The Role of Exchange Rate
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Transcript of The Role of Exchange Rate
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The Role of Exchange Rate
Chapter 19-2
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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.
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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.
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Exchange Rates In order to demand one currency, you
must supply another. Equilibrium is where the quantity supplied
equals the quantity demanded.
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The Foreign Exchange Market
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Equilibrium in the Foreign Exchange Market: A
Hypothetical Example
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Effects of Increased Capital Inflows
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An Increase in the Demand for U.S. Dollars
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Back to the book! Real exchange rates are exchange rates adjusted for international differences in aggregate price levels.
Positive real exchange ratePositive real exchange rate = Pesos per U.S. = Pesos per U.S. dollars × Pdollars × PUSUS /P /PMexMex
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Real Versus Nominal Exchange Rates, 1992–2003
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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/
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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
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Purchasing Power Parity Purchasing Power Parity Versus the Nominal Exchange Versus the Nominal Exchange
Rate, 1990–2003Rate, 1990–2003
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Economics in Action: The Dollar Economics in Action: The Dollar and the Current Account Deficit, and the Current Account Deficit,
1973–20031973–2003