and relative prices. The two most important factors that shift the supply of foreign exchange are changes in foreign income and domestic prices relative to prices in the foreign country.
The dollar would need to appreciate against the Mexican peso by approximately 3 percent. Put another way, the Mexican peso would need to depreciate by approximately 3 percent.
If the British economy slides into a recession this would cause a decrease in British imports from the US. This decline in imports would cause a decrease in the supply of foreign exchange and the dollar-pound exchange rate would rise.
If the US economy grows unusually fast, then the demand for imports from the UK would rise. This would appear as an increase in the demand for foreign exchange.
If the US encounters severe inflation while prices are stable in the UK this would cause a decrease in British imports from the US and an increase in US imports from the UK as US-produced goods become relatively more expensive. These effects would cause a decrease in the supply of foreign exchange and an increase in the demand for foreign exchange and the dollar/pound exchange rate would rise.
If the US economy slides into a recession this would cause a decrease in US imports from the UK. This decline in imports would cause a decrease in the demand for foreign exchange and the dollar/pound exchange rate would fall.
Everything else equal, when a country has higher inflation than another country its currency will need to depreciate. The reverse is also true. As a result high inflation is associated with “weak” currencies and low inflation with “strong” currencies.
In order to forecast an exchange rate one would need a forecast of GDP growth, inflation, and interest rates for the two countries in question.
The law of one price states that, disregarding trade barriers and transportation costs, identical goods sold in competitive markets should cost the same everywhere when prices are expressed in terms of the same currency. The law of one price is useful in that it states comparative advantage in terms of currencies and through the process of arbitrage traders will tend to move goods from low-price to higher-priced markets. The process would continue until all excess profits disappear.
Given these prices the exchange rate would have to be $0.2 per pound.
Absolute purchasing power parity (PPP) is the theory that that the bilateral exchange rate is related to differences in the level of prices between countries. More specifically this relationship is expressed as [R($/₤)] = PUS/PUK. Using this equation, if a certain basket of goods were to cost $1,000 in the US (PUS) and the same basket of goods were to cost 500 pounds in the UK (PUK), then the implied PPP exchange rate would be $2 per pound. From absolute PPP, it is possible to obtain another version of PPP known as relative purchasing power parity. Relative PPP states that the percentage change in the bilateral exchange rate is equal to the difference in the percentage change in the national price levels over any given period of time. Absolute PPP is a statement about absolute prices and exchange rates. On the other hand, relative PPP is a statement about price and exchange rate changes over time. Relative PPP is a very useful concept because price changes in a country are normally expressed as a percentage change in the price level (the rate of inflation). As a result, relative PPP becomes %ΔXR = %ΔPUS – %ΔPUK
One Mexican peso equals $4.
Evidence indicates that changes in relative prices and exchange rates do move together over long periods of time. However, in the short run, exchange rates can deviate significantly from PPP. With respect to PPP, one has to decide if the cup is half full or half empty. Both versions of PPP fail as reliable predictors of short-run changes in the exchange rate. In this sense the glass is half empty. However, over sufficiently long periods of time the glass is half full as market exchange rates tend to move toward PPP.
Disregarding barriers to trade and transportation costs, the law of one price states that identical goods sold in competitive markets should cost the same everywhere when prices are expressed in terms of the same currency. For example, assume that the dollar–pound exchange rate is $2 per pound. If a pair of shoes cost £200 in the UK, the same pair of shoes should cost $400 in the US. The price of the same pair of shoes in the US and the UK expressed in a common currency should be identical. At the exchange rate of $2 per pound, the price of £200 or $400 is the same price.
Suppose that prices in the US rise by 10 percent and prices in the UK rise by 2 percent. Given that the relative version of PPP can be expressed as %ΔXR = %ΔPus – %ΔPUK, one would predict that the US dollar would depreciate by 8 percent relative to the British pound. This change in the exchange rate would occur as US prices became more expensive relative to UK prices. US imports from the UK would expand and US exports to the UK would contract. These changes would cause the exchange rate to depreciate.
