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ECON1002 Introductory Macroeconomics

Tutorial 11

(Week 12)

Reading Guide:  Review Chapter 17 (Chapter 15 of BOF 4e). You should also look over your lectures notes for Week 11.

Key Concepts: Nominal and Real Exchange rates; Purchasing power parity; Equilibrium exchange rates; the Relationship between Monetary policy and Exchange rates.

Problems

1. How would each of the following be likely to affect the value of the dollar, all else being equal? Explain.

a. Australian shares are perceived as having become much riskier financial investments.

b. European computer firms switch from Australian-produced software to software produced in India, Israel and other nations.

c. As East Asian economies recover, international financial investors become aware of many new, high-return investment opportunities in the region.

d. The Australian government imposes a large tariff on imported automobiles.

e. The Reserve bank reports that it is less concerned about inflation and more concerned about an impending recession in Australia.

f. Australian consumers increase their spending on imported goods.

2. A British-made car is priced at 20,000 pounds and a comparable Australian-made car costs $26,000. One pound trades for $1.50 in the foreign exchange market. Find the real exchange rate for cars from the perspective of Australia and from the perspective of Great Britain. Which country’s cars are more competitively priced?

3. The demand for and supply of shekels in the foreign exchange market is

Demand = 30,000 – 8,000 e

Supply = 25,000 + 12,000 e

where the nominal exchange rate is expressed as dollars per shekel.

a. What is the fundamental value of the shekel?

b. The shekel is fixed at $0.30. Is the shekel overvalued, undervalued or neither? Find the balance of payments deficit or surplus in both shekels and dollars. What happens to the country’s international reserves over time?

c. Repeat part b. for the case in which the shekel is fixed at $0.20.

The following is an extract from The Economist July 22nd, 2010:

ASK Western policymakers how they intend to squeeze growth from their sluggish economies and most pin their hopes on higher exports. That makes exchange rates an especially sensitive topic. A weaker currency improves the competitiveness of a country by making exports cheaper. It also encourages domestic consumers to switch from expensive imports to domestic goods. The Economist’s exchange-rate scorecard, the Big Mac index, shows that currencies continue to be cheap in the developing world but overvalued in Europe.

The index is a lighthearted attempt to gauge how far currencies are from their fair value. It is based on the theory of purchasing-power parity (PPP), which argues that in the long run exchange rates should move to equalise the price of an identical basket of goods between two countries. Our basket consists of a single item, a Big Mac hamburger, produced in nearly 120 countries. The fair-value benchmark is the exchange rate that leaves burgers costing the same in America as elsewhere.

Asia remains the cheapest place to enjoy a burger. China’s recent decision to increase the “flexibility” of the yuan has not made much difference yet. A Big Mac costs $1.95 in China at current exchange rates, against $3.73 in America. Our index suggests that a fair-value rate would be 3.54 yuan to the dollar, compared with the current rate of 6.78. In other words the yuan is undervalued by 48%.

Other Asian currencies such as the Thai baht and the South Korean won are also undervalued. The Brazilian real is one of the few emerging-market currencies that is trading well above its Big Mac benchmark. With interest rates high—the policy rate now stands at 10.75%—Brazil has attracted lots of attention from yield-hungry investors. Burgernomics suggests that the real is overvalued by 31%.

The Big Mac numbers should be taken with a generous pinch of salt. They are not a precise predictor of currency movements. The bulk of a burger’s cost depends on local inputs such as rent and wages, which tend to be lower in poor countries. Consequently PPP comparisons are more reliable between countries with similar levels of income.    

So it is particularly interesting to see that on a burger basis the euro is still overvalued when compared with many other rich-world currencies. Sovereign-debt worries and soggy growth rates have helped shift the currency towards its fair value over the past 12 months. A year ago the euro was overvalued by 29% on the burger benchmark; that figure is now down to 16%. (Britain’s currency has gone from being mildly overvalued this time last year to slightly undervalued now.) And the single currency has been moving back up again in recent weeks, on hopes that stress-test results, which were due out on July 23rd, will shore up confidence in Europe’s banking system.

Other currencies are dearer still. Investors looking for a safe place to put their money have sought refuge in the Swiss franc. Despite attempts by the Swiss central bank to stem the appreciation, the Swiss franc is overvalued by 68%. Those on the hunt for a value meal should also steer clear of Scandinavia. In Norway a Big Mac would set you back by 45 kroner or $7.20, nearly twice the cost in America.

Source: http://www.economist.com/node/16646178?story_id=16646178#footnote1c 

4. Using the table above taken from the Economist, answer the following questions.

a. Explain some of the advantages and disadvantages of the Big Mac index.

b. On 21 July 2010, the nominal exchange rate was $1A = $0.8850US. On 8 October 2010, the nominal exchange rate was $1A = $0.9835US. Suppose currency speculators read The Economist. Can you explain this change in the nominal exchange rate?  Discuss.

Reach for the stars:

BOF Chapter 17 pages 462 and 463 (Chapter 15 pages 450 and 451 of BOF 4e).  Problems 3, 8 and 9.