Mechanics of Foreign Exchange (FOREX) International Trade Mechanics of Foreign Exchange (FOREX)

Foreign Exchange (FOREX) The buying and selling of currency Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros. Any transaction that occurs in the Balance of Payments necessitates foreign exchange The exchange rate (e) is determined in the foreign currency markets. Ex. The current exchange rate is approximately 8 Yuan to 1 dollar Simply put: The exchange rate is the price of a currency.

Appreciation and Depreciation Appreciation of a currency occurs when the exchange rate of that currency increases (e↑) Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓) Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.

Exports and Imports The exchange rate is a determinant of both exports and imports Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing X and increasing M Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing X and reducing M

of U.S. Dollars relative to the Euro .: $ depreciates relative to € Increase in the Supply of U.S. Dollars relative to the Euro € / $ S$ S$ 2 e e1 D$ Q$ q q1 S$ → .: e (ex. rate) ↓ & Q$ ↑ .: $ depreciates relative to €

of Yen relative to the Euro .: ¥ appreciates relative to € Decrease in the Supply of Yen relative to the Euro €/¥ S¥2 S¥ e1 e D¥ Q¥ q1 q S¥ ← .: e ↑ & Q¥ ↓ .: ¥ appreciates relative to €

for the British Pound relative to the U.S. Dollar Increase in the Demand for the British Pound relative to the U.S. Dollar $/£ S£ e1 e D£ 2 D£ Q£ q q1 D£ → .: e ↑ & Q£ ↑ .: £ appreciates relative to the $

for Yen relative to the British Pound Decrease in the Demand for Yen relative to the British Pound £/¥ S¥ e e1 D¥ D¥ 2 Q¥ q1 q D¥ ← .: e ↓ & Q¥ ↓ .: ¥ depreciates relative to the £

Exchange Rate Determinants Consumer Tastes Ex. a preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen Relative Income Ex. If Mexico’s economy is strong and the U.S. economy is in recession, then Mexico will buy more American goods, increasing the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate. The stronger economy does the buying.

Exchange Rate Determinants Relative Price Level/Inflation Ex. If the price level is higher in Canada than in the United States, then American’s will not buy from Canada. The supply of American dollars decreases and the demand for the Canadian dollar decreases. Countries do not buy from countries with high inflation. Interest Rates Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Franc to appreciate. Countries will invest their money in the countries with high interest rates.

Big Graphs 15 and 16!! Foreign Exchange

Graph for both countries and list the determinant 1. The interest rate in the United States is decreasing to very low levels. Graph for the US and Japan.

Graph for both countries and list the determinant 2. Inflation is high in England. Graph for England and the US.

Graph for both countries and list the determinant 3. Americans are buying more and more Hyundai cars. Graph for Korea and the US.

Graph for both countries and list the determinant 4. Mexico’s economy is doing very well. Graph for Mexico and the US.

Expansionary Monetary Policy to Counteract a Recession w/ reinforcing effect on Net Exports Res. Ratio Disc. Rate Buy Bonds → ER , therefore MS causing nir which leads to IG → → → → → = so AD , resulting in PL and GDPR , making u% → → → → And now! Because nir either D$ or S$ which causes $ making U.S. goods relatively and foreign goods relatively causing X & M which means XN thereby reinforcing the increase in AD already caused by the increase in IG. → → ← ← cheaper more expensive → → → AD = Aggregate Demand PL = Price Level GDPR = Real Gross Domestic Product u% = Unemployment Rate S$ = Supply of Dollars in FOