Download Exchange Rate

International Trade
and Finance:
Foreign Exchange
Market
AP Economics
Mr. Bordelon
Exchange Rates
• Exchange rate. Price at which currencies trade.
• Foreign exchange market. Market in which
currencies are traded.
• G/S/Assets produced in a country must be paid for
in that country’s currency, hence the market for
foreign currency.
• Even if sellers accept payment in foreign currency, they
will exchange that foreign currency for domestic
currency.
Exchange Rates
Looking at this table,
there are two ways to
write any of the
exchange rates.
$1 = €0.75 or €1 = $1.34
There is no specific rule
in reading or writing the
exchange rate.
Exchange Rates
• Appreciation. When a currency becomes
more valuable in terms of other currencies.
• Depreciation. When a currency becomes
less valuable in terms of other currencies.
• Example. The value of €1 increases from $1 to
$1.25. The value of $1 decreased from €1 to
€0.80 (1/1.25 = 0.80).
• The euro appreciated against the dollar.
• The dollar depreciated against the euro.
Equilibrium Exchange Rate
Equilibrium exchange
rate. Rate at which
quantity of currency
demanded in foreign
exchange market equals
quantity supplied.
The rate is determined
by the free market.
Exchange Rate
Modeling this idea of appreciation and
depreciation, we use the exchange rate
model. First and foremost, on the xaxis, typically the AP exam, will make
it a matter of “foreign currency” per
dollar, which would would write as
“foreign currency”/dollar.
An increase in demand for dollars
would indicate that the dollar would
appreciate, as it now costs more of the
foreign currency to buy the U.S. dollar.
A decrease in demand for dollars
would indicate that the dollar would
depreciate, as it now costs less of the
foreign currency to buy the U.S. dollar.
Exchange Rates
• As the demand for dollars shifts to the right,
the equilibrium price of dollars rises and the
dollar appreciates.
• Because the U.S. dollar has appreciated
against the foreign currency, American
consumers will increase purchases of g/s
from the foreign country.
• More U.S. dollars will be supplied and will
flow out of the U.S. current account.
Exchange Rates
• Because the quantity of dollars demanded
and supplied is the same at the equilibrium
exchange rate, the increased quantity of
dollars demanded must be equal to the
increased quantity of dollars supplied.
• Any increase in the U.S. balance of
payments on the financial account is exactly
offset by a decrease in the U.S. balance of
payments on the current account.
Exchange Rates
• Key points:
• An increase in capital flows into the U.S. leads
to a stronger dollar, which then creates a
decrease in U.S. net exports.
• A decrease in capital flows into the U.S. leads
to a weaker dollar, which then creates an
increase in U.S. net exports.
Real Exchange Rate
• Real exchange rate. Exchange rates
adjusted for international differences in
aggregate price levels (inflation).
Real Exchange Rate
• Example. Exchange rate we are looking at
is the number of Mexican pesos per U.S.
dollar. Let PUS and PMex be indices of the
aggregate price levels in the United States
and Mexico, respectively.
• Real exchange rate between the Mexican
peso and the U.S. dollar is defined as:
• Real exchange rate = (Exchange rate)(PUS/PMex)
Real Exchange Rate
• Real exchange rate = (Exchange rate)(PUS/PMex)
• Exchange rate in this equation is the nominal
exchange rate (not adjusted for inflation).
• Example. There is no difference in
aggregate price levels between the U.S. and
Mexico in the base year. The nominal
exchange rate is 12.5 pesos per dollar.
• Real exchange rate = (12.5)(100/100) = 12.5
pesos per dollar
Real Exchange Rate
• Example. Suppose the Mexican economy
has suffered 10% aggregate inflation and
PMex =110. Nominal exchange rate is 12.5
pesos per dollar.
• Real exchange rate = (12.5)(100/110) = 11.4
pesos per dollar
• In real terms, even though the exchange rate
hasn’t changed, inflation in Mexico means that
each U.S. dollar will buy fewer pesos and thus
fewer Mexican goods.
Purchasing Power Parity
• Purchasing power parity. Occurs between two
countries’ currencies and is the nominal exchange
rate at which a given basket of goods and services
would cost the same amount in each country.
• Example. A basket of goods and services that
costs $100 in the United States costs 1,000 pesos
in Mexico.
• Purchasing power parity is 10 pesos per U.S. dollar. At
that exchange rate, 1,000 pesos = $100, so the market
basket costs the same amount in both countries.
Question 1
January 2, 2009
January 4, 2010
$1.45 = £1
$1.61 = £1
32.82 Taiwan dollars = $1
31.75 Taiwan dollars = $1
$0.82 = 1 Canadian dollar
$0.96 = 1 Canadian dollar
90.98¥ = $1
92.35¥ = $1
$1.39 = €1
$1.44 = €1
1.07 Swiss francs = $1
1.03 Swiss francs = $1
Based on the exchange rates for the first trading days of
2009 and 2010 in this table, did the U.S. dollar appreciate or
depreciate during 2009? Did the movement in the value of
the U.S. dollar make American goods and services more or
less attractive to foreigners?
Question 2
In each of the following scenarios, suppose that the two nations are the
only trading nations in the world. Given inflation and the change in the
nominal exchange rate, which nation’s goods become more attractive?
a. Inflation is 10% in the U.S. and 5% in Japan; the U.S. dollarJapanese yen exchange rate remains the same.
b. Inflation is 3% in the U.S. and 8% in Mexico; the price of the U.S.
dollar falls from 12.50 to 10.25 Mexican pesos.
c. Inflation is 5% in the U.S. and 3% in the eurozone; the price of the
euro falls from $1.30 to $1.20.
d. Inflation is 8% in the U.S. and 4% in Canada; the price of the
Canadian dollar increases from $0.60 to $0.75.
Question 3
Suppose the U.S. and Japan are the only two trading countries
in the world. What will happen to the value of the U.S. dollar
if the following occur, other things equal?
a. Japan relaxes some of its import restrictions.
b. The U.S. imposes some import tariffs on Japanese goods.
c. Interest rates in the U.S. rise dramatically.
d. A report indicates that Japanese cars are much safer than
previously thought, especially compared with American
cars.