Wednesday, May 21, 2008

Lecture 8 - Foreign Exchange Rates

As of 5/15/2008,

exchange rate, e = euro/$ = 0.6469

Dollar depreciation makes US products less expensive in Japan, if other things are equal. I.e. for given domestic and foreign price levels.

Real exchange rate ε (epsilon) = e PUS / PJapan, where e = yen/$.

Ex: Assume Ford Taurus and Toyota Camry are essentially equivalent products.
Taurus: $20,000
Camry: 2.5m Yen

(i) e = 100
ε = e PUS / PJapan = 100(20,000)/(2.5m) = 2m/2.5m = 0.8

Therefore, the Taurus is cheaper than the Camry.

(ii) e=90
ε = e PUS / PJapan = 90(20,000)/2.5 = 1.8m/2.5m = 0.72

Nominal depreciation of the exchange rate, makes US products cheaper.

(iii) e=100, but the price of the Taurus goes down to 15k due to innovations and increase labor productivity
ε = 100(15,000)/(2.5m) = 1.5m/2.5m = 0.6

Even without depreciation, US producers can make their products cheaper.

A strong dollar policy was favored by Robert Rubin when he was Secretary of the Treasury and Larry Summers who succeeded him in that position. But a high exchange rate is not always desirable. Italy and Spain are experiencing a recession and do not want a strong Euro.

In general, a strong Euro policy makes sense for them now. It hurts European manufacturing in the short term, but it will help them advance their productivity, which is currently lagging, in the long run. It will force them to innovate. Japan had a similar experience.

Trade balance depends on the real exchange rate, not the nominal exchange rate.

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