International Trade and Finance: Foreign Exchange Market AP Economics Mr. Bordelon Exchange Rates Exchange rate. Price at which currencies trade. Foreign exchange market. Market in which currencies are traded. G/S/Assets produced in a country must be paid for in that countrys currency, hence the market for foreign currency. Even if sellers accept payment in foreign currency, they will exchange that foreign currency for domestic currency. Exchange Rates Looking at this table, there are two ways to write any of the exchange rates. $1 = 0.75 or 1 = $1.34 There is no specific rule in reading or writing the exchange rate. Exchange Rates Appreciation. When a currency becomes more valuable in terms of other currencies. Depreciation. When a currency becomes less valuable in terms of other currencies. Example. The value of 1 increases from $1 to $1.25. The value of $1 decreased from 1 to 0.80 (1/1.25 = 0.80). The euro appreciated against the dollar. The dollar depreciated against the euro. Equilibrium Exchange Rate Equilibrium exchange rate. Rate at which quantity of currency demanded in foreign exchange market equals quantity supplied. The rate is determined by the free market. Exchange Rate Modeling this idea of appreciation and depreciation, we use the exchange rate model. First and foremost, on the x- axis, typically the AP exam, will make it a matter of foreign currency per dollar, which would would write as foreign currency/dollar. An increase in demand for dollars would indicate that the dollar would appreciate, as it now costs more of the foreign currency to buy the U.S. dollar. A decrease in demand for dollars would indicate that the dollar would depreciate, as it now costs less of the foreign currency to buy the U.S. dollar. Exchange Rates As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. Because the U.S. dollar has appreciated against the foreign currency, American consumers will increase purchases of g/s from the foreign country. More U.S. dollars will be supplied and will flow out of the U.S. current account. Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied. This tells us that any increase in the U.S. balance of payments on the financial account is exactly offset by a decrease in the U.S. balance of payments on the current account. Summary: An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports. A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports. Exchange Rates Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied. Any increase in the U.S. balance of payments on the financial account is exactly offset by a decrease in the U.S. balance of payments on the current account. Summary: An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports. A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports. Exchange Rates Key points: An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports. A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports. Real Exchange Rate Real exchange rate. Exchange rates adjusted for international differences in aggregate price levels (inflation). Real Exchange Rate Example. Exchange rate we are looking at is the number of Mexican pesos per U.S. dollar. Let P US and P Mex be indices of the aggregate price levels in the United States and Mexico, respectively. Real exchange rate between the Mexican peso and the U.S. dollar is defined as: Real exchange rate = (Exchange rate)(P US /P Mex ) Real Exchange Rate Real exchange rate = (Exchange rate)(P US /P Mex ) Exchange rate in this equation is the nominal exchange rate (not adjusted for inflation). Example. There is no difference in aggregate price levels between the U.S. and Mexico in the base year. The nominal exchange rate is 12.5 pesos per dollar. Real exchange rate = (12.5)(100/100) = 12.5 pesos per dollar Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and PMex=110. Real exchange rate = 12.5*(100/110) = 11.4 pesos per dollar. So in real terms, even though the exchange rate hasnt changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods. Real Exchange Rate Example. Suppose the Mexican economy has suffered 10% aggregate inflation and P Mex =110. Nominal exchange rate is 12.5 pesos per dollar. Real exchange rate = (12.5)(100/110) = 11.4 pesos per dollar In real terms, even though the exchange rate hasnt changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods. Purchasing Power Parity Purchasing power parity. Occurs between two countries currencies and is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Example. A basket of goods and services that costs $100 in the United States costs 1,000 pesos in Mexico. Purchasing power parity is 10 pesos per U.S. dollar. At that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries. Question 1 January 2, 2009January 4, 2010 $1.45 = 1$1.61 = Taiwan dollars = $ Taiwan dollars = $1 $0.82 = 1 Canadian dollar$0.96 = 1 Canadian dollar 90.98 = $192.35 = $1 $1.39 = 1$1.44 = Swiss francs = $11.03 Swiss francs = $1 Based on the exchange rates for the first trading days of 2009 and 2010 in this table, did the U.S. dollar appreciate or depreciate during 2009? Did the movement in the value of the U.S. dollar make American goods and services more or less attractive to foreigners? Question 2 In each of the following scenarios, suppose that the two nations are the only trading nations in the world. Given inflation and the change in the nominal exchange rate, which nations goods become more attractive? a.Inflation is 10% in the U.S. and 5% in Japan; the U.S. dollar- Japanese yen exchange rate remains the same. b.Inflation is 3% in the U.S. and 8% in Mexico; the price of the U.S. dollar falls from to Mexican pesos. c.Inflation is 5% in the U.S. and 3% in the eurozone; the price of the euro falls from $1.30 to $1.20. d.Inflation is 8% in the U.S. and 4% in Canada; the price of the Canadian dollar increases from $0.60 to $0.75. Question 3 Suppose the U.S. and Japan are the only two trading countries in the world. What will happen to the value of the U.S. dollar if the following occur, other things equal? a.Japan relaxes some of its import restrictions. b.The U.S. imposes some import tariffs on Japanese goods. c.Interest rates in the U.S. rise dramatically. d.A report indicates that Japanese cars are much safer than previously thought, especially compared with American cars.