Foreign ExchanGe

FOREX

Foreign Exchange Rates

• Exchange rate – price of one currency in terms of another (multiply foreign price by exchange rate to get

U.S. price)

• Fixed rate – rate of exchange stays the same; in past basis was gold

• Flexible rate (floating) – based on supply and demand for each currency

Foreign Exchange Rates

• Flexible rates – began in 1971 when U.S. went off the gold standard

• U.S. imports increased and foreigners were gaining U.S. dollars & exchanging them for U.S. gold

• Foreign exchange market - wherever one currency is exchanged for another

• Appreciation (strong dollar) – dollar buys more of another currency & results in less expensive imports and more expensive exports

SID

• Strong Currency

• Imports Increase (b/c cheaper)

• Trade Deficit

Depreciation (weak dollar) – dollar buys less of another currency & results in more expensive imports and less expensive exports

WES

• Weak Currency:

• Cheap Exports:

• Trade Surplus

Graph Time

“Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005

The Market for Yen

Quantity of Yen

Doll

ar P

rice

of

1 Y

en

0

P

Q Qe

Sy

Dy

THE FOREIGN EXCHANGE MARKET

Foreign Exchange

$ price for yen

$/Y

Yen price for $

Y/$

Qty of yen Qty of $

S

D

S

D

Supply of yen from Japanese importers who must exchange them for $$ to buy U.S. goods

Demand for yen by U.S. importers who need them to buy Japanese goods

Draw a FOREX graph with Increase in the

Supply of U.S. Dollars

relative to the Euro

Q$

S$

D$

e

q

S$ .: e (ex. rate) ↓ & Q$ ↑

.: $ depreciates relative to €

S$ 1

e1

q1

Increase in the Supply

of U.S. Dollars relative to the Euro € / $

Now Draw a

Decrease in the

Supplyof Yen relative

to the Euro

€/¥

Q¥

S¥

D¥

e

q

S¥ .: e ↑ & Q¥ ↓

.: ¥ appreciates relative to €

S¥1

e1

q1

Decrease in the Supply

of Yen relative to the Euro

Increase in the Demand

for the British Pound

relative to the U.S. Dollar

$/£

Q£

S£

D£

e

q

D£ 1

e1

q1

D£ .: e ↑ & Q£ ↑

.: £ appreciates relative to the $

Increase in the Demand

for the British Pound relative to the U.S. Dollar

Decrease in the Demand

for Yen relative to the

British Pound

£/¥

Q¥

S¥

D¥ 1

e1

q1

D¥

e

q

D¥ .: e ↓ & Q¥ ↓

.: ¥ depreciates relative to the £

Decrease in the Demand

for Yen relative to the British Pound

FOREIGN EXCHANGE MARKETS

• THE RATE OF EXCHANGE BETWEEN TWO CURRENCIES IS DETERMINED IN THE FOREIGN CURRENCY MARKET.

• SOME NATIONS FIX THEIR EXCHANGE RATE WHILE OTHERS ARE ALLOWED TO “FLOAT” WITH THE FORCES OF DEMAND AND SUPPLY.

18

• THE EXCHANGE RATE BETWEEN TWO CURRENCIES TELLS YOU HOW MUCH OF ONE CURRENCY YOU MUST GIVE UP TO GET ONE UNIT OF THE SECOND CURRENCY.

EX. US AND MEXICO IS $1.OO TO 10 PESOS.

$1.00 = 10 PESOS AND 10 PESOS WILL BUY $1

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APPRECIATING AND DEPRECIATING CURRENCY

• APPRECIATION OCCURS WHEN ONE CURRENCY BECOMES WORTH MORE UNITS OF ANOTHER CURRENCY.

• IF A CURRENCY APPRECIATES, IT BECOMES STRONGER, BUT IT DECREASES ITS EXPORTS AND INCREASES ITS IMPORTS.

20

ADVANTAGE OF STRONGER CURRENCY

• CONSUMERS CAN BUY IMPORTS AT A LOWER PRICE

• TRAVELERS ABROAD CAN GET MORE FOREIGN CURRENCY

• INVESTORS CAN BUY MORE FOREIGN ASSETS

21

DISADVANTAGES OF STRONGER CURRENCY

• PRODUCERS WILL SELL FEWER EXPORTS

• FOREIGNERS TRAVELING INTO THE COUNTRY WILL FIND IT MORE EXPENSIVE

• FOREIGN INVESTMENT OF DOMESTIC ASSETS WILL BE MORE EXPENSIVE

22

CURRENCY DEPRECIATION

• DEPRECIATION OF CURRENCY OCCURS WHEN ONE CURRENCY BECOMES WORTH FEWER UNITS OF ANOTHER CURRENCY.

