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CHAPTER 10
How Exchange Rates are Determined
Learning Objectives
 What exchange rates are
 How exchange rates affect prices of imports and exports
 How exchange rates are determined by supply and demand in the
foreign exchange market
 The factors that cause exchange rates to change
 What the balance of payments is and why it must balance
Chapter Outline
I.
II.
III.
IV.
V.
VI.
The More Things Change, the More Things Stay the Same
Defining Exchange Rates
Determining Exchange Rates
The Demand for Dollars in the Foreign Exchange Market
The Supply of Dollars in the Foreign Exchange Market
Changes in Supply and Demand and How They Affect the Exchange
Rate
VII. Defining the Balance of Payments and Its Influence on the
Exchange Rate, the Financial System, and the U.S. Economy
A.
The Current Account
B.
The Capital Account
VIII. The Balance of Payments and the Exchange Rate
A.
The Causes and Consequences of Dollar Exchange Rate
Movements in the 1980s
B.
The Effects of Policy on Interest Rates and Exchange
Rates since 1990
Answers to Review Questions
Define exchange rate, foreign currency, and foreign exchange
market.
Exchange rate: The number of units of foreign currency that can be acquired with one unit of
domestic money
Foreign currency: The supplies of foreign exchange.
Foreign exchange market: The market for buying and selling the various currencies of the
world.
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How Exchange Rates Are Determined
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Distinguish between a change in the quantity demanded of foreign
exchange and a change in demand for foreign exchange. Do the
same for the quantity supplied and the supply of foreign
exchange.
A change in the quantity demanded of foreign exchange is a movement along the foreign
exchange demand curve, whereas a change in demand for foreign exchange is a shift of the
entire demand curve. Quantity demanded changes when the exchange rate changes. Deman d
changes when the demand by foreigners for U.S. goods, services, and financial claims changes.
The quantity supplied of foreign exchange is a movement along the foreign exchange supply
curve, whereas a change in the supply of foreign exchange results i n a shift of the entire supply
curve. There is a change in quantity supplied when the exchange rate changes. The supply of
foreign exchange changes when U.S. demand for foreign goods, services, and financial claims
changes.
Explain the relationship between the supply of dollars in the
foreign exchange market and debit items in the balance of
payments. Do the same for the demand for dollars in the
foreign exchange market and credit items in the balance of
payments.
All transactions that result in payments by Americans to foreigners are recorded as payments in
the balance of payments. They are negative or debit items. These payments include payments
for U.S. purchases of foreign goods, services and financial instruments. To purchase these
goods, you would need to exchange dollars for the foreign currency. By exchanging dollars for
the foreign currency, American's are in fact adding to the supply of dollars in the foreign
exchange market.
In the balance of payments, all transactions that result in payments by foreigners to Americans
are recorded as receipts in the balance of payments. They are credit or plus items. These
payments include foreign purchases of U.S. goods, services, and financial instruments. For
foreigners to obtain these goods, services, and financial instruments, they must exchange their
currency for dollars in the foreign exchange market. By exchanging foreign currency for
dollars, the foreigners are in fact increasing the demand for dollars.
Defend the following statement: The balance of payments always
balances.
The balance of payments is the record of transactions between the United States and its trading
partners in the rest of the world. The balance of payments is based on a standard double -entry
bookkeeping scheme, such as that used by business firms or households to record receipts and
payments. What this means is that receipts (i.e., sources of funds such as income or borrowing)
will by definition equal payments (i.e., uses of funds). Every use of funds has a source of
funds and vice versa.
Also, the equilibrium exchange rate adjusts to equalize the sum of receipts from foreigners
with the sum payments to foreigners. In other words, the exchange rate adjusts so that the
quantity demanded of foreign exchange equals the quantity sup plied. Thus, changes in
exchange rates will always cause the balance of payments to balance.
Explain how the trade balance, the balance of goods and services,
and the balance of payments differ.
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The trade balance is the difference between merchandise exports and imports. The balance of
goods and services includes net exports of services plus the trade balance. The balance of
payments is the record of transactions between the United States and its trading partners in the
rest of the world over a particular period of time. The balance of payments includes the balance
of goods and services (the current account) plus the capital account.
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How is a surplus in the current account related to a deficit in
the capital account? How is a deficit in the current account
related to a surplus in the capital account?
