Post on 21-Dec-2015
Lectures in Macroeconomics- Charles W. Upton
Exchange Rate Basics
TS
CD
p
pS
TS
CD
p
pD
Q
4
1000200
3
100 1200
TS
CD
p
p
Exchange Rate Basics 2
The ProcessComparative Advantage & Supply and Demand set
relative prices of
goods
Domestic Prices are set via the Quantity Theory
The Combination
Sets Exchange
Rates
Exchange Rate Basics 3
An Example
Output Per Day of Work
T-shirts Music CDs Relative Cost
United States
20 10 2:1
Mexico 5 1 5:1
Exchange Rate Basics 4
The price of a t-shirt
• With International Trade– The price of a Music CD, in terms of a T-shirt,
the terms of trade, must be the same in both countries.
– The price must be between 2 and 5 t-shirts; just what depends on supply and demand
– We will assume (so that we can get on with this example) that the actual price is 3:1.
Exchange Rate Basics 5
The Market for CD’s
Q
PPesos
200
1000200
150
100 1200
S
D
Exchange Rate Basics 6
The Mexican Market for CD’s
TS
CD
p
pS
TS
CD
p
pD
Q
4
1000200
3
100 1200
TS
CD
p
p
Exchange Rate Basics 7
The US Market for T-shirts
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
⅓
Exchange Rate Basics 8
The Two Markets
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
Exchange Rate Basics 9
Equilibrium
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
CDsMexicoCDsshirtsT
USshirtsT pImportspImports
Exchange Rate Basics 10
Equilibrium (Cont)
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
BigMacsMexicoBigMacsCDs
MexicoCDs
TequilaUSTequilashirtsT
USshirtsT
pImportspImports
pImportspImports
Exchange Rate Basics 11
Equilibrium (Cont)
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
BigMacsMexicoBigMacsCDs
MexicoCDs
TequilaUSTequilashirtsT
USshirtsT
pImportspImports
pImportspImports
Other Countries, Other Goods
Exchange Rate Basics 12
Demand and Supply
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
Exchange Rate Basics 13
Demand and Supply
Q
CD
TS
p
pS
CD
TS
p
pD
CD
TS
p
p
Q
4
1000200
3
100 1200
TS
CD
p
pS
TS
CD
p
pD
TS
CD
p
p
Mexican Demand for CD Imports
US Demand for T-shirt Imports
We will assume (so that we can get on with this example) that the actual price is 3:1
3pTS= pCD
Exchange Rate Basics 14
Determining Exchange Rates
• Domestic monetary policies in the US mean that CDs cost $15 each.
• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos.
3pTS = pCD
Exchange Rate Basics 15
Determining Exchange Rates
• Domestic monetary policies in the US mean that CDs cost $15 each. (T-shirts = $5)
• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos. (CDs = 150P)
3pTS = pCD
Exchange Rate Basics 16
Determining Exchange Rates
• Domestic monetary policies in the US mean that CDs cost $15 each. (T-shirts = $5)
• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos. (CDs = 150P)
3pTS = pCD
$1=10 Pesos
Exchange Rate Basics 17
The ProcessComparative Advantage & Supply and Demand set
relative prices of
goods
Domestic Prices are set via the Quantity Theory
The Combination
Sets Exchange
Rates
Exchange Rate Basics 18
The ProcessComparative Advantage & Supply and Demand set
relative prices of
goods
Domestic Prices are set via the Quantity Theory
The Combination
Sets Exchange
Rates
But there are numerous ways this process can work
out.
Exchange Rate Basics 19
Four Scenarios
• Floating Exchange Rates– Exchange rates are determined by supply and
demand
Exchange Rate Basics 20
Four Scenarios
• Floating Exchange Rates
• Fixed Exchange Rates– The government manages the exchange rate
Exchange Rate Basics 21
Four Scenarios
• Floating Exchange Rates
• Fixed Exchange Rates
• Currency Boards– A form of fixed exchange rates
Exchange Rate Basics 22
Four Scenarios
• Floating Exchange Rates
• Fixed Exchange Rates
• Currency Boards
• Monetary Unions– Several nations, one currency
Exchange Rate Basics 23
End
©2005 Charles W. Upton. All rights reserved