The Role of Exchange Rate

Chapter 19-2

Currencies are traded in the foreign exchange market.

The prices at which currencies trade are known as exchange rates.

When a currency becomes more valuable in terms of other currencies, it appreciates.

When a currency becomes less valuable in terms of other currencies, it depreciates.

Exchange Rates

Supply and demand determine currency exchange rates.

When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.

Exchange Rates

In order to demand one currency, you must supply another.

Equilibrium is where the quantity supplied equals the quantity demanded.

The Foreign Exchange Market

Equilibrium in the Foreign Exchange Market: A

Hypothetical Example

Effects of Increased Capital Inflows

An Increase in the Demand for U.S. Dollars

Your book simplifies

Your book simplifies the shift in demand for dollar to capital inflow.

This is true. But why is there an inflow? Your book hints at the following on

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Fundamental Forces Determining Exchange

Rates Fundamental analysis – the

consideration of the fundamental forces that determine the supply of and demand for currencies: Country’s income. Changes in a country’s prices. The interest rate in a country. Country’s trade policy.

Changes in a Country’s Income

When a country’s income falls, the demand for imports falls.

Then demand for foreign currency to buy those imports falls.

Changes in a Country’s Income

This means that the supply of the country’s currency to buy the foreign currency falls.

This finally leads to an increase in the price of that country’s currency relative to foreign currency.

Changes in a Country’s Prices

If the U.S. has more inflation than other countries, foreign goods will become cheaper.

U.S. demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.

Changes in a Country’s Prices

This rise in U.S. inflation will shift the dollar supply to the right and the dollar demand to the left.

Changes in Interest Rates

A rise in U.S. interest rates relative to those abroad will increase demand for U.S. assets.

The demand for dollars will increase. The supply of dollars will decrease as

fewer Americans sell their dollars to buy foreign assets.

Changes in Trade Policy

An increase in trade restrictions increases the price of imports.

The demand for foreign currency falls and the supply of the country’s currency falls.

One nation’s trade restrictions may lead to retaliation by other nations.

Exchange Rate Determination Is

Complicated Fundamentals can be overwhelmed by

expectations of a change in exchange rates.

If the market expects exchange rates to change, it will become a self-fulfilling prophesy.

Back to the book!

Real exchange rates are exchange rates adjusted for international differences in aggregate price levels.

Positive real exchange ratePositive real exchange rate = Pesos per U.S. = Pesos per U.S. dollars × Pdollars × PUSUS /P /PMexMex

Real Versus Nominal Exchange Rates, 1992–2003

Purchasing Power Parity

Purchasing Power Parity between two countries is the nominal exchange rate at which a given basket of goods and services would cost the same in each country

Big Mac Index Link to NBC http://www.msnbc.msn.com/id/

14270071/

Long Run PPP & Exchange Rate

Over the long run purchasing power are good at predicting actual changes in nominal exchange rates for countries of similar economic development. So in the long run a big mac should cost

the same in both U.S. and Japan

Purchasing Power Parity Purchasing Power Parity Versus the Nominal Exchange Versus the Nominal Exchange

Rate, 1990–2003Rate, 1990–2003

Economics in Action: The Dollar Economics in Action: The Dollar and the Current Account Deficit, and the Current Account Deficit,

1973–20031973–2003