According to the accounting procedure underlying the balance of payments, any surplus in the
current account must be equal to a deficit of the same amount in the capital account. Likewise,
any deficit in the current account must be equal to a surplus of the same amount in the capital
account. In other words, because the balance of payments always balances, any surplus in the
current account must be equal to the deficit in the capital account and vice versa .
If interest rates in the United States were lower than rates in
the rest of the world, would the United States be more likely
to be experiencing a net capital inflow or a net capital
outflow? Ceteris paribus, would the current account be in
surplus or deficit?
If interest rates were lower in the United States than in the rest of the world, the United States
would most likely experience a capital outflow. Investors would seek the higher return of
securities outside the United States. The capital account would move into a deficit position.
Ceteris paribus, the current account would move towards a surplus to offset the deficit in the
capital account.
If the demand for U.S. exports falls, what will happen to the
exchange rate? What will happen to the trade balance and the
balance of goods and services?
If the demand for U.S. exports falls, the demand for dollars will fall. The lower demand for
dollars will cause the exchange rate to fall.
Other factors held constant, if the demand for U.S. exports falls, the trade balan ce, which is
exports minus imports, will fall. Assuming the balance of services remains unchanged, the
balance of goods and services will also fall when the trade balance falls.
What would happen to the exchange rate if foreigners decided to
sell U.S. securities?
If foreigners decided to sell U.S. securities, they are reducing their demand for U.S. financial
instruments. The demand for dollars would fall and the exchange rate would decrease as the
United States experienced a capital outflow.
What is the difference between the trade balance and the current
account balance?
The trade balance is the difference between merchandise exports and imports. The current
account balance is the balance resulting from transactions that involve currently produced
goods and services, including the balance of goods and services and net unilateral transfers .
What are the assumptions of the purchasing power parity theory?
What are the reasons why the theory may not offer a complete
explanation of exchange rate differentials?
The theory of purchasing power parity asserts that in the long run, exchange rates adjust so that
the relative purchasing power of various currencies is equalized. Thus, after full adjustment
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has occurred, each currency will purchase the same market baske t of goods and services in
every country. The assumptions of the purchasing power parity theory include that goods are
identical from one country to the next, that all goods and services are tradable, that there are
no transportation costs, and that there are no barriers to trade, such as tariffs. Many of the
assumptions are extremely unrealistic.
Answers to Analytical Questions
If a hotel room in downtown Tokyo costs 20,000 yen per night and
the yen/dollar exchange rate is 100, what is the dollar price
of the hotel room? If the yen/dollar exchange rate increases
to 150, what happens to the dollar price of the hotel room?
If the yen/dollar exchange rate is 100, the dollar price of the hotel room can be found by using
the following formula:
U.S. dollar price of foreign goods = Foreign price of foreign goods/exchange rate
In this case, the dollar price of the hotel room is $200 ($200 = 20,000/100)
If the yen/dollar exchange rate increases to 150, the dollar price of the hotel room decreases to
$133.33 ($133.33 = 20,000/150).
If a hotel room in downtown Los Angeles costs $100 per night and
the yen/dollar exchange rate is 100, what is the yen price of
the hotel room? If the yen/dollar exchange rate increases to
150, what happens to the yen price of the hotel room?
If the yen/dollar exchange rate is 100, the yen price of the hotel room can be found by the
following formula:
Yen price = Dollar price x yen/dollars exchange rate.
If the yen/dollar exchange rate is 100, the yen price of the hotel room is 10,000 ye n (10,000
yen = $100 x 100). If the yen/dollar exchange rate is 150, the yen price of the hotel room is
15,000 yen (15,000 = $150 x 100).
Assume that the dollar appreciates by 10 percent in terms of the
Mexican peso. Explain what happens to the dollar price of
tequila from Mexico after the appreciation. What happens if
the dollar depreciates by 10 percent?
The dollar price of tequila from Mexico is the Peso Price divided by the peso/dollar exchange
rate. If the dollar appreciates by 10 percent in terms of the Mexican peso, then the peso/dollar
exchange rate increases 10 percent and the dollar price of tequila falls by 10 percent.
If the dollar depreciates by 10 percent, the dollar price of tequila will increase by 10 percent.
When the dollar appreciates, the dollar price of foreign goods falls and vice versa.
