Transcript The Role of Exchange Rate

The Role of Exchange Rate
Chapter 19-2
 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.
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.
Exchange Rates
 In order to demand one currency, you
must supply another.
 Equilibrium is where the quantity supplied
equals the quantity demanded.
The Foreign Exchange Market
Equilibrium in the Foreign Exchange
Market: A Hypothetical Example
Effects of Increased Capital
Inflows
An Increase in the Demand for U.S.
Dollars
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
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.
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.
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.
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.
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.
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.
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.
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.
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
Real Versus Nominal Exchange Rates,
1992–2003
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/
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
Purchasing Power Parity Versus the
Nominal Exchange Rate, 1990–2003
Economics in Action: The Dollar and the
Current Account Deficit, 1973–2003