The Role of Exchange Rate

1. The Role of Exchange Rate Chapter 19-2

2. Currencies are traded in the foreign exchange market. • The prices at which currencies trade are known as exchange rates. • When a currency becomes more valuable in terms of other currencies, it appreciates. • When a currency becomes less valuable in terms of other currencies, it depreciates.

3. Exchange Rates • Supply and demand determine currency exchange rates. • When comparing the currencies of two countries, the supply of one currency equals the demand for another currency.

4. Exchange Rates • In order to demand one currency, you must supply another. • Equilibrium is where the quantity supplied equals the quantity demanded.

5. The Foreign Exchange Market

6. Equilibrium in the Foreign Exchange Market: A Hypothetical Example

7. Effects of Increased Capital Inflows

8. An Increase in the Demand for U.S. Dollars

9. Your book simplifies • Your book simplifies the shift in demand for dollar to capital inflow. • This is true. • But why is there an inflow? • Your book hints at the following on Page 467-468

10. Fundamental Forces Determining Exchange Rates • Fundamental analysis – the consideration of the fundamental forces that determine the supply of and demand for currencies: • Country’s income. • Changes in a country’s prices. • The interest rate in a country. • Country’s trade policy.

11. Changes in a Country’s Income • When a country’s income falls, the demand for imports falls. • Then demand for foreign currency to buy those imports falls.

12. Changes in a Country’s Income • This means that the supply of the country’s currency to buy the foreign currency falls. • This finally leads to an increase in the price of that country’s currency relative to foreign currency.

13. Changes in a Country’s Prices • If the U.S. has more inflation than other countries, foreign goods will become cheaper. • U.S. demand for foreign currencies will tend to increase, and foreign demand for dollars will tend to decrease.

14. Changes in a Country’s Prices • This rise in U.S. inflation will shift the dollar supply to the right and the dollar demand to the left.

15. Changes in Interest Rates • A rise in U.S. interest rates relative to those abroad will increase demand for U.S. assets. • The demand for dollars will increase. • The supply of dollars will decrease as fewer Americans sell their dollars to buy foreign assets.

16. Changes in Trade Policy • An increase in trade restrictions increases the price of imports. • The demand for foreign currency falls and the supply of the country’s currency falls. • One nation’s trade restrictions may lead to retaliation by other nations.

17. Exchange Rate Determination Is Complicated • Fundamentals can be overwhelmed by expectations of a change in exchange rates. • If the market expects exchange rates to change, it will become a self-fulfilling prophesy.

18. Back to the book! • Real exchange rates are exchange rates adjusted for international differences in aggregate price levels. Positive real exchange rate= Pesos per U.S. dollars × PUS /PMex

19. Real Versus Nominal Exchange Rates, 1992–2003

20. Purchasing Power Parity • Purchasing Power Parity between two countries is the nominal exchange rate at which a given basket of goods and services would cost the same in each country • Big Mac Index • Link to NBC http://www.msnbc.msn.com/id/14270071/

21. Long Run PPP & Exchange Rate • Over the long run purchasing power are good at predicting actual changes in nominal exchange rates for countries of similar economic development. • So in the long run a big mac should cost the same in both U.S. and Japan

22. Purchasing Power Parity Versus the Nominal Exchange Rate, 1990–2003

23. Economics in Action: The Dollar and the Current Account Deficit, 1973–2003