Exchange RatesGraphing Currency Movements

• Nominal exchange rate- rate at which a person can exchange currency – Example: Dollars for Euros => Give $1.35 dollars to receive 1.0 Euro

• Real exchange rate- rate at which a person can trade goods & services between countries – Example: Rice in Japan vs. Rice in USA

– Purchasing Power Parity = “law of one price”

Exchange Rates

Changing Exchange Rates

• Appreciation = increase in value of currency – Dollar appreciates => Imports cheaper & Exports more expensive

– Leads to larger Trade Deficit (NX↓ ) & AD shifts left

• Depreciation = decrease in value of currency – Dollar depreciates => Imports more expensive & Exports cheaper

– Leads to smaller Trade Deficit (NX↑ ) & AD shifts right

Flexible Exchange Rates

• FIXED exchange rates – a set, agreed upon relationship between currencies or a currency value

expressed in a precious asset (gold)

– Example: Chinese Yuan

• FLOATING exchange rates – free market rates- supply & demand determine exchange ratesfree market rates- supply & demand determine exchange rates

– Example: almost all major currenciesExample: almost all major currencies

Euro Priceof a dollar

Qty of Dollars

D1

S1

----------------------------

.75 Euro

Q1

Graphing Exchange Rates

This label determines the marketyou are graphing:

Market for US dollars Priced in Euros

Market for Dollars

1) Currency are priced in other currencies2) All FX trades are executed in the market for

foreign exchangeHint: pretend a “house of foreign exchange” is located on a

remote island where all currency is exchanged….

House of

ForeignExchange

Determinants of Exchange RatesDeterminants of Exchange Rates

1. Changes in Consumer Tastes2. Relative Income Changes3. Relative Price Level Changes

“Purchasing Power Parity Theory”

4. Relative Real Interest Rates5. Speculation & Investment

U.S. Income Rises

Demand Imports

DemandForeign Currency

Products should costthe same in real terms

in each country

Dollar Priceof a Euro

Qty of Euros

D1D1

S1S1

----------------------------

1.35 Dollars

Q1

Market for Euros

Euro Priceof a dollar

Qty of Dollars

D1D1

S1S1

----------------------------

.75 Euro

Q1

Market for Dollars

Event: US invents new breakthroughs in technology products

The Market for Foreign ExchangeThe Market for Foreign ExchangeP

Q

D

S

Euro price of

1 $Dollar

Quantity of dollars

3

2

1

S1

Dollar depreciates

Supply of US dollars increases

Dollar depreciates

Against Euro

Market for Dollars

Worksheet #1