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9.5 End-of-Chapter Material

In Conclusion

We began this chapter with a deceptively simple question about money: why do people want it? To answer that question, we first looked at what money is. We discovered that money is an asset that has certain defining characteristics, such as portability, divisibility, and durability. Most importantly of all, though, we said that money must have acceptability. What turns an asset into a money, ultimately, is the simple fact that enough people are willing to treat it as such.

If we look through history, we find that many different things have served as money in different places and at different times. As well as the familiar notes and coins, these include seashells, stones, cigarettes, cans of food, gold, and silver. These could successfully function as money because they were acceptable as money in their particular context.

We then imagined that you were lucky enough to find a $100 bill on the sidewalk and explored the various things that you could do with this money, including buying goods and services, buying other currencies, and buying assets. As we did so, we explored a number of different arguments, all based on arbitrage, that help us to understand the relationships between interest rates, exchange rates, asset prices, and inflation rates. We argued that arbitrageurs will step in when there are easy profit opportunities. Arbitrage does not say that riskless profit opportunities cannot exist. It says that they will not persist. If a riskless profit opportunity were to exist, then people would very quickly take advantage of it and, by so doing, eliminate it.

Expressed more metaphorically, economists often say that there are no $100 bills lying on the ground waiting to be picked up. It is not that it is impossible for someone to drop a $100 bill, but if one person has dropped a large bill, someone else will almost certainly pick it up very quickly. There is an immediate and powerful lesson of arbitrage, one that you should bear in mind throughout life. If someone tells you of a surefire way to make easy money, beware!

Exercises

  1. Suppose you go to a local café to order a drink. Instead of paying with the currency used in your home country, imagine you try to pay with the currency of another country. What do you think the response would be at the café? Why? What could you do to convince them to accept foreign currency at a local café? Imagine that you are at the border of two countries, say in a café near the US border with Canada. Do you think you could use Canadian currency in a US café near the border?
  2. When you are traveling in a foreign country and want to use your debit card, what type of fees do you pay to withdraw money in foreign currency? Usually fees take two forms: a fixed fee, say $5, for any size transaction or a fee that is proportional to the amount you withdraw. If you want to make a large withdrawal, which type of fee do you prefer? If the fee is fixed, will this create an incentive to make more or fewer withdrawals? What does the fixed fee do to the size of the withdrawal you make?
  3. Suppose the dollar price of euros is $10 and the euro price of dollars is EUR 1. Explain how you could make a profit in this market. What would you buy and what would you sell? Can this be an equilibrium in the foreign exchange market? Show that there are no arbitrage profits if the dollar price of the euro is $1.25 and the euro price of the dollar is EUR 0.80.
  4. (Advanced) Using the relationship

    price of euro in dollars × price of dollar in euros = 1,

    how would you draw the supply and demand curves and depict equilibrium in the market for dollars and the market for euros?

  5. Look at the left-hand table in Figure 9.6 "Exchange Rates". How are the numbers on the bottom left connected to the numbers on the top right? The diagonal has been left blank. What number could go on the diagonal?
  6. Look at the left-hand table in Figure 9.6 "Exchange Rates". Suppose you start with GBP 100. Convert those pounds into euros and then convert the euros into dollars. How many dollars would you get? How many pounds do you get if you then convert your dollars into pounds?
  7. Perform the same exercise as in Question 6 but use the table on the right-hand side of Figure 9.6 "Exchange Rates". How many pounds do you end up with?
  8. If the nominal interest rate is 5 percent in France and 3 percent in Europe, according to uncovered interest parity, what do investors think is going to happen to the euro-dollar exchange rate?
  9. If the real interest rate is 2 percent in China and 6 percent in India, and investors are not expecting any change in the rupee-yuan exchange rate, then what can you conclude about inflation rates in China and India?
  10. Explain how inflation reduces the real value of a currency both domestically and in other countries.

Economics Detective

  1. Think of a “basket of goods” you buy often. It should include at least four items (for example, an espresso, a CD, a hamburger, and a copy of Newsweek). E-mail a friend in another country to find the prices for that same basket of goods. Check the exchange rate between your country’s currency and that in your friend’s country. Contrasting the prices in the two countries, look for violations of the law of one price. Is there some way you could make some profit?
  2. Check rental car rates across two countries. (This is easy to do online at large car rental companies.) Make sure you choose the same car and insurance options. How might you explain the differences in these rates? Are there arbitrage profits for you to make?
  3. Find an issue of the Economist from the period in the 1990s when Argentina was pegging the peso to the US dollar through a currency board, and look up the Big Mac index. What was the exchange rate then? What was the price of a Big Mac in Argentina during that period? Compare the peso prices of Big Macs and dollars between the two time periods.
  4. Which countries use the kwacha, the dram, the ringgit, the leke, the baht, and the rial?
  5. Suppose you want to convert some US dollars to euros, deposit them in a bank in Italy for one year, and then convert your euros to dollars. Search the Internet to determine how you could arrange now to buy dollars with euros in one year’s time. What price would you have to pay for dollars?
  6. Go to http://www.oanda.com and look at the latest exchange rate data. Find two currencies that have recently appreciated relative to the dollar and two currencies that have recently depreciated relative to the dollar.
  7. Find a currency that has appreciated relative to the dollar since March 2007. Can you discover any explanations about why there was this change in the exchange rate?
  8. Find data on the dollar price of the euro starting from the inception of the euro. Find periods when the dollar was appreciating relative to the euro. Find periods when the dollar was depreciating relative to the euro.
  9. Who holds US government debt? What type of foreign exchange supported this?
  10. Use http://www.minneapolisfed.org/community%5Feducation/teacher/calc to calculate the value of a dollar at different points in time. What would a dollar in 1955 buy today?
  11. When you deposit money in the United States, you receive deposit insurance. If you deposit money in a bank in Italy or Japan or Mexico, will you receive deposit insurance? How does the existence of this insurance influence your decision about making deposits in foreign banks?
  12. Call your bank to ask a hypothetical question: What will you have to do to deposit a large euro check in your dollar account? What will the bank charge you for this transaction? Are these costs proportional to the size of the euro check or is the cost a fixed number?

Spreadsheet Exercises

  1. Suppose there are three currencies: dollars, pesos, and yuan. Write a spreadsheet program to find the dollar price of yuan given the dollar price of a peso and the peso price of the yuan such that there are no arbitrage profits to be made.
  2. Suppose there are two countries: the United States and Mexico. Write a spreadsheet program to determine the interest rate on deposits in Mexico given the interest rate on deposits in the United States, the current exchange rate, and the expected future exchange rate so that there are no arbitrage profits to be made. All else being the same, how does a change in the US deposit rate affect the current exchange rate?