1. How does a change in the exchange rate affect the prices of goods traded between countries?

Changes in exchange rates change the prices people must pay for imported products. When the domestic currency depreciates (decreases in value) against another currency, foreign goods become more expensive for domestic buyers and domestic goods become less expensive for foreign buyers. When the domestic currency appreciates (increases in value) against another currency, foreign goods become less expensive for domestic buyers and domestic goods become more expensive for foreign buyers.

2. Why don’t similar goods sell for the same price all over the world?

In world markets, we would expect arbitrage to make the cost of a good the same in all countries.

In reality, prices around the world frequently differ from purchasing power parity. A McDonald’s Big Mac may cost $2.20 in New York but cost the equivalent of $3.15 in Paris. Deviations from PPP occur for the following reasons:

1. Goods are not identical in different countries. Although McDonald’s tries hard to make Big Macs identical around the world, the atmosphere of eating on Seventh Avenue in New York isn’t the same as on the Champs Elysees.
2. Information is costly. A Parisian would have to make an international phone call to find out the price of a Big Mac today in New York.
3. Shipping costs affect proces. The cost of mailing a Big Mac from New York to Paris is more than the price difference.
4. Tariffs and other restrictions on trade affect prices. If the French government has tax on imported hamburgers, the cost to the Parisian will be higher.

3. What is the relationship between inflation and changes in the exchange rate?

Exchange rates tend to change with differences in inflation rates between countries. Starting with purchasing power parity, if prices in the United States go up 10 percent faster than they do in France, the dollar must depreciate by 10 percent to restore GDP.

4. How do we find the domestic currency return on a foreign bond?

To be able to decide whether buying a U.S. bond or buying a Japanese bond is the better choice, you need to calculate the domestic currency return on the Japanese bond to find how much the interest paid in yen is expected to be worth in dollars in the future; you already know the return in dollars for the U.S. bond, since it pays interest in dollars. The domestic currency return on the Japanese bond is the interest rate paid by the bond plus percentage change in the exchange rate.

5. What is the relationship between domestic and foreign interest rates and changes in the exchange rate?

Interest rate parity (IRP) occurs when the domestic currency return is the same for investments in different countries. When interest rate parity does not hold, arbitrageurs can make a profit by buying financial assets in one country and simultaneously selling similar assets in another country. In the process, exchange rates will change to make domestic currency returns move toward equality.

6. Why don’t similar financial assets yield the same return all over the world?

The reasons why interest rate parity doesn’t always hold are similar to some of the reasons why purchasing power parity doesn’t always hold: financial assets are not identical in different countries (some investments are riskier than others and a risk premium must be paid), there are government controls on international financial transactions (similar to other restrictions on international trade), and there are differences in tax structures (similar in effects to tariffs).

7. How does fiscal policy affect exchange rates?

Fiscal policy affects exchange rates through its effects on interest rates. When the U.S. government increases borrowing to finance a larger deficit, U.S. interest rates rise relative to foreign interest rates. Investments in U.S. bonds become more attractive to foreigners, who increase their demand for dollars to buy U.S. bonds. The increased demand for dollars causes the dollar to appreciate. The dollar appreciation in turn reduces U.S. exports (they’ve become more expensive to foreigners) and increases U.S. imports (they’ve become cheaper for U.S. buyers). If the government decreases borrowing, all the changes go in the opposite direction.

8. How does monetary policy affect exchange rates?

Monetary policy also affects exchange rates through interest rates. If the money supply is increased to finance a larger deficit, nominal interest rates will rise in the United States because of increased inflation caused by the increase in the money supply. To maintain PPP, the dollar must depreciate to counteract the increased inflation. IRP will also be maintained, since the depreciation of the dollar will counterbalance the increased inflation rate and higher nominal interest rates. If both PPP and IRP are maintained, U.S. monetary policy will not affect the amounts of U.S. imports and exports.

9. What can countries gain by coordinating their macroeconomic policies?

By coordinating their macroeconomic policies, countries have a better chance of attaining their policy goals, have greater access to economic information, and can achieve better outcomes than they could by acting on their own.