• IF IT DEPRECIATES IT BECOMES WEAKER.

• DEPRECIATION INCREASES ITS EXPORTS AND DECREASES ITS IMPORTS.

23

ADVANTAGE OF A WEAKER CURRENCY

• PRODUCERS WILL SELL MORE EXPORTS

• IT BECOMES CHEAPER FOR FOREIGNERS TO TRAVEL INTO THE COUNTRY

• FOREIGN INVESTMENT IN DOMESTIC ASSETS WILL BECOME CHEAPER

24

DISADVANTAGES WEAKER CURRENCY

• DOMESTIC CONSUMERS PAY MORE FOR IMPORTS

• IT BECOMES MORE EXPENSIVE TO TRAVEL OUTSIDE THE COUNTRY

• MORE EXPENSIVE TO INVEST IN FOREIGN ASSETS

25

Other countries want U. S. goods when:

-Ours are cheaper -Our inflation is less that theirs -Our interest rate is higher -The other country is growing faster

These cause the dollar to APPRECIATE

The $dollar depreciates when the opposite events occur.

I have no idea why I made this purple

THE EURO

• JAN. 1999, 11 OF THE COUNTRIES IN THE EU DECIDED TO GIVE UP THEIR OWN CURRENCIES AND ADOPT THE EURO.

Today, the euro is one of the world's most powerful currencies, used by more than 320 million Europeans in twenty-three countries.

27

Countries that use the Euro

1) Andorra 2) Austria 3) Belgium 4) Cyprus 5) Estonia 6) Finland 7) France 8) Germany 9) Greece 10) Ireland

11) Italy 12) Kosovo 13) Luxembourg 14) Malta 15) Monaco 16) Montenegro 17) Netherlands 18) Portugal 19) San Marino 20) Slovakia

21) Slovenia 22) Spain 23) Vatican City

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• Tastes (Consumer Preference)

– Ex. a preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen

real Interest Rate (Leads to Speculation)

– Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Franc to appreciate.

• Speculation: trade in currency at a low price, trade it later at a high price and make money, make money money

• Income

– Ex. If Mexico’s economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate

• Price Level

– Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. Dollar to appreciate and the Canadian Dollar to depreciate.

TrIPS cont…

Speculation: If U.S.

investors expect that Swiss interest rates will climb in the future, then American will D Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Franc to appreciate.

Exports and Imports

• The exchange rate is a determinant of both exports and imports

• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports

• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports

Expansionary Monetary Policy to Counteract a Recession w/ reinforcing effect on

Net Exports

Res. Ratio

Disc. Rate Buy Bonds

ER ,therefore MS causing i% which leads to IG

so AD ,resulting in PL and GDPR ,making u%

AD = Aggregate Demand

PL = Price Level

GDPR = Real Gross Domestic Product

u% = Unemployment Rate

S$ = Supply of Dollars in FOREX

M = Imports, XN = Net Exports

ER = Excess Reserves

MS = Money Supply

i% = Nominal Interest Rate

IG = Gross Private Investment

D$= Demand for dollars in FOREX

X = Exports

=

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the increase in AD already caused by

the increase in IG.

cheaper more expensive

Contractionary Monetary Policy to Counteract Inflation w/ reinforcing effect on

Net Exports

Res. Ratio

Disc. Rate Sell Bonds

ER ,therefore MS causing i% which leads to IG

so AD ,resulting in PL and GDPR ,making u%

AD = Aggregate Demand

PL = Price Level

GDPR = Real Gross Domestic Product

u% = Unemployment Rate

S$ = Supply of Dollars in FOREX

M = Imports, XN = Net Exports

ER = Excess Reserves

MS = Money Supply

i% = Nominal Interest Rate

IG = Gross Private Investment

D$= Demand for dollars in FOREX

X = Exports

=

And now! Because i% either D$ or S$ which causes $ making U.S. goods

relatively and foreign goods relatively causing X and

M which means XN thereby reinforcing the decrease in AD already caused by

the decrease in IG.

more expensive cheaper

Expansionary Fiscal Policy Side-effect:

‘Crowding-out’ of Investment and Net Exports

A possible side-effect of increased government spending

and reduced taxes is a budget deficit which may lead to the ‘crowding-out’ of Gross Private Investment (IG) and

Net Exports (XN)

When G or T , then government must borrow in order to continue

spending. This leads to an increase in the demand for loanable funds

or a decrease in the supply of loanable funds, which results in r % .

This change in r % leads to IG . In addition, the increase in r% causes

D$ and/or S$ as investors seek higher returns in the U.S. This leads to

$ which leads to X and M , so XN . Because IG and XN are direct

components of AD, these decreases offset some of the increase in AD.

