1. Nominal exchange rates refer to the price of a currency in terms of another currency, while real exchange rates refer to the quantity of goods and services that can be purchased with a currency. 2. In equilibrium, the law of one price suggests that identical goods should sell for the same price across markets, while purchasing power parity suggests that exchange rates should equal the ratio of price levels between countries. 3. Both theories are limited in the short run but tend to hold in the long run as arbitrage acts to equalize prices and purchasing power across markets over time.

1. Introduction to Exchange Rates
(part 1)

2. Introduction to Exchange Rates:
3.) Change in Equilibrium – Appreciate vs Depreciate
1.) Classical Dichotomy - Nominal vs. Real
2.) Equilibrium - LoOP vs. PPP
4.) Change in Equilibrium – Reasons
5) Foreign Exchange regimes 制度

3. - the theoretical 理论 separation of nominal
and real variables.
Hume and the classical economists
suggested that monetary developments
affect nominal variables but not real variables.
If central bank doubles the money supply,
Hume & classical thinkers contend:
 all nominal variables – including prices –
will double.
 all real variables – including relative prices –
will remain unchanged.
Classical
Dichotomy
Classical Dichotomy 两分

4. are measured in monetary units.
The day to day number in exchange
rates
Nominal exchange rate is the price of a
currency in terms of domestic dollars.
Nominal
variables
Real
variables
are measured in physical units.
What you can actually buy with what
you have
Real exchange rates are the price of
goods in terms of domestic goods.
1.) Classical Dichotomy - Nominal vs. Real

5. - the rate at which one country’s
currency trades for another.
Nominal exchange rate:
( Nominal variables )
1.) Classical Dichotomy - Nominal vs. Real

6. Nominal exchange rate:
1.) Classical Dichotomy - Nominal vs. Real
( Real variables )
- the rate at which the good and
service of one country trade for the
goods and services of another.
Real exchange rate:
Equation:
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign
currency per unit of domestic currency
e x P
P*

9. Real Exchange
Rate Example
with McDonalds

10. Example with one good…
A Big Mac costs $2.50 in U.S., 400 yen in Japan
e = 120 yen per $
e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
= 0.75 Japanese Big Macs per US Big Mac
300 yen per U.S. Big Mac
400 yen per Japanese Big Mac
=
Real Exchange Rate
e x P
P*

11. The real exchange rate =
0.75 Japanese Big Macs per 1 U.S. Big Mac
Correct interpretation:
A Japanese citizen can buy
0.75 Big Macs in Japan or 1 Big Mac in the
U.S.
An American citizen can buy 1 Big Mac in
the U.S. or 0.75 Big Macs in Japan
Interpretation…Real Exchange Rate

13. e = 10 pesos per $
price of a tall Starbucks coffee
P = $3 in U.S., P* = 24 pesos in Mexico
A.) Calculate the price of a US coffee measured
in pesos, the nominal exchange?
B.) Calculate the real exchange rate,
measured as Mexican coffee per US latte.
Another example…Real Exchange Rate
Two steps:…

14. e x P = (10 pesos per $) x (3 $ per US latte)
= 30 pesos per US coffee
B.) Calculate the real exchange rate.
30 pesos per U.S. coffee
24 pesos per Mexican coffee
=
e x P
P*
= 1.25 Mexican coffee per US coffee
e = 10 pesos per $
price of a tall Starbucks coffee
P = $3 in U.S., P* = 24 pesos in Mexico
A.) What is the price of a US coffee in pesos?
Interpretation…Real Exchange Rate

15. 1.) Classical Dichotomy - Nominal vs. Real
How many things can
I buy with the
exchange?
Summary so far…
Nominal exchange rate: Real exchange rate:
What is the amount of
money do I need to
exchange today?

16. Introduction to Exchange Rates:
3.) Change in Equilibrium – Appreciate vs Depreciate
1.) Classical Dichotomy - Nominal vs. Real
2.) Equilibrium - LoOP vs. PPP
4.) Change in Equilibrium – Reasons
5) Foreign Exchange regimes 制度

17. Law of One Price
( LoOP)
- A good should sell for the
same price in all markets.
Easy definition:
Ceteris Paribus
( Real = Nominal)
2.) Equilibrium - LoOP vs. PPP
Short run – things can worth different amounts.

