CONVERTING CURRENCIES AND ASSESSING VALUE

Foreign Exchange

Exchange Markets

The foreign exchange marketIs the market where one buys or sells

the currency of country A with the currency of country B

A currency exchange rateIs simply the ratio of

a unit of currency of country A to a unit of the currency of country B at the time of the buy or sell transaction

Formula for Currency Values

USD/PesoPeso/USD

Appreciation v. Depreciation

A – When a currency becomes more valuable in terms of another currency

D – When a currency becomes less valuable in terms of another currency

Factors affecting Currency Values

Inflation RatesInterest RatesCountry's Current Account / Balance of

Payments Government DebtTerms of TradePolitical StabilitySpeculation

Exchange rate v. Real exchange rate

ER - the price at which currencies trade on the market

RER – Exchange rates adjusted for international differences in aggregate price levels (inflation)

PPP – Purchasing Power Parity – Nominal exchange rate at which goods and services would cost the same amount in each country

Example

The exchange rate between Pesos and Dollars is 10 to 1 in Jan.’14

Assume 0 inflation in the USBy Dec of ‘14 the nominal exchange rate is 14

to 1 and Mexican inflation is 20%. Calculate the real exchange rate between the

two countries in Dec ‘14. Did the dollar appreciate or depreciate against the Peso?

Question set 1

Draw a correctly labeled graph of the foreign exchange between US and Japan showing the equilibrium exchange rate if capital flows from Japan decreases due to a change in Japanese investors.

Has the US dollar appreciated or depreciated?

Question set 2

Suppose the US and India are the only two countries in world

1. Draw a diagram (correctly labeled) of the FOREX market for US dollars showing equilibrium

2. On the graph, show a fixed exchange rate above equilibrium, show and label the surplus or shortage.

3. What actions should the US government take to bring the graph into equilibrium and draw the results on your graph.

Balance of Payments Accounts

Summary of a country’s transactions with another country

Divided into two categories – Current Accounts and Financial Accounts

Current Account Financial Account

Sales and purchases of goods and services

Factor IncomeTransfers

Official Asset salesPrivate sales and

purchases of assets

US balance of payments

Trade Balance

Difference between exports and imports of goods alone – not including services

Incomplete measure but most often quoted and used in media

Difficult to measure value of services and information slower to arrive

US ran a 534 billion dollar deficit in 20122013 – 476 billion 2014 – 505 billion

Factor income/Transfers

FI- Payments for the use of factors of production owned by citizens of other countries; mostly investment income

2012 – US had net surplus of 224 billion

T – Funds sent by residents of one country to another

2012 – Approximately -130 billion

Financial Accounts

Purchase of foreign governments/banks/Individuals and businesses of assets in a foreign country

Often includes purchase of foreign currency reserves

Sale of bonds or T-bills creates a current positive inflow but a future liability

2012 – US had 447 billion $ surplus

In 2012, US Balance of payment was 7 billion$ surplus

Example

Assume the US exports 1.2 trillion dollars worth or goods; Imports 1.6 trillion dollars worth of goods. Foreign governments/businesses invest 800 billion in the US and US companies invest 550 billion in foreign countries and that foreign nationals/immigrants send 150 billion to foreign countries. What would be the US Current Account?

Examples part II

Assume the US pays out 200 billion$ in debt and interest payments to foreign countries, China purchases 100 billion in US Bonds, the EU acquires 200 billion in US currency reserves, US citizens invest 400 billion in foreign companies and currency, foreign citizens purchase 200 billion in US bonds , and foreign governments/businesses employ American citizens and pay them a total of 100 billion.

What is the current financial account for the US? What is the US balance of payments in that year?