Lectures in Macroeconomics- Charles W. Upton

Exchange Rate Basics

TS

CD

p

pS

TS

CD

p

pD

Q

4

1000200

3

100 1200

TS

CD

p

p

Exchange Rate Basics 2

The ProcessComparative Advantage & Supply and Demand set

relative prices of

goods

Domestic Prices are set via the Quantity Theory

The Combination

Sets Exchange

Rates

Exchange Rate Basics 3

An Example

Output Per Day of Work

T-shirts Music CDs Relative Cost

United States

20 10 2:1

Mexico 5 1 5:1

Exchange Rate Basics 4

The price of a t-shirt

• With International Trade– The price of a Music CD, in terms of a T-shirt,

the terms of trade, must be the same in both countries.

– The price must be between 2 and 5 t-shirts; just what depends on supply and demand

– We will assume (so that we can get on with this example) that the actual price is 3:1.

Exchange Rate Basics 5

The Market for CD’s

Q

PPesos

200

1000200

150

100 1200

S

D

Exchange Rate Basics 6

The Mexican Market for CD’s

TS

CD

p

pS

TS

CD

p

pD

Q

4

1000200

3

100 1200

TS

CD

p

p

Exchange Rate Basics 7

The US Market for T-shirts

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

⅓

Exchange Rate Basics 8

The Two Markets

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

Exchange Rate Basics 9

Equilibrium

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

CDsMexicoCDsshirtsT

USshirtsT pImportspImports

Exchange Rate Basics 10

Equilibrium (Cont)

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

BigMacsMexicoBigMacsCDs

MexicoCDs

TequilaUSTequilashirtsT

USshirtsT

pImportspImports

pImportspImports

Exchange Rate Basics 11

Equilibrium (Cont)

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

BigMacsMexicoBigMacsCDs

MexicoCDs

TequilaUSTequilashirtsT

USshirtsT

pImportspImports

pImportspImports

Other Countries, Other Goods

Exchange Rate Basics 12

Demand and Supply

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

Exchange Rate Basics 13

Demand and Supply

Q

CD

TS

p

pS

CD

TS

p

pD

CD

TS

p

p

Q

4

1000200

3

100 1200

TS

CD

p

pS

TS

CD

p

pD

TS

CD

p

p

Mexican Demand for CD Imports

US Demand for T-shirt Imports

We will assume (so that we can get on with this example) that the actual price is 3:1

3pTS= pCD

Exchange Rate Basics 14

Determining Exchange Rates

• Domestic monetary policies in the US mean that CDs cost $15 each.

• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos.

3pTS = pCD

Exchange Rate Basics 15

Determining Exchange Rates

• Domestic monetary policies in the US mean that CDs cost $15 each. (T-shirts = $5)

• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos. (CDs = 150P)

3pTS = pCD

Exchange Rate Basics 16

Determining Exchange Rates

• Domestic monetary policies in the US mean that CDs cost $15 each. (T-shirts = $5)

• Domestic monetary policy in Mexico means that T-shirts cost 50 Pesos. (CDs = 150P)

3pTS = pCD

$1=10 Pesos

Exchange Rate Basics 17

The ProcessComparative Advantage & Supply and Demand set

relative prices of

goods

Domestic Prices are set via the Quantity Theory

The Combination

Sets Exchange

Rates

Exchange Rate Basics 18

The ProcessComparative Advantage & Supply and Demand set

relative prices of

goods

Domestic Prices are set via the Quantity Theory

The Combination

Sets Exchange

Rates

But there are numerous ways this process can work

out.

Exchange Rate Basics 19

Four Scenarios

• Floating Exchange Rates– Exchange rates are determined by supply and

demand

Exchange Rate Basics 20

Four Scenarios

• Floating Exchange Rates

• Fixed Exchange Rates– The government manages the exchange rate

Exchange Rate Basics 21

Four Scenarios

• Floating Exchange Rates

• Fixed Exchange Rates

• Currency Boards– A form of fixed exchange rates

Exchange Rate Basics 22

Four Scenarios

• Floating Exchange Rates

• Fixed Exchange Rates

• Currency Boards

• Monetary Unions– Several nations, one currency

Exchange Rate Basics 23

End

©2005 Charles W. Upton. All rights reserved