Over the years, economists have developed a number of explanations of why PPP fails empirical tests. First, there is the question of which market basket of goods to use in the calculation of PPP. In practice, there are three price indexes that could be used in the calculation: the consumer price index (CPI), the GDP price deflator, and the Producer Price Index (PPI). For most countries, determining PPP based on the producer price index is the best choice because a higher proportion of the goods in this index are tradeable goods. Once the market basket has been chosen to calculate PPP, there is a secondary problem associated with variations in the composition of the market basket among countries. Since price indexes are weighted averages of the prices of various products, it is unlikely that any two country’s price index would measure exactly the same thing. A second group of problems associated with testing PPP has to do with barriers that inhibit the free flow of goods between countries. First, there is a problem associated with transportation costs. The higher the transportation costs with respect to the product’s value, the more likely prices of the same product in different countries could diverge. This means that even in a free market some products could have widely different prices in various countries and these differences could persist indefinitely. Second, differences in market structures among countries could cause the prices of the same product in two countries to vary. A product that is sold in a competitive market in one country will be less expensive than the same product sold in a non-competitive market in another country. International differences in market structures could lead to international price differences for the same product. Third, government policies may reinforce international differences in prices. Many products still have tariffs, quotas, and other taxes levied on them. To the extent that these tariffs, quotas, and various other taxes differ across countries, the prices of identical goods may likewise differ. A final problem associated with testing PPP has to do with the existence of nontradeable goods. The problem associated with non-tradable goods is that their prices are determined wholly by domestic demand and supply. Their prices are determined domestically and can differ greatly from country to country. This means that it is very difficult to compare prices in Japan with those in the US because nontradable goods are more expensive in Japan than in the US, making the calculation of PPP between the yen and the dollar less than ideal. From these empirical failures of PPP, one might be tempted to dismiss the entire concept as useless. However, part of the failure of PPP is one of measurement. The price indexes that we would ideally like to use to test the theory do not exist. As a result, part of the reason PPP fails empirical tests is poor data. In addition, if you lengthened the time period, the probability of a wrong answer diminishes.
The nominal or posted exchange rate is the relative price of two currencies. The real exchange rate is the relative price of two currencies after adjusting for changes in domestic prices in the two countries. For example, consider the dollar/pound exchange rate. The real exchange rate (RXR) is defined as the dollar price of a British market basket relative to a US market basket. The real exchange rate (RXR) becomes [RXR($/₤)] = [R($/₤)][PUK/PUS]. Changes in the real exchange rate indicate when a domestic currency has appreciated or depreciated relative to a foreign currency in real terms, meaning the domestic currency is worth more or less after adjusting for inflation in the two countries.
Suppose that the nominal exchange rate [R($/₤)] is $2 dollars per pound, and the prices of a market basket in the UK and the US are 50 pounds and $100, respectively. In this case the real exchange rate is 1. Now, consider what happens if the nominal exchange rate changes from $2 per pound to $3 per pound, and US prices increased from $100 to $200. The dollar has depreciated in nominal terms, and it has also appreciated in real terms. The real exchange rate under these conditions would now be .75 instead of 1. The reason for this change in the real exchange rate is that the price increases in the US were larger than the nominal exchange rate change, and it now takes more pounds to purchase a market basket in the US. In real terms the dollar is worth more in the UK.
In general, there are three major factors that would cause the real exchange rate to change in the long run. First, foreign (world) demand for domestically produced products. For example, assume that tastes or preferences in the UK or the US shift in favor of US-produced products. This change in demand for US goods will tend to cause an excess demand for US goods at the prevailing real exchange rate. This excess demand causes PUS to rise relative to prices in the UK. The previous equation makes it clear that the dollar will appreciate in real terms to offset this long-run price increase. The second major factor that causes real exchange rate changes in the long run is changes in a country’s productivity. Suppose that in the long run, both US capital and labor become more productive, meaning that the amount of output produced for any given amount of capital and/or labor rises. If US demand for this increased output does not rise as fast, then there will be an excess supply of goods and services produced domestically. In this case, market forces would tend to eliminate this excess supply by finding its way into exports and the real exchange rate would depreciate. Third, changes in the real exchange rate are related to real interest rate changes. Suppose that the real interest rate in the US increases relative to the real interest rate in the UK. In this case, capital would flow from the UK into the US in search of the higher real rate of return. This would translate into a real appreciation of the dollar.
The real interest rate is the nominal interest rate minus the expected rate of inflation. If the real interest rate increases, then the real exchange rate would appreciate. The reverse would be true for a fall in the real interest rate.