Download Assume that incomes in Europe have fallen dramatically and there is

AP Macro
Foreign Exchange Practice Problems

What was a buck worth in this activity?

What was a riyal worth?

How can we best express the relationship of riyals to bucks?

How was the value of riyals to bucks determined in round one?

What happened to the value of the riyal relative to the buck in rounds 2 and 3?

Did the buck gain in value?

In the classroom activity, why do you think the value of the riyal decreased relative to the buck?

What caused the change in demand?

What sorts of things might cause the demand for a currency to change?
Foreign Currency and Exchange
The world of foreign currency often seems confusing. Euro, rubles, yen and krona are terms difficult enough to
comprehend on their own without adding the task of trying to figure out what each is worth in terms of United States
dollars.
All of these currencies are money, so all serve the same functions. Money is a medium of exchange, a store of value and
a measure of value.
As a medium of exchange, money is accepted as a means for purchasing goods and services. Both the consumer and
producer agree to the form of money.
As a store of value, money can be saved for future use, a characteristic that many items used as barter goods did not
have. Where crops would spoil or animals die, money lasts for a long period of time.
As a measure of value, money allows us to compare the worth of one object with the worth of another. We can say
a car is worth so many dollars, and a CD is worth so many dollars.
Foreign currencies all serve the same three functions.
Now to the important question: How do we know how much any currency is worth? The simple answer is that money is
worth whatever people are willing to exchange for it. This means it is simply a case of supply and demand. If there is
little demand for a country’s currency and it is in large supply, the money will be worth less than if there is a high
demand for it and a small supply.
As an example, if the United States buys more imports, there is a greater supply of U.S. dollars outside the country. As
the supply increases, each dollar is worth less. Thus we say the money is devalued. If, on the other hand, there are
relatively few U.S. dollars outside the country and/or many foreigners want U.S. currency, each dollar will be worth
more.
Currency values and exchanges are usually made at currency markets. These are places where countries and banks can
find out relative values of different currencies. Each day the values change, and often change several times during a
single day. In the past, currency values were set at a rate and maintained for a period of time. Now supply and demand
allow constant fluctuations.
The situation of foreign exchange is eased somewhat because many financial deals are calculated in United States
dollars. At present, approximately 70% of all international trade is invoiced in United States dollars, because business
people have found this practice easier. A hundred years ago when the British pound was the most important currency in
the world, almost all transactions were recorded in British pounds.
Round 1:
Round 2:
Round 3:
Appreciation & Depreciation
 The currency you want, gains strength. The currency you don’t want, becomes weak. Strong currency appreciates. Weak currency depreciates.
 The currency you don’t want is the one that you supply more of for exchange. The currency you do want you supply less of for exchange.
 The currency that you do want is the one you demand more. The currency that you don’t want you demand less.
Ways to show appreciation and depreciation
D↑/S↓
(want)
D↓/S↑
(don’t want)
APPRECIATES = STRONG
DEPRECIATES = WEAK
Side-by-Side Graph Pairs
 A currency’s value is always relative to another currency’s. Therefore, graphs are always drawn in pairs, side-by-side, with one graph for each currency.
 Supply and Demand move in the same direction for each graph pair. Increasing supply of one currency to trade, increases demand for the other currency.
 When one currency appreciates, the other always depreciates. If one currency is strong, the other is weak.
Domestic Currency
USD
Variations of GRAPH PAIRINGS
Foreign Currency
Domestic Currency
X
USD
Foreign Currency
X
D↑
(want)
S↑
(don’t want)
S↓
(want)
D↓
(don’t want)
Appreciates
Depreciates
Appreciates
Depreciates
D↓
(don’t want)
S↓
(want)
S↑
(don’t want)
D↑
(want)
Depreciates
Appreciates
Depreciates
Appreciates
EXAMPLES
Determinants of Exchange Rate
Determinant
or ∆
(“PI-TIES”)
Price Level
(inflation)
Description
Domestic
Currency
USD
Foreign
Currency
X
Domestic
Currency
USD
Foreign
Currency
X
S↑/D↓
D↑/S↓
Depreciates
Appreciates
(don’t want)
or
(want)
or
or
&
S↓/D↑
D↓/S↑
(want)
(don’t want)
Appreciates
Consumers seek low prices and greater purchasing power.
(Consumers will buy more from the country with the relatively lower inflation rate.)
U.S. inflation rate = 5%
Canada’s inflation rate = 2%
This makes the USD weak / strong.
Changes in income match changes in consumption.
Income
Tastes
(The more money people make, the more they buy of everything, foreign and domestic.)
American’s real income increases by 10%.
This makes the USD weak / strong.
