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C h a p t e r
1 4
Exchange Rates and
Their Determination:
A Basic Model
To accompany
International Economics, 3e by Sawyer/Sprinkle
PowerPoint slides created by Jeff Heyl
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
CHAPTER ORGANIZATION
•
•
•
•
•
•
•
•
Introduction
Exchange Rates
The Demand for Foreign Exchange
The Supply of Foreign Exchange
Equilibrium in the Foreign Exchange Market
Changes in the Equilibrium Exchange Rate
Exchange Rate Volatility and International Trade
Summary
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14 – 2
INTRODUCTION
• The international value of a country’s currency has
•
•
•
become an inescapable part of the daily flow of
economic information
Most people don’t have a clear understanding of
why the exchange rate matters and what causes it to
change
Why does the supply and demand model work for
foreign exchange?
What do economists know about the effects of
exchange-rate volatility on international markets?
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14 – 3
EXCHANGE RATES
• Exchange rates are the price of one country’s
•
•
•
•
currency in terms of another
Demand for foreign currency comes from demand
for foreign goods and services
Demand for foreign currency relative to supply of
foreign currency determines the exchange rate
An increase in the value of a currency is referred
to as appreciation
A decrease in the value of a currency is referred to
as depreciation
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EXCHANGE RATES
• The way exchange rates are reported can create
•
•
•
some confusion
Quoting as domestic currency per unit of foreign
currency is a direct quote
Quoting as units of foreign currency per unit of
domestic currency as an indirect quote
Each country has its own conventions concerning
how the exchange rate is reported for each foreign
currency
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EXCHANGE RATES
• In the spot market transactions are concluded at
•
the same time the price is agreed on
The percentage appreciation or depreciation of
the spot rate over time using direct quotes can be
measured using
 beginning rate  ending rate 
%Δ in Spot Rate  
100

begining rate


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EXCHANGE RATES
• A rise in the exchange rate means the domestic
•
currency has depreciated
If the exchange rate falls the domestic currency
has appreciated
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EXCHANGE RATES
Figure 14.1(a)
Foreign Exchange Rates of the U.S. Dollar
U.S. Dollars per Canadian Dollar
0.95 –
0.90 –
0.85 –
0.80 –
0.75 –
0.70 –
0.65 –
0.60 –
1980
1983
1986
1989
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1992
1995
1998
2001
2004
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EXCHANGE RATES
Figure 14.1(b)
Foreign Exchange Rates of the U.S. Dollar
U.S. Dollars per Japanese Yen
0.012 –
0.010 –
0.008 –
0.006 –
0.004 –
0.002 –
1980
1983
1986
1989
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1992
1995
1998
2001
2004
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EXCHANGE RATES
Figure 14.1(c)
Foreign Exchange Rates of the U.S. Dollar
U.S. Dollars per UK Pound
2.4 –
2.2 –
2.0 –
1.8 –
1.6 –
1.4 –
1.2 –
1.0 –
1980
1983
1986
1989
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1992
1995
1998
2001
2004
14 – 10
EXCHANGE RATES
Figure 14.1(d)
Foreign Exchange Rates of the U.S. Dollar
U.S. Dollars per Euro
1.4 –
1.3 –
1.2 –
1.1 –
1.0 –
0.9 –
0.8 –
1999
2000
2001
2002
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2003
2004
2005
2006
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THE DEMAND FOR
FOREIGN EXCHANGE
• The demand for foreign exchange is a result of
•
•
domestic residents demanding foreign goods and
services
The exchange rate is price of foreign exchange
As the exchange rate changes, the quantity
demanded of foreign goods and services will
change
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THE DEMAND FOR
FOREIGN EXCHANGE
Figure 14.2
The Demand for Foreign Exchange
$/Pounds
$3
A
B
$2
C
$1
Demand for
Pounds (D)
£1
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£2
£3
Pounds
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THE DEMAND FOR
FOREIGN EXCHANGE
• Shifts in the Demand for Foreign Exchange
• Changes in the demand for foreign exchange are
•
related to the income level, the relative price
levels, and tastes and preferences
The most important factors are changes in
income and prices relative to the foreign country
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THE DEMAND FOR
