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International Trade
Mechanics of Foreign Exchange
(FOREX)
Foreign Exchange (FOREX)

The buying and selling of currency
 Ex.
In order to purchase souvenirs in France, it is
first necessary for Americans to sell their Dollars
and buy Euros.
Any transaction that occurs in the Balance of
Payments necessitates foreign exchange
 The exchange rate (e) is determined in the
foreign currency markets.

 Ex.
The current exchange rate is approximately 8
Yuan to 1 dollar

Simply put: The exchange rate is the price of a
currency.
Increase in the Supply
of U.S. Dollars relative to the Euro
€/$
S$
S$ 2
e
e1
D$
Q$
q q1
S$  .: e (ex. rate) ↓ & Q$ ↑
.: $ depreciates relative to €
€/¥
Decrease in the Supply
of Yen relative to the Euro
S¥2
S¥
e1
e
D¥
q1 q
S¥  .: e ↑ & Q¥ ↓
Q¥
.: ¥ appreciates relative to €
Increase in the Demand
for the British Pound relative to the U.S. Dollar
$/£
S£
e1
e
D£
q q1
D£  .: e ↑ & Q£ ↑
Q£
.: £ appreciates relative to the $
D£ 2
Decrease in the Demand
for Yen relative to the British Pound
£/¥
S¥
e
e1
D¥ 2
q1 q
D¥  .: e ↓ & Q¥ ↓
Q¥
.: ¥ depreciates relative to the £
D¥
Exchange Rate Determinants

Consumer Tastes


Ex. a preference for Japanese goods creates an
increase in the supply of dollars in the currency
exchange market which leads to depreciation of the
Dollar and an appreciation of Yen
Relative Income

Ex. If Mexico’s economy is strong and the U.S.
economy is in recession, then Mexico will buy more
American goods, increasing the demand for the
Dollar, causing the Dollar to appreciate and the Peso
to depreciate. The stronger economy does the
buying.
Exchange Rate Determinants

Relative Price Level/Inflation


Ex. If the price level is higher in Canada than in the United
States, then American’s will not buy from Canada. The
supply of American dollars decreases and the demand for
the Canadian dollar decreases. Countries do not buy from
countries with high inflation.
Interest Rates

Ex. If U.S. investors expect that Swiss interest rates will
climb in the future, then Americans will demand Swiss
Francs in order to earn the higher rates of return in
Switzerland. This will cause the Dollar to depreciate and the
Swiss Franc to appreciate. Countries will invest their money
in the countries with high interest rates.
Exports and Imports
The exchange rate is a determinant of both
exports and imports
 Appreciation of the dollar causes American
goods to be relatively more expensive and
foreign goods to be relatively cheaper thus
reducing exports and increasing imports
 Depreciation of the dollar causes American
goods to be relatively cheaper and foreign goods
to be relatively more expensive thus increasing
exports and reducing imports

Graph for both countries and list
the determinant

1. The interest rate in the United States is
increasing. Graph for the US and Japan.
Graph for both countries and list
the determinant

2. Inflation is high in England. Graph for
England and the US.
Graph for both countries and list
the determinant

3. Americans are buying more and more
Hyundai cars. Graph for Korea and the US.
Graph for both countries and list
the determinant

4. Mexico’s economy is doing very well.
Graph for Mexico and the US.


either D$  or S$

And now! Because nir
and GDPR
which causes $
, making u%

so AD  , resulting in PL
which leads to IG

causing nir


, therefore MS

=
ER


Res. Ratio
Disc. Rate
Buy Bonds

Expansionary Monetary Policy
to Counteract a Recession w/ reinforcing
effect on Net Exports
making U.S. goods

M
which means XN


relatively cheaper and foreign goods relatively more expensive causing X and
thereby reinforcing the increase in AD already caused by
the increase in IG.
ER = Excess Reserves
MS = Money Supply
nir = Nominal Interest Rate
IG = Gross Private Investment
D$= Demand for dollars in FOREX
X = Exports
AD = Aggregate Demand
PL = Price Level
GDPR = Real Gross Domestic Product
u% = Unemployment Rate
S$ = Supply of Dollars in FOREX
M = Imports, XN = Net Exports
or S$  which causes $
,making u%


and GDPR




either D$
which leads to IG

And now! Because nir
, resulting in PL

so AD
causing nir

, therefore MS

=
ER

Res. Ratio
Disc. Rate
Sell Bonds

Contractionary Monetary Policy
to Counteract Inflation w/ reinforcing effect
on Net Exports
making U.S. goods

relatively more expensive and foreign goods relatively cheaper causing X and


M
which means XN
thereby reinforcing the decrease in AD already caused by
the decrease in IG.
ER = Excess Reserves
MS = Money Supply
nir = Nominal Interest Rate
IG = Gross Private Investment
D$= Demand for dollars in FOREX
X = Exports
AD = Aggregate Demand
PL = Price Level
GDPR = Real Gross Domestic Product
u% = Unemployment Rate
S$ = Supply of Dollars in FOREX
M = Imports, XN = Net Exports