Exchange Rates

Georgia Council on Economic Education w w w . g c e e . o r g

Why do we have currency exchange?

• In a foreign exchange market, various national currencies are exchanged for one another so that international trade can take place.

• Germans want euros, Mexicans want pesos, and the Japanese want yen when they sell their products

Appreciation v. Depreciation• Appreciation

– The value of one currency rises relative to another currency

– So, if the dollar appreciates relative to the yen, each dollar will be able to buy more yen

• Thus we will be able to buy more Japanese products

• Depreciation– The value of one currency falls relative to another

currency– So, if the dollar depreciates relative to the yen, each dollar

will be able to buy fewer yen• Thus, we will be able to buy fewer Japanese products

Exchange Rates

Why do they fluctuate?

Relative Rate Interest rates

Relative Economic health

Foreign trade

Official interventions

Shocks and speculation

Relative Price Level

Relative National Income

What causes the value of a currency toappreciate or depreciate?

What causes the value of a currency toappreciate or depreciate?

Safe Haven

Afghanistan 14%

Argentina 11.38%

Belarus 10 %

9.6% inflation

8.4% inflation

10% inflationInterest Rate

Just because interest rates are high doesn’t mean that’s where we will automatically invest. For example…

A rising US currency makes dollar-priced crude more expensive for foreign buyers and

therefore tends to dampen demand. The dollar was stronger due to speculation

that the European Central Bank will cut interest rates again

in May.

What causes the supply and demandfor currency to change?

2. The price level in one country relative to another country’s.

3. The real interest rate in one countryrelative to the real interest rate inanother country for the purchase

of interest-bearing instruments.

4. The purchase of real assets fromanother country.

1. Safe haven.

Assume that the United States and France are theonly two countries in the world and that exchange rates between the two countries are flexible.

Assume that there is an increase in the U.S. demand for French goods. Explain how this increase in demand will affect each of thefollowing.

(i) The supply of dollars(ii) The international value of the dollar

S

D

Currency doesn’t flow this way

S

D

Dollar Euro

dollar

Euro

S1

P

Q

P

Q

P1P

Q Q1

D1P

Q

P1

Q1

Supply

buy

Pay

French goods

Assume that there is an increase in real interestrates in the U.S., but not in France. Explain howthis increase in interest rates will affect each ofthe following:

(i) The international value of the dollar in the foreign exchange market

(ii) The quantity of dollars supplied in the foreign exchange market

Increase in interest rates in U.S.relative to France.

If you lived in France, where would you like to invest yourhard-earned money?

S

D

P

Q Euro

S1

Supply

In the U.S.

How do youdo it?

Go throughthe--

P1

Q1

S

D

P

Q Dollar

D1

Q1

P1Buy Dollars

INVEST

Receive higher interest rate

Practice FRQ• The exchange rate between the Canadian dollar and other currencies

has been free to fluctuate since the mid-1960s. For each of the following (in some cases hypothetical) events, indicate whether the value of the Canadian dollar in terms of the U.S. dollar will tend to appreciate, depreciate or remain unchanged. Explain your answer. Use a supply and demand graph to illustrate each situation.

• (A) Montreal hosts the Olympics.

• (B) The rate of inflation in Canada increases relative to the U.S. inflation rate.

• (C) Investors in Quebec purchase substantial real estate in nearby New England and New York.

• (D) A consortium of U.S. oil companies constructs a pipeline in Canada to transport natural gas to the United States.

• (E) Interest rates rise in the U.S. relative to interest rates in Canada.

Answers• (A) Montreal hosts the Olympics.

– Demand shifts right; Appreciate. Visitors exchange their currency for Canadian dollars

• (B) The rate of inflation in Canada increases relative to the U.S. inflation rate.– Supply shifts right; Depreciate. U.S. goods become relatively cheaper, stimulating

imports by Canadians and reducing Canadian exports to the U.S

• (C) Investors in Quebec purchase substantial real estate in nearby New England and NY.– Supply shifts right; Depreciate. Outflow of investment funds requires U.S. dollars

• (D) A consortium of U.S. oil companies constructs a pipeline in Canada to transport natural gas to the United States. – Demand shifts right; Appreciate. investment funds shift from the U.S. to Canada.

• (E) Interest rates rise in the U.S. relative to interest rates in Canada. – Supply shifts right; Depreciate. The U.S. should attract Canadian investment funds