FOREIGN EXCHANGE
• Changes in Domestic Income
• As U.S. income increases, demand for all goods
•
•
including imports increases
This leads to an increase in the demand for
foreign currency and a shift in the demand curve
to the right
If income declines, the effect will be the
opposite and the demand curve will shift to the
left
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THE DEMAND FOR
FOREIGN EXCHANGE
Figure 14.3
The Change in Demand for Foreign Exchange
$/Pounds
D’
D”
D
Pounds
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THE DEMAND FOR
FOREIGN EXCHANGE
• Changes in Relative Prices
• A change in the relative prices between countries
•
•
will change or shift the demand curve
If the prices for goods rise in a foreign country
and the exchange rate did not change, then prices
of those foreign goods would ride in the U.S. as
well
If the demand curve for foreign currency shifts to
the left, less of the foreign currency is demanded
at a given exchange rate
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14 – 17
THE DEMAND FOR
FOREIGN EXCHANGE
• In practice, price level changes in a country are not
•
•
•
so discrete
Most countries experience a continuous change in
prices as measured by the inflation rate
Thus the discussion of relative prices changes and
their impact on demand for foreign currency can be
generalized to relative inflation rates between
countries
Countries with high levels of inflation tend to
experience increases in demand for foreign goods
and foreign exchange
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THE DEMAND FOR
FOREIGN EXCHANGE
Figure 14.4
U.S. Trade Balance and GDP Growth Differential
Percent
Index, March 1973 = 100
0–
– 1.5
–50 –
– 1.0
Trade Balance
–100 –
– 0.5
–150 –
–
–200 –
– –0.5
–250 –
– –1.0
–300 –
– –1.5
–350 –
– –2.0
–400 –
– –2.5
–450 –
– –3.0
1992
1995
1998
2001
0
2004
GDP Growth Differential (Foreign minus U.S.)
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THE SUPPLY OF
FOREIGN EXCHANGE
• Supply of Foreign Exchange
• The supply in the foreign exchange in the
•
•
foreign exchange market is determined by the
demand for foreign goods in a domestic market
Demand for foreign goods is influenced by the
exchange rate and as the exchange rate increases,
the quantity of currency supplied to the foreign
exchange market increases
The amount of currency supplied to the foreign
exchange market depends on the foreign demand
for imported goods
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THE SUPPLY OF
FOREIGN EXCHANGE
Figure 14.5
The Supply for Foreign Exchange
$/Pounds
Supply of
Pounds (S)
$3
F
$2
E
$1
D
£1
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£2
£3
Pounds
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THE SUPPLY OF
FOREIGN EXCHANGE
• Shifts in the Supply of Foreign Exchange
• There are two important factors that shift the
•
supply of foreign exchange
Changes in Foreign Income
• If foreign income rises, demand for imported
goods increases
• As a result, more foreign currency is sold in
the foreign exchange market and the supply of
foreign currency increases
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14 – 22
THE SUPPLY OF
FOREIGN EXCHANGE
• Changes in Relative Prices
• If domestic prices rise relative to foreign prices,
•
demand for imports will rise
This will cause a right shift in the supply curve
for foreign exchange
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14 – 23
THE SUPPLY OF
FOREIGN EXCHANGE
Figure 14.6
The Change in Supply for Foreign Exchange
$/Pounds
S”
S
S’
Pounds
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14 – 24
EQUILIBRIUM IN THE
FOREIGN EXCHANGE MARKET
• The equilibrium exchange rate occurs when the
•
•
quantity demanded of foreign exchange equals
the quantity supplied
Because exchange rates fluctuate over the course
of a trading day, a precise equilibrium would
only be achieved if everything else remained
constant
However, exchange rates move very quickly as
economic conditions and expectations change
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EQUILIBRIUM IN THE
FOREIGN EXCHANGE MARKET
Figure 14.7
The Equilibrium Exchange Rate
$/Pounds
Supply of
Pounds (S)
$3
$2
E
$1
Demand for
Pounds (D)
£1
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Pounds
14 – 26
CHANGES IN THE
EQUILIBRIUM EXCHANGE RATE
• If U.S. incomes increase, the demand for imports
•
•
•
in the U.S. will increase which will cause an
increase in the demand for foreign exchange
If supply is held constant, the exchange rate will
increase
If U.S. inflation is greater than a foreign inflation
