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Lecture 2A

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A Brief Diversion before
* Note: The use of these concepts will reoccur
throughout the course. They are examinable in
the mid-session and the final exam
Maos Communism
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Exchange Rates
The currency exchange rate (R) is how much
of one currency can be exchanged for another,
or the price of one currency in terms of
another.
Also defined as the nominal exchange rate.
Trade-weighted exchange rate: average of different
exchange rates weighted by the share of each
foreign country in trade.
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Recent Exchange Rates US Dollar
CURRENCY
R (UNITS OF FOREIGN
CURRENCY PER $)
1/R ($ PER UNIT OF
FOREIGN CURRENCY)
January 2005 January 2006 January 2005 January 2006
Euro (E)
0.76 0.82 1.31 1.21
J apanese yen ()
($/100)
103 115 0.97 0.87
Trade-weighted $
($/100 units)
109 110 0.92 0.91
January 2007 January 2008 January 2007 January 2008
Euro (E)
0.77 0.68 1.30 1.47
J apanese yen ()
($/100)
120 108 0.83 0.93
Trade-weighted $
($/100 units)
108 98 0.93 1.02
4 Source: Federal Reserve Statistical Release, Foreign Exchange Rates(Monthly)
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Lecture 2A
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Australian Dollar exchange rate
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Australian Dollar Trade-Weighted Index
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Real and nominal exchange rate
The real exchange rate (e*) is the nominal
exchange rate (R) multiplied by the ratio
between the domestic price level (Pd) and the
foreign price level (Pf)
e*= R(Pd/Pf)
where R = Yen/US$
Therefore e*= [(Yen/US$)Pd]/Pf
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Lecture 2A
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Real and nominal exchange rate
The real exchange rate (e*) is the nominal
exchange rate (R) multiplied by the ratio
between the domestic price level (Pd) and the
foreign price level (Pf)
e*= R(Pd/Pf)
where R = Yen/US$
Therefore e*= [(Yen/US$)Pd]/Pf
e*= Pd()/Pf()
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As e* increases, so the competiveness
of the US decreases. This might be
because of an increase in R and/or Pd
and/or a decrease in Pf.
Australian Dollar Trade-Weighted Index
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x
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In the short-run, real and
nominal rates tend to
move together because
inflation levels are similar
for major trading partners.
REER: Real Effective
Exchange Rate.
REER =OS$ x P
A
AU$ P
OS
x
Australian Dollar Trade-Weighted Index
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Lecture 2A
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1) When a country's export spending exceeds import spending, the country is experiencing a:
A) trade surplus. B) budget deficit. C) trade deficit. D) all of the above E) none of the above.
2) As a currency appreciates exports: A) decrease and imports decrease. B) decrease and
imports increase. C) increase and imports increase. D) increase and imports decrease.
E) none of the above.
3) An index of the weighted exchange value of the U.S. dollar against the currencies of a broad
group of major U.S. trading partners is called: A) bilateral dollar. B) exchange-weighted dollar.
C) trade-weighted dollar. D) dollarization. E) All of the above
4) The difference between nominal and real exchange rates is: A) domestic prices. B) foreign
prices. C) absolute prices. D) inflation E) ratio of domestic prices to foreign prices.
5) The exchange rate is determined by the interaction of the supply and demand for currencies in
which exchange rate system? A) fixed. B) flexible. C) regulated D) all of the above.
D) none of the above.
Exercises
Exchange Rate Crises
Southeast Asia: An Attempt to Maintain Fixed Exchange Rates
The Asian Financial Crisis
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Fixed Exchange Rate System
Equilibrium
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R = F/TB
Q
$
D
0
S
0
S
1
1
.5
100 125 150
D
1
Asian Financial Crisis 1997-98
Lecture 2A
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Fixed Exchange Rate System
Equilibrium
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R = F/TB
Q
$
D
0
S
0
S
1
1
.5
100 125 150
D
1
Asian Financial Crisis 1997-98
Fixed Exchange Rate System
Equilibrium
The Central Bank
intervenes to maintain a
fixed exchange rate.
In response to an
increased supply of
Baht, the Central
Bank must increase
the demand for Baht
by selling its reserve
assets (of Yen and
US$s) for Baht
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R = F/TB
Q
$
D
0
S
0
S
1
1
.5
100 125 150
D
1
Asian Financial Crisis 1997-98
until it runs out
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END
Part 1