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Sem 5 Prep
← Open Economy MacroExchange rate systems, cross rates and arbitrage

Formulas for this chapter

The exchange rate R

R = units of domestic currency per unit of foreign currency R rises = domestic currency depreciates R falls = domestic currency appreciates

Every question in this course. Fix the direction once and every sign in chapters 9, 16 and 18 follows.

R
For example dollars per euro, or rupees per dollar: the domestic currency is on top
Depreciation
An increase in the domestic price of the foreign currency: imports dearer, exports cheaper

Cross exchange rate

R(A per B) = dollar value of B / dollar value of A Chained form: R(Rs per EUR) = R(Rs per $) x R($ per EUR)

Given two quotes against a common currency, to find the third. Cancel the units to decide whether to divide or multiply; do not rely on memory.

A
The currency you are pricing in, the denominator
B
The currency being priced, the numerator

Arbitrage profit

Profit per unit = higher quote - lower quote Units bought = sum committed / lower quote Total profit = units bought x profit per unit

Two quotes for the same currency in two markets. Always cross-check by revaluing the whole position at the selling quote and subtracting the sum committed.

Lower quote
The market you buy in, and the divisor when converting the sum committed
Higher quote
The market you sell in

Percentage depreciation of the domestic currency

% depreciation = (R(new) - R(old)) / R(old) x 100

Comparing regimes, or sizing a currency move before applying the Marshall-Lerner arithmetic of chapter 9. Class case: 1.00 to 1.50 is 50 %, 1.00 to 1.25 is 25 %.

R(old)
The starting rate, always the denominator
R(new)
The new rate after the market moves or the authorities allow it to move
Step 1 of 23
The ideaTheory

A price, like any other price

Tomatoes cost forty rupees a kilo. Euros cost ninety rupees each. Both are prices, and both are set the same way: by how many people want the thing and how much of it is on offer.

The exchange rate is the price of a currency, so everything you know about demand and supply applies unchanged.

The only genuinely new idea is that the seller can be a government which refuses to let the price move. What then happens to the excess is the whole of this chapter.

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