Changes in popularity of a good match changes in demand for its
currency. (The more popular the good, the greater the demand for its currency.)
Researchers find that Belgian chocolate cures cancer.
This makes the USD weak / strong.
IR determine yields (potential profits) from investing in financial assets.
Interest Rates
(IR↑=>Bond Prices↓=>yields↑, meaning demand for currency increases with IR)
Interest rates rise in the United States.
Expected
Return
Investors put money into opportunities for economic growth.
(Higher expected returns on a foreign country's stocks, real estate, or production
facilities increases international demand for those assets and demand for its currency.)
With 9.5% growth in 2015, Ethiopia is projected to grow 10.5% in 2016.
Speculation
This makes the USD weak / strong.
This makes the USD weak / strong.
Currency traders will seek to profit from buying a currency at a low rate
and selling it at a higher rate in the future. (When any of determinant leads to
depreciated currency, an investor will buy it cheap causing the value to rise again.)
The Price Level in the United States rises.
This makes the USD weak / strong.
&
or
Depreciates
The strength of currencies fluctuate. A weak currency buys less (lower purchasing power). A strong currency buys
more (greater purchasing power).
What will happen to the net export component of the US GDP if… (Explain.)
1. the dollar is weak?
2. the dollar is strong?
Assume that American taste for Japanese goods has increased and Americans are now purchasing more imported goods
from Japan. The increased demand for Japanese goods means that there is now an increased demand for Japanese yen.
Simultaneously there is an increased supply of US dollars “seeking” Japanese yen. Draw two graphs, one for the USD
market and one for the Yen market that depicts these situations.
Assume that incomes in Europe have fallen dramatically and there is a greatly reduced demand for American goods in
Europe. Thus there will be reduced demand for US dollars and simultaneously reduced supply of Euros “seeking” dollars.
Show these scenarios drawing a graph of the dollar market and a graph of the euro market.
1.
The price of one nation’s currency expressed in
terms of another nation’s currency is called
(A) The world price
(B) The exchange rate
(C) The law of one price
(D) Terms of trade
(E) Purchasing-power parity
2.
An increase in the international value of the
United States dollar will tend to cause
(A) United States exports to fall
(B) The national income of the United States
to increase
(C) Employment in the manufacturing sector
of the United States to increase
(D) The inflation rate in the United States to
increase
(E) The growth rate of the United States
economy to increase
3.
If a French firm buys computers from the United
States, there would be an increase in which of the
following in the foreign exchange market?
(A) Demand for the United States dollars and
supply of euros
(B) Demand for both the United States
dollars and euros
(C) Supply of the United States dollars and
demand for euros
(D) Supply of both the United States dollars
and euros
(E) International value of the euro relative to
the United States dollar
4.
If the exchange rate between the United States
dollar ($) and the British pound (£) changed from
$2 per £1 to $3 per £1, and domestic prices in
both countries stayed the same, then the United
States dollar would
(A) Depreciate, making United States
imports from Britain more expensive.
(B) Depreciate, making United States
imports from Britain cheaper.
(C) Appreciate, making United States
imports from Britain more expensive.
(D) Appreciate, making United States
imports from Britain cheaper.
(E) Purchase 3 times more British goods than
before the change occurred.
5.
If the real interest rates in the United States rise
relative to the rates in other countries, what will
happen to the international value of the United
States dollar and the United States net exports?
Value of the Dollar
Net Exports
(A) Depreciate
Increase
(B) Depreciate
Decrease
(C) Depreciate
No change
(D) Appreciate
Decrease
(E) Appreciate
Increase
6.
Assume the inflation rate in Country X is very high
relative to the inflation rates in all of its trading
partners. Which of the following is likely to
happen to Country X’s currency on the foreign
exchange market?
(A) The demand curve for the currency will
shift to the right, and the currency will
appreciate.
(B) The demand curve for the currency will
shift to the left, and the currency will
depreciate.
(C) The supply curve for the currency will
shift to the left, and the currency will
appreciate.
(D) The supply curve for the currency will
shift to the left, and the currency will
depreciate.
(E) There will be no shift in the demand
curve for the currency, but the currency
will depreciate.
7.
An appreciation of the United States dollar on the
foreign exchange market could be caused by a
decrease in which of the following?
(A) United states interest rates
(B) The United States consumer price index
(C) Demand for the dollar by United States
residents
(D) Exports from the United States
(E) The tariff on goods imported into the
United States