Contractionary Fiscal Policy Side-effect:

‘Crowding-in’ of Investment and Net Exports

A possible side-effect of decreased government spending

and increased taxes is a budget surplus which may lead to the ‘crowding-in’ of Gross Private Investment (IG) and

Net Exports (XN)

When G or T , then government develops a budget surplus

This leads to a decrease in the demand for loanable funds

or an increase in the supply of loanable funds, which results in r % .

This change in r % leads to IG . In addition, the decrease in r% causes

D$ and/or S$ as investors seek higher returns abroad. This leads to

$ which leads to X and M , so XN . Because IG and XN are direct

components of AD, these increases offset some of the decrease in AD.

An appreciation of the U.S. dollar on the foreign exchange market could be caused by a decrease in which of the following? (a) U.S. interest rates (b) The U.S. consumer price index (c) Demand for the dollar by U.S. residents (d) Exports from the U.S. (e) The tariff on goods imported into the U.S.

(b) The U.S. consumer price index Lower prices increase demand for U.S. exports and appreciate the dollar.

If the real interest rate in the U.S. increases relative to that of the rest of the world, capital should flow (a) into the U.S. and the dollar will depreciate (b) into the U.S. and the dollar will appreciate (c) out of the U.S. and the dollar will depreciate (d) out of the U.S. and the dollar will appreciate (e) out of the U.S. and the value of the dollar will not change

(b) into the U.S. and the dollar will appreciate Higher U.S. interest rates attract more demand for our financial capital [CDs and bonds] & financial flows of foreign money will flow in to the U.S. to purchase these.

Assume that the world operates under a flexible exchange rate system. If the central bank of Mexico increases its MS but other countries do not change theirs, Mexico’s inflation rate and the international value of the Mexican peso will most likely change in which of the following ways? International Inflation Rate Value of the Peso a. Increase Appreciate b. Increase Depreciate c. Increase No change d. Decrease Appreciate e. Decrease Depreciate

b. Increase Depreciate An increase in Mexico’s MS means “more pesos chasing the same goods” as before, bringing on higher prices. This would decrease demand for Mexico’s exports, depreciating the peso.

Assuming fixed exchange rates, if Mexico’s rate of inflation increases relative to its trading partners, Mexico’s imports and exports will most likely change in which of the following ways? Imports Exports a. Decrease Decrease b. Decrease Increase c. Increase Decrease d. Increase Increase e. No change No change

c. Increase Decrease A higher price level in Mexico will decrease demand for their products, depreciating the peso. However, the increase in the peso currency price relative to other countries makes their goods cheaper so their imports increase while their exports decrease as they have to pay more pesos

If the exchange rate between the U.S. dollar and the British pound changed from $2 per one pound to $3 per one pound, and domestic prices in both countries stayed the same, then the U.S. dollar would (a) depreciate, making U.S. imports from Britain more expensive (b) depreciate, making U.S. imports from Britain cheaper (c) appreciate, making U.S. imports from Britain more expensive (d) appreciate, making U.S. imports from Britain cheaper (e) purchase 3 times more British goods than before the change occurred

(a) depreciate, making U.S. imports from Britain more expensive

If the exchange rate went from $2 per one pound to $3 per one pound, and domestic prices in both countries stayed the same, then………The U.S. dollar goes down in value because a pound cost me $2, now it costs $3, making pounds more expensive and therefore the Supply of U.S. dollars would decrease because that is what Americans and Brits will be taking out of the banks to use.

Which of the following groups would most likely gain from unanticipated inflation?

(a) Landlords who own apartments in cities with rent controls.

(b) Individuals who have fixed retirement incomes.

(c) Individuals who earn high incomes

(d) Individuals who have borrowed money at fixed interest rates

(e) Banks that have loaned all excess reserves at a fixed interest rate.

(d) Individuals who have borrowed

money at fixed interest rates

Borrowers borrowed todays money & paid back “cheaper” money.

We need an acronym for LF market. Come up with one on the

next slide.

“Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005

Loanable Funds Market Graph (Long-Term Interest Rates)

What changes Supply:

1. Increase in Household savings

2. Increase in Gov’t savings

3. Increase in Business savings

4. Increase in Business savings

5. Increase in Foreigners’ savings

What changes Demand: 1. Increase in Household

borrowing 2. Increase in business

Investment 3. Increase in Foreign

borrowing 4. Increase in Government

borrowing (When the gov’t has a budget deficit!) = (the crowding -out effect)

“Redelsheimer’s Graphs to Know” AP Macro Review Copyright 2005

Rea

l In

tere

st R

ate

, r

Quantity of Loanable Funds

LOANABLE FUNDS MARKET

r

D

Q

S

This graph shows how the supply and demand for loanable funds affects real interest rates!