If a bottle of rare French wine sells for 40 euros in Paris and
the exchange rate is .9 euros = $1, how much will the bottle
of wine sell for in New York City? (Ignore transportation
costs, etc.)
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The dollar price of rare wine from France is the euro Price divided by the euro/dollar exchange
rate. If the wine sells for 40 euros in Paris and the exchange rate is .9 euros/dollar, then 1 euro
= $1.1, and the bottle of wine will sell for $36.36 ($36.36 = 40/1.1) in New York.
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Use graphs to show what happens to the demand for and supply of
dollars in the foreign exchange market in the event of each of
the following:
a.
b.
c.
d.
Domestic income rises.
Foreign income rises.
Domestic inflation rises relative to foreign inflation.
Domestic interest rates rise relative to foreign interest
rates.
a.
If there is an increase in U.S. income, the supply curve shifts to the right. Also, the quantity
demanded of dollars increases. The equilibrium poi nt moves from A to B.
b.
If foreign income rises, the demand for dollars curve shifts to the right. Also, quantity supplied
of dollars increases. The equilibrium point shifts from A to B.
c.
The effects are similar to graph a.
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d.
If domestic interest rates rise, the supply curve shifts to the left. The demand curve shifts to
the right. The equilibrium point moves from A to B.
Use graphs to demonstrate that when both domestic and foreign incomes are rising, we
cannot be sure of the direction of exchange rates.
As shown on graph a of question 16, when domestic income rises, the supply curve shifts to the
right. Also, as shown on graph b of question 1 6, when foreign income rises, the demand curve
shifts to the right. Since both curves are moving at the same time, there is no way to be sure of
the direction of exchange rates. The exchange rate will depend on the magnitude of the shifts.
If merchandise exports are $600 and merchandise imports are $500,
what is the trade balance?
The trade balance is the value of merchandise exports minus the value of merchandise imports.
In this case, the trade balance is $100 ($600 - $500) and the United States is running a trade
surplus.
If there is a surplus of $100 in the capital account, no
unilateral transfers, and a $50 deficit in the net exports of
services, what is the trade balance?
In the balance of payments, exchange rates adjust so that the surplus/deficit of the cur rent
account is exactly offset by a deficit/surplus in the capital account. The current account
consists of the balance of trade, the net export of services, and unilateral transfers. In this
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case, if there is a surplus of $100 in the capital account, th en there must be a deficit of $100 in
the current account. If there is a $50 deficit in the net export of services and no unilateral
transfers, then there must be a $50 deficit in the trade balance. Only then will the $100 surplus
in the capital account be offset by a $100 deficit in the current account.
If $1 = 150 yen and 1 yen = 75 British pounds, what is the
pound/dollar exchange rate? What is the dollar/pound exchange
rate?
If $1 = 150 yen and 1 yen = 75 British pounds, then 150 x 1 yen =
150 x 75 British pounds and $1 = 11,250 pounds.
If $1 = 11,250 pounds, then 1 pound = $1/11,250 = .000888.
If the yen/dollar exchange rate is 125, how much will 25,000 yen
cost? If the exchange rate appreciates to 150, how much will
the 25,000 yen cost?
If the yen/dollar exchange rate is 125, then 25,000 yen will cost $200 (25,000/125 = $200). If
the exchange rate appreciates to 150, then 25,000 yen will cost $166.67 (25,000/150).
If the yen/dollar exchange rate is 125, how many yen will $15,000
be worth? If the exchange rate depreciates to 100, how many
yen will $15,000 be worth?
If the yen/dollar exchange rate is 125, then $15,000 will be worth 1,875,000 yen (1,875,000 =
$15,000 x 125). If the exchange rate depreciates to 100, then $15,000 will be worth 1,500,000
yen (1,500,000 = $15,000 x 100).
Explain how, according to the purchasing power parity theory,
exchange rates will adjust if inflation in the United States
is 3 percent and inflation in Japan is 1 percent.
According to the purchasing power parity theory, in the long run, exchange rates adjust so that
the relative purchasing power of two currencies is equalized. If inflation in the United States
is 3 percent and inflation in Japan is 1 percent, then in the long run, the dollar should be
depreciating and the yen should be appreciating by 2 percent to keep the relative purchasing
power equalized.