rate, demand for foreign exchange will increase as
consumers demand less expensive foreign goods
The supply of foreign currency to the market falls
as U.S. goods have become relatively more
expensive
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CHANGES IN THE
EQUILIBRIUM EXCHANGE RATE
• The exchange rate attempts to correct for changes
•
•
•
•
in relative prices between countries
Countries with relatively high inflation rates will
tend to have currencies that depreciate over time
Countries with relatively low inflation rates will
tend to have currencies that appreciate over time
Depreciation is the market’s way of compensating
for differential rates of inflation
Many combinations of factors could occur leading
to a very large number of possible changes to the
equilibrium exchange rate
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CHANGES IN THE
EQUILIBRIUM EXCHANGE RATE
Figure 14.8
Changes in the Equilibrium Exchange Rate
$/Pounds
S
$3
F
$2
E
$1
D’
D
£0
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£1
Pounds
14 – 29
CHANGES IN THE
EQUILIBRIUM EXCHANGE RATE
Table 14.1
The Impact of Changes in the Demand and Supply of
Foreign Exchange and the Equilibrium Exchange Rate
Changes in Determinant
Changes in the DollarPound Exchange Rate
Changes in the Value
of the U.S. Dollar
Increase in U.K. Demand for U.S. Exports
Decreases
Appreciation
Decrease in U.K. Demand for U.S. Exports
Increases
Depreciation
Increase in U.S. Demand for U.K. Exports
Increases
Depreciation
Decrease in U.S. Demand for U.K. Exports
Decreases
Appreciation
Increase in U.S. Prices
Increases
Depreciation
Decrease in U.S. Prices
Decreases
Appreciation
Increase in U.K. Prices
Decreases
Appreciation
Decrease in U.K. Prices
Increases
Depreciation
Increase in U.S. Incomes
Increases
Depreciation
Decrease in U.S. Incomes
Decreases
Appreciation
Increase in U.K. Incomes
Decreases
Appreciation
Decrease in U.K. Incomes
Increases
Depreciation
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EXCHANGE RATE VOLATILITY
AND INTERNATIONAL TRADE
• Changes in exchange rates make international
•
•
•
trade different from interregional trade within a
large country
In the short run, changes can be partially mitigated
through use of forward or futures markets for
foreign exchange
The reduction of risk can be purchased only at
some additional cost
Changes in the exchange rate are difficult to
forecast in the long run
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EXCHANGE RATE VOLATILITY
AND INTERNATIONAL TRADE
• Risk and uncertainty depress international trade
•
•
•
•
and investment
However, the magnitude of effect is not known
This creates a bias toward domestic transactions if
exchange rates are allowed to fluctuate in response
to changes in the factors that determine them
Forecasting exchange rate changes is a difficult
exercise
A forecast should consider at least changes in the
two countries’ GDP and price levels
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EXCHANGE RATE VOLATILITY
AND INTERNATIONAL TRADE
• There are many other factors that influence
•
•
exchange rates
Long run forecasts based on pronounced trends
might be reasonably accurate
Short run forecasts are especially difficult and
could misforecast the exchange rate by a
considerable margin
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SUMMARY
1. The exchange rate is the price of one country’s
currency in terms of another country’s currency
2. Appreciation of the domestic currency is a
decrease in the number of units of domestic
currency necessary to buy a unit of foreign
currency
3. The demand for foreign exchange is related to
changes in domestic income and changes in
relative prices
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SUMMARY
4. The supply of foreign exchange is related to
changes in foreign income and changes in foreign
prices
5. The interaction of the supply and demand for
foreign exchange determines the equilibrium
exchange rate in a free market
6. Everything else equal, a country that has faster
economic growth than its trading partners will
tend to find that its currency is depreciating in the
foreign exchange market
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SUMMARY
7. A country that has higher inflation than its trading
partners will tend to find that the value of its
currency is depreciating in the foreign exchange
market
8. Fluctuations in the exchange rate tend to depress
the amount of international trade in goods and
services relative to domestic trade in goods and
services
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