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
Top Related