18. Law of One Price
( LoOP)
- A good should sell for the
same price in all markets.
Easy definition:
Ceteris Paribus
( Real = Nominal)
2.) Equilibrium - LoOP & PPP
Long run – Everything should balance be worth the same

19. Law of One Price
( LoOP)
- A good should sell for the
same price in all markets.
Easy definition:
Ceteris Paribus
( Real = Nominal)
arbitrage 套利 should insure that
identical goods should sell for the
same price in different markets.
(same Real values everywhere)
Arbitrage
- Taking advantage of different
prices of the same thing by
buying the item and then selling
it somewhere else.
Hard definition
2.) Equilibrium - LoOP & PPP

20. There is an opportunity for arbitrage, making a quick profit by
buying coffee in Seattle and selling it in Boston.
Such arbitrage drives up the price in Seattle and drives down the
price in Boston, until the two prices are equal.
Arbitrage
Suppose coffee
sells for $4/KG
in Seattle…
and sells for $5/KG
in Boston, and can
be transported for
free.
(LoOP) Law of One Price example…

21. So basically
always moving
towards this…

22. Law of One Price
( LoOP)
- A good should sell for the
same price in all markets.
Easy definition:
Ceteris Paribus
( Real = Nominal)
2.) Equilibrium - LoOP & PPP
arbitrage 套利 should insure that
identical goods should sell for the
same price in different markets.
(same Real values everywhere)
Arbitrage
- Taking advantage of different
prices of the same thing by
buying the item and then selling
it somewhere else.
Hard definition

23. - the number of goods or services
that can be purchased with a unit
of currency.
Purchasing Power
Law of One Price
Strong:Weak:
2.) Equilibrium - LoOP & PPP

24. Law of One Price
- A unit of any currency should be
able to buy the same quantity of
goods in all countries.
(should end up with same.
nominal values everywhere )
- based on the law of one price.
Purchasing Power Parity
( PPP)
(Nominal = Real)
2.) Equilibrium - LoOP & PPP
Short run – things can worth different amounts.

25. Law of One Price
- A unit of any currency should be
able to buy the same quantity of
goods in all countries.
(should end up with same.
nominal values everywhere )
- based on the law of one price.
Purchasing Power Parity
( PPP)
(Nominal = Real)
2.) Equilibrium - LoOP & PPP
Long run – Everything should balance be worth the same

26. A Big Mac costs $2.50 in U.S., 400 yen in Japan
e = 120 yen per $
e x P = price in yen of a U.S. Big Mac
= (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
= 0.75 Japanese Big Macs per US Big Mac
300 yen per U.S. Big Mac
400 yen per Japanese Big Mac
=
e x P
P*
Purchasing Power Parity Back to this example…

27. Example: a Big Mac
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
According to PPP: e x P = P*
price of Japanese
Big Mac, in yen
 Solve for e: P*
P
e =
price of US
Big Mac, in yen
PPP implies that the nominal
exchange rate between two
countries should equal the
ratio of price levels.
Purchasing Power Parity Back to this example…

28. Limitations:
- Many goods cannot easily be traded.
Examples: haircuts, going to the movies.
Price differences on such goods cannot be arbitraged away
- Foreign, domestic goods not perfect substitutes.
Example: some U.S. consumers prefer Toyotas over Chevys,
or vice versa.
Price differences reflect taste differences.
2.) Equilibrium - LoOP & PPP
Purchasing Power Parity
( PPP)

29. Limitations:
2.) Equilibrium - LoOP & PPP
Purchasing Power Parity
( PPP)
- In the short run:
Doesn’t hold, things are too volatile. 挥发物
- In the long run:
- The theory seems to be mostly true.

30. So to summarize so far…

31. are measured in monetary units.
The day to day number in exchange
rates
Nominal exchange rate is the price of a
currency in terms of domestic dollars.
Nominal
variables
Real
variables
are measured in physical units.
What you can actually buy with what
you have
Real exchange rates are the price of
goods in terms of domestic goods.
1.) Classical Dichotomy - Nominal vs. Real

32. Law of One Price
( LoOP)
- A good should sell for the
same price in all markets.
Easy definition:
Ceteris Paribus
( Real = Nominal)
arbitrage 套利 should insure that
identical goods should sell for the
same price in different markets.
(same Real values everywhere)
Arbitrage
- Taking advantage of different
prices of the same thing by
buying the item and then selling
it somewhere else.
Hard definition
2.) Equilibrium - LoOP & PPP

33. Nominal
Summary…
- what is the amount of money do I
need to exchange today?
Real
LoOP
PPP
- how many things can I buy with the exchange?
- Ceteris Paribus, Goods should sells for the same
price in all markets. ( Real = Nominal)
- Ceteris Paribus, Prices should buy the same number
of goods (Nominal = Real)

34. End of part 1
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