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Welcome to Econ 414 International Economics

Study Guide

Week Thirteen

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Exchange Rates and Their Determination:

A Basic Model

CHAPTER 13CHAPTER 13

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What is the exchange rate?

• Value of one currency in terms of another currency

• Spot rate = rate for transaction on spot

Is the exchange rate flow or stock?

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Has dollar appreciated or depreciated?

• Yesterday the spot rate was€1 = $1.43

• Today the spot rate is€1 = $1.53

• Dollar has depreciated

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What is the rate of depreciation of dollar?

Beginning Rate- Ending Rate%Δ in Spot Rate= *100

Beginning Rate

%Δ = (1.43-1.53)* 100 /1.43 = -7%

Dollar depreciated by 7%

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Euros per Dollar: What is causing these fluctuations?

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Average yearly exchange rate of euro

• $1.0658 in 1999• $0.9236 in 2000• $0.8956 in 2001• $0.9456 in 2002• $1.1312 in 2003• $1.2439 in 2004• $1.2441 in 2005• $1.2556 in 2006

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Demand and Supply ForcesAffect the Exchange Rate.

• Foreign Exchange Market 1. Demand Curve

• Shows the quantity demanded for a currency by residents of another country at different exchange rates.

2. Supply Curve• Shows the amount of a currency

supplied at a different exchange rates.

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Consider demand for euro by Americans

• Why will Americans demand euro?• To import European goods and

services• To buy European bonds/stocks• To sell the euros later or in a

different location for profits

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The Demand for euro

euros

$/€

Demand for Euros

$1

$2

$3

€ 1 € 2 € 3

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Shifts: What if US GDP goes up?

Euros

$/€

Demand for euros

D1

D2

US income goes up Demand D1

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International Economics

• Week Ten –Class 2– Wednesday, November 7– 11:10-12:00– Tyndall

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Shifts: What if US Prices go down?

Euros

$/€

Demand for euros

D1

D2

Americans buy fewer European goods Demand goes down D2

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Shifts: What if interest rates in Europe go up?

Euros

$/€

Demand for euros

D1

D2

US residents would want to buy more European bonds Demand D1

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Consider supply of Euro by Europeans

• Why will Europeans supply euro?• To importers American goods and

services• To buy American bonds/stocks• To sell later or in the different location for

profits

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The Supply of The Supply of EurosEuros

Supply of Euros

euros

$/€

$1

$2

$3

€1 €2 €3

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Shifts: What if European’s Shifts: What if European’s income goes up?income goes up?

Supply of Euros

Euros

$/€

S1

S2

Europeans will want to buy more American goods Supply of euro goes up to S1

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Shifts: What if Europeans expect Shifts: What if Europeans expect euro to appreciate further in the euro to appreciate further in the

near future?near future?

Supply of Euros

Euros

$/€

S1

S2

Europeans will supply less now Supply of euro goes down to S2

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• Equilibrium Exchange:– The exchange rate where the quantity

demanded of foreign exchange equals the quantity supplied.

• In our examples, the amount of euros U.S. residents want to buy equals the amount of euros Europeans want to sell.

Equilibrium in the Equilibrium in the Foreign Exchange MarketForeign Exchange Market

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Equilibrium Exchange RateEquilibrium Exchange Rate

Supply of Euros

$/Euro

1.5

2.0

2.5

100 200 400 Euros

Demand for Euros

300 500

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What if Europe’s GDP goes What if Europe’s GDP goes up?up?

Supply of Euros

$/Euro

1.5

2.0

2.5

100 200 400 Euros

Demand for Euros

300 500

Supply of euro goes up to S1

S1

Euro depreciates

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What if US prices go up What if US prices go up and EU prices don’tand EU prices don’t

Supply of Euros

Demand for Euros

$/Euro

1.5

2.0

2.5

100 200 400 Euros300 500

3.0

D1

S1

Demand goes up because Americans would want to buy more European goods

Supply goes down because Europeans buy fewer American goods

Euro appreciates

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Are fluctuations in the value of a currency good or bad for the

economy?• No surplus/ shortage

– Good

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But fluctuations in the value of a currency discourages international trade or investment.

• I order a US car today for $30,000• Delivery and payment in 6 months• In 6 months, what if $ appreciates against euro?• I have to spend more euros than expected.• Uncertainty discourages international trade

– Bias toward trade within a nation

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But wait; there is a solution

• I can buy dollars in a forward market.– Sign a contract today to buy $30,000 in six

months for €0.8 per dollar.• There is a fee involved

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• Need reasonably accurate forecasts for country’s

– GDP – Inflation – Interest rate

• The supply/demand model is good for general comments about exchange over the medium to long run.

Fluctuating exchange rates Fluctuating exchange rates have led to an industry of have led to an industry of

forecastersforecasters..

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Asst 7: Due before 10:00 PM on Saturday November 24

• Question 9, Page 316• This is an individual assignment.• Make sure to draw a separate graph for each

case. • This Assignment has 20 points.• Hey I know it is Thanksgiving.

– That is why I gave one extra day this time.– Do it before thanksgiving.– It is really short.

• Happy Thanksgiving– Save some for me!!!!