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C hapter 32

C hapter 32. Exchange Rates, Balance of Payments, and International Debt. Economic Principles. Exchange rates Foreign exchange markets Appreciation and depreciation of currencies Floating and fixed exchange rates. Economic Principles. Arbitrage Devaluation Balance of payments

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C hapter 32

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  1. Chapter 32 Exchange Rates, Balance of Payments, and International Debt

  2. Economic Principles • Exchange rates • Foreign exchange markets • Appreciation and depreciation of currencies • Floating and fixed exchange rates Gottheil - Principles of Economics, 4e

  3. Economic Principles • Arbitrage • Devaluation • Balance of payments • International debt and debt service Gottheil - Principles of Economics, 4e

  4. The Foreign Exchange Market: The Buying and Selling of Currencies Foreign exchange market • A market in which currencies of different nations are bought and sold. Gottheil - Principles of Economics, 4e

  5. The Foreign Exchange Market: The Buying and Selling of Currencies Exchange rate • The number of units of foreign currency that can be purchased with one unit of domestic currency. Gottheil - Principles of Economics, 4e

  6. The Foreign Exchange Market: The Buying and Selling of Currencies 1. Suppose that a kite costs 40 yaps, and the exchange rate is 10 yaps to the dollar. What is the dollar price of the kite? • 40 yaps/10 = 4 dollars. Gottheil - Principles of Economics, 4e

  7. EXHIBIT 1 FOREIGN EXCHANGE MARKET Gottheil - Principles of Economics, 4e

  8. Exhibit 1: Foreign Exchange Market At $2 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? • Since the equilibrium price is $3 per yap, at $2 per yap there would be an excess demand for yaps. Gottheil - Principles of Economics, 4e

  9. Exhibit 1: Foreign Exchange Market At $4 per yap, is the foreign exchange market in Exhibit 1 in equilibrium, or is there an excess demand or excess supply of yaps? • Since the equilibrium price is $3 per yap, at $4 per yap there would be an excess supply of yaps. Gottheil - Principles of Economics, 4e

  10. The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • When the price of a foreign currency declines, the quantity of that foreign currency demanded increases. Gottheil - Principles of Economics, 4e

  11. The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • For example, if a dollar can buy more yaps than before, then a dollar can also buy more yap-priced goods and services than before. Gottheil - Principles of Economics, 4e

  12. The Foreign Exchange Market: The Buying and Selling of Currencies 2. Why is the demand curve for foreign currency downward-sloping? • As a result, Americans wish to exchange dollars for more yaps in order to buy more yap-priced goods, increasing the quantity of yaps demanded in the foreign exchange market. Gottheil - Principles of Economics, 4e

  13. The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • When the price of a foreign currency rises, then the purchasing power of the foreign currency rises when it comes to buying imported goods and services. Gottheil - Principles of Economics, 4e

  14. The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • For example, if it takes more dollars to buy a yap, then it takes fewer yasps to buy a dollar, and so the price of American goods are cheaper for people who use the yap. Gottheil - Principles of Economics, 4e

  15. The Foreign Exchange Market: The Buying and Selling of Currencies 3. Why is the supply curve for foreign currency upward-sloping? • As a result, people who use yaps wish to exchange more yaps for dollars in order to buy more American goods, increasing the quantity of yaps supplied in the foreign exchange market. Gottheil - Principles of Economics, 4e

  16. The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates Gottheil - Principles of Economics, 4e

  17. The Foreign Exchange Market: The Buying and Selling of Currencies 4. Which of the following will cause an increase in the demand for yaps? a. Decreasing American incomes b. Increasing yap-priced interest rates c. Increasing American interest rates Gottheil - Principles of Economics, 4e

  18. EXHIBIT 2 EFFECT OF AN INCREASE IN THE DEMAND FOR YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

  19. Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in demand from D1 to D2, Is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? • There is excess demand of (70 - 30) = 40 thousand yaps. Gottheil - Principles of Economics, 4e

  20. Exhibit 2: Effect of an Increase in the Demand for Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in demand from D1 to D2, what is the new equilibrium exchange rate? • The new equilibrium exchange rate is $5 per yap. Gottheil - Principles of Economics, 4e

  21. The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap-priced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes Gottheil - Principles of Economics, 4e

  22. The Foreign Exchange Market: The Buying and Selling of Currencies 5. Which of the following will cause a decrease in the supply of yaps? a. Decreasing American tastes for yap-priced goods b. Decreasing yap-priced interest rates c. Decreasing yap-priced incomes Gottheil - Principles of Economics, 4e

  23. EXHIBIT 3 EFFECT OF AN INCREASE IN THE SUPPLY OF YAPS ON THE DOLLARS-FOR-YAPS RATE OF EXCHANGE

  24. Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 1. After the increase in supply from S1 to S2, is there excess supply, excess demand, or equilibrium at an exchange rate of $3 per yap? • There is an excess supply of (50 - 30) = 20 thousand yaps. Gottheil - Principles of Economics, 4e

  25. Exhibit 3: Effect of an Increase in the Supply of Yaps on the Dollars-for-Yaps Rate of Exchange 2. After the increase in supply from S1 to S2, what is the new equilibrium exchange rate? • The new equilibrium exchange rate is $2 per yap. Gottheil - Principles of Economics, 4e

  26. Floating Exchange Rates Floating exchange rate • An exchange rate determined strictly by the demands and supplies for a nation’s currency. Gottheil - Principles of Economics, 4e

  27. Floating Exchange Rates Appreciation • A rise in the price of a nation’s currency relative to foreign currencies. Gottheil - Principles of Economics, 4e

  28. Floating Exchange Rates Depreciation • A fall in the price of a nation’s currency relative to foreign currencies. Gottheil - Principles of Economics, 4e

  29. Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has _____ in value. Gottheil - Principles of Economics, 4e

  30. Floating Exchange Rates 1. Complete the sentence: When journalists say that the dollar has “weakened,” they mean that the dollar has depreciated in value. Gottheil - Principles of Economics, 4e

  31. Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before. Gottheil - Principles of Economics, 4e

  32. Floating Exchange Rates 2. If the dollar has appreciated in value relative to the yap, then which of the following is true: a. The exchange rate has more yaps per dollar than before. b. The exchange rate has fewer yaps per dollar than before. Gottheil - Principles of Economics, 4e

  33. Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? • Depreciated in value. Gottheil - Principles of Economics, 4e

  34. Tourists at the Mall Has the U.S. dollar appreciated or depreciated in value relative to the Japanese yen between 1960 and 1996? • In 1960 the exchange rate was 358 yen per dollar. By 1996 there were only 131 yen per dollar. Gottheil - Principles of Economics, 4e

  35. Floating Exchange Rates Arbitrage • The practice of buying a foreign currency in one market at a low price and selling it in another at a higher price. Gottheil - Principles of Economics, 4e

  36. Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? • Suppose that the price of an internationally traded good changes during the time between when a purchase is negotiated and the product is delivered. Gottheil - Principles of Economics, 4e

  37. Floating Exchange Rates 3. How might floating exchange rates make international trade riskier? • Then the change in exchange rates is like an unforeseen change in the price of the good, which redistributes the gains from trade in an unforeseen way. Gottheil - Principles of Economics, 4e

  38. Floating Exchange Rates Fixed exchange rate • A rate determined by government and then maintained through the process of buying and selling quantities of its own currency on the foreign exchange market. Gottheil - Principles of Economics, 4e

  39. EXHIBIT 4A TRADE UNDER FREE AND FIXED EXCHANGE RATES

  40. EXHIBIT 4B TRADE UNDER FREE AND FIXED EXCHANGE RATES

  41. Exhibit 4: Trade Under Free and Fixed Exchange Rates 1. If there is a system of free or floating exchange rates, then what happens if the demand for a foreign currency increases? • The exchange rate (dollars per unit of foreign currency) increases and there is neither excess demand nor excess supply of the foreign currency. Gottheil - Principles of Economics, 4e

  42. Exhibit 4: Trade Under Free and Fixed Exchange Rates 2. If there is a system of fixed exchange rates, then what happens if the demand for a foreign currency increases? • Since the exchange rate cannot change, an increase in demand will create excess demand for the foreign currency. Gottheil - Principles of Economics, 4e

  43. Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • The yap government will need to exchange some of its own yaps for dollars on the foreign exchange market. Gottheil - Principles of Economics, 4e

  44. Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • This will increase the supply of yaps on the foreign exchange market and eliminate the excess demand. Gottheil - Principles of Economics, 4e

  45. Exhibit 4: Trade Under Free and Fixed Exchange Rates 3. If there is excess demand for yaps under a system of fixed exchange rates, what will the yap government need to do to eliminate the excess demand for the yap? • In order for the yap government to do this, it must have sufficient stock of yaps to exchange for dollars. Gottheil - Principles of Economics, 4e

  46. Exhibit 4: Trade Under Free and Fixed Exchange Rates 4. Continuing the yap example, what might the yap government be forced to do if it did not have a sufficient quantity of yaps on reserve to eliminate the excess demand? • The yap government might be forced to borrow yaps from another country, or even agree to increase the exchange rate ($ per yap). Gottheil - Principles of Economics, 4e

  47. Floating Exchange Rates Foreign exchange reserves • The stock of foreign currencies a government holds. Gottheil - Principles of Economics, 4e

  48. Floating Exchange Rates Devaluation • Government policy that lowers the nation’s exchange rate; its currency instantly is worth less in the foreign exchange market. Gottheil - Principles of Economics, 4e

  49. Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves. Gottheil - Principles of Economics, 4e

  50. Floating Exchange Rates 4. In which of the following circumstances would a country most likely be forced into a devaluation of its currency: a. The excess supply of its currency in the foreign exchange market exceeds its foreign exchange reserves. b. The excess demand for its currency in the foreign exchange market exceeds its foreign exchange reserves. Gottheil - Principles of Economics, 4e

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