AP Macroeconomics

1. Please read this slowly to yourself. THINK about it. Ever been out of the country?Ever bought something from another country?Then you were part of the Foreign Exchange market.

2. When you buy something from Wal-Mart that was made in another country, Wal-Mart pays for it in the OTHER country’s currency. To get the foreign currency to pay for it, Wal-Mart must change their US $ to the OTHER currency. They put their dollars on the ForEx market (they SUPPLY dollars) and they ask for (DEMAND) Euros. This leads us to:

5. AP Macroeconomics Mechanics of Foreign Exchange (FOREX)

6. Foreign Exchange (FOREX) • The buying and selling of currency • Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their Dollars and buy (demand) Euros. • The exchange rate (e) is determined in the foreign currency markets. • Ex. The current exchange rate is approximately 77 Japanese Yen to 1 US dollar • Simply put. The exchange rate is the price of a currency. • Do not try to calculate the exact exchange rate

7. Scenario—Assume only two currencies in the world—Euro and US $ • Americans buy more German cars than ever before • Americans travel to France

8. An American has $1,000,000 she/he wants to put in a bank account. • She wants a HIGH rate of interest because the bank is going to PAY him interest. • Banks in Germany are PAYING a higher interest rate than banks in the US. • Where will he deposit his money? In a US bank that PAYS him 2% interest or in a German bank which will pay him 7% interest? • Right, the German bank so he will demand… • Euros and supply… • US dollars in the ________________ Market… • Foreign Exchange Market

9. Increase in the Demand of Euros relative to the U.S. Dollar $/€ Dollars per one Euro S€ e1 e D€1 D€ Q€ q q1 D€ .: e ↑ & Q€ ↑ .: € appreciates relative to the $

10. Increase in the Supply of U.S. Dollars relative to the Euro € / $ Euros per ONE Dollar S$ S$ 1 e e1 D$ Q$ q q1 S$ .: e (ex. rate) ↓ & Q$↑ .: $ depreciates relative to €

11. Demand $—exports and capital inflows When the US exports goods/services to other countries, they need OUR dollar to complete the transaction. So they demand OUR money First, they need to supply theirs. Supply $—imports and capital outflows When we import goods/services from other countries, we need THEIR money to complete the transaction. So we demand THEIR money. We need to SUPPLY ours

12. Tips • Always change the D line on one currency graph, the S line on the other currency’s graph • Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer. • If D on one graph increases, S on the other will also increase • If D moves to the left, S will move to the left on the other graph.

13. Changes in Exchange Rates • Exchange rates (e) are a function of the supply and demand for currency. • An increase in the supply of a currency will make it cheaper to buy one unit of that currency • A decrease in supply of a currency will make it more expensive to buy one unit of that currency

14. Changes in Exchange Rates • An increase in demand for a currency will make it more expensive to buy one unit of that currency • A decrease in demand for a currency will make it cheaper to buy one unit of that currency

15. Appreciation • Appreciation of a currency occurs when the exchange rate of that currency increases (e↑) • Hypothetical: 100 Yen used to buy $1. Now two hundred Yen buy 1US$. • The dollar is “stronger” because one buys more Yen than it used to

16. Depreciation • Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓) • One hundred yen used to buy one dollar. Now 50 yen buys one dollar. • The dollar is weaker because it takes fewer Yen to buy one dollar

17. Example of Appreciation and Depreciation • Ex. If more German tourists visit America then the demand of US dollars will… increase. This will cause the US dollar to appreciate. The supply of the Euro will increase causing it to depreciate

18. Decreased Demand and Decreased Supply of Currencies

19. Decrease in the Demand for Euro relative to the Dollar $/€ S€ e e1 D€ D€1 Q€ q1 q D€  .: e ↓ & Q€↓ .: € depreciates relative to the $

20. Decrease in the Supply of the Dollar relative to the Euro €/$ S$1 S$ e1 e D$ Q$ q q1 S$  .: e ↑ & Q$↓ .: $ appreciates relative to €

21. Exchange Rate Determinants • Consumer Tastes • Ex. a preference for Japanese goods creates an increase in the demand of Yen and an increase in the supply of dollars in the currency exchange market. • The increase in demand of the Yen leads to the appreciation of the Yen. • The increase in the supply of dollars leads to the depreciation of the Dollar.

22. Exchange Rate Determinants (cont.) • Relative Income • Imports tend to be normal goods • Ex. If Mexico’s economy is becoming stronger and the U.S. economy is in recession, then Mexicans will buy more of everything, including American goods. • This increases the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate

23. Exchange Rate Determinants (cont) • Relative 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. • Demand for the US Dollar increased, supply of the Canadian Dollar increased

24. Exchange Rate Determinants (cont) • 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 Swiss Franc to appreciate as demand for it will increase. • Supply of the Dollar will increase causing it to depreciate

25. Xn • The exchange rate is a determinant of both exports and imports • Xn is a component of GDP • GDP’s rate of change is the determinant of economic status (recession or expansion)

26. Depreciation of the dollar makes it to where “they” have to spend less of “their” currency for one US dollar. • Therefore our products are cheaper over “there” • Therefore “they” will buy more of our products • Therefore our _______ will increase

27. Appreciation of the dollar causes foreigners to spend more of their currency to buy one dollar. • Therefore they have to spend more of their currency to buy our product. • Therefore American goods are relatively more expensive and foreign goods are relatively cheaper. • That reduces our exports and increases our imports

28. Xn • 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