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2 Exchange Rates
Unit Overview
Exchange Rates
Online:
Exchange Rates
Currency
Purchasing Power
Parity
Foreign
Exchange Mark
ets
Exchange Rates
Video Lessons
Worksheets and
Practice
Activities
International Ec
onomics Glossary
S$
Notice:
the
Notice:
the value
value of
of one
one
currency
currency is
is the
the reciprocal
reciprocal of
of
the
the value
value of
of the
the other
other
currency:
currency:
and
and
0.65
1.56
D$
Qe
Q$
Qe
Euro
British
Pound
Indian
Rupee
Australi
an $
Canadia
n$
1 US $ =
0.81
0.64
55.51
0.95
Inverse:
1.23
1.56
0.02
1.05
Japanes
e Yen
Chinese
yuan
1.23
78.13
6.36
0.81
0.013
0.16
African
rand
Zealand
$
8.23
0.12
The first row tells us how much one dollar costs in each of the foreign currencies. In
other words, its the dollar exchange rate in Europe, Britain, India, and so on
The second row tells us how much the foreign currency costs to Americans. For
example,
One euros worth of goods from Germany costs Americans $1.23. 100 euros of
output would cost $123.
One rand worth of South African output would only cost an American $0.12. But
100 rand of output would cost $12.
0.81
0.64
55.51
0.95
Price of a
$1000
American
product in
each currency
In each case we have simply to multiply the price of the good in US dollars by the
exchange rate of the dollar in each country.
If the dollar were to appreciate, the price of the $1,000 American product would go
UP for foreign consumers. This helps explain why Americas net exports decrease
when the exchange rate rises.
If the dollar were to depreciate, US products would become cheaper to foreign
consumers, which is why net exports will rise when a currency depreciates.
S$
0.65
D$
Qe
Q$
US$ in Britain
/$
related to the currencys value:
Because as a currency becomes less
S$
expensive, so do the goods, services
and assets of that country
As dollars get cheaper,
As dollars get stronger,
Foreign consumers and investors will
so do American goods
Americans want to buy
wish to buy more of the countrys
and assets, so Brits
more British goods, so
want more!
supply more $!
goods, services and assets, therefore,
0.65
they demand greater quantities of
the currency as it depreciates.
Supply of a currency is directly
related to the currencys value:
Because as it appreciates, foreign
D$
goods become cheaper, so holders of
the currency will supply greater
Qe
quantities in order to buy more
Q$
S1
0.80
0.65
D$1
depreciates
$
appreciates
We now know that an exchange rate is determined by supply and demand for
a currency.
if supply or demand change,
the exchange rate
US$ in Britain
/$ Therefore,
$/
British in the US
S$
S
changes.
1.56
1.25
D$
Qe
Q1
Q$
D
Qe
Q1
The new equilibrium exchange rate for the Euro can be calculated
Because demand for it has fallen while its supply increased, the euro is much less
scarce in Switzerland
European goods can be bought much more cheaply as a result (only 0.8125 CHF
The Determinants of Exchange Rates: If any of the following change, the demand
and supply of a currency will change and it will either appreciate or depreciate against
other currencies.
Tastes and
preference
s
Relative
interest
rates
Relative
price
levels (or
inflation
rates)
Speculatio
n
As a countrys exports become more popular among international consumers, demand for its
currency will increase and supply of other countries currency in its forex market will increase.
There is a direct relationship between the interest rates in a country and the value of its currency.
At higher interest rates, foreigners will demand more financial assets from the country, and
therefore more of the currency.
If a countrys inflation rate is high relative to its trading partners, demand for the countrys exports
will fall and demand for its currency will fall. If inflation is lower at home than abroad, foreigners will
demand more of its exports and its currency.
If international financial investors expect a countrys currency to appreciate in the future, demand
for it will rise today. If a currency is expected to depreciate demand for it will decrease today.
Speculation is simply betting on the future value of an asset or currency.
1.80
1.56
D1
D
/$
Qe
Q1
$ in Britain
S$
S$1
0.65
0.55
D$
Qe
Q1
Q$
increase?
Tastes: If British goods became more fashionable
in the US
Interest rates: If the Bank of England (the
central bank) increased British interest rates,
Americans would with to invest more money in
British assets
Price levels: If US inflation were to increase
while British inflation rates remained low,
Americans would demand more relatively cheap
British goods
Speculation: If investors in the US expected the
pound to get stronger, the demand for pounds
would increase today.
Income levels: If the economic growth rate in
Introduction to Balance of
Payments
Financial account: Records the flow of money for the acquisition of real
and financial assets (factories, office buildings, real estate, government
bonds, shares of companies, etc) by the people of one nation in all other
nations.
Financial account deficit: If the people of a country owns more financial and
real assets abroad than foreigners own of its own assets, its financial account is
Economic
Growth
Unemployment
rate
Balance of
payments
As a
result of
appreciati
on
Inflation will be
lower, since
imported goods and
services and raw
materials are now
cheaper
Unemployment could
rise if net exports
decline. Also,
domestic firms may
choose to move
production overseas,
where costs are now
lower due to strong
currency
As a
result of
depreciati
Inflation will
increase, since
imports are more
expensive, and
there could be costpush inflation if raw
Growth should
increase, since the
countrys exports
are cheaper and
more attractive to
foreigners. AD will
Unemployment
should fall as net
exports increase,
shifting AD out.
Domestic firms may
choose to relocate
some of their
Chinese Yuan
in the US
S$
DCNY
Interest rates:
Official
reserves:
SCNY
Qe
The CB can raise or lower interest rates to attempt to change foreign demand for
its currency
The CB can buy or sell foreign currencies to manipulate their supplies and
exchange rates
Switzerland
1.
3
D1
1.
2
S1
1.
1
D
Qe
Monetary policy freedom: With a floating ER, a central bank may focus its
monetary policies on domestic macroeconomic goals. Interest rates may be altered
to stimulate and contract AD, rather than to manipulate demand for the currency.
Automatic adjustment: A floating exchange rate should be the right exchange
rate, meaning that it reflects the true demand for the nations currency abroad.
Through management, a government may over-value or under-value its currency on
forex markets, which can lead to persistent deficits or surpluses in the current and
financial accounts of the balance of payments.
Foreign reserves: A central bank committed to managing its currencys exchange
rate must keep large reserves of foreign currencies on hand to intervene in forex
markets to manage its exchange rates. This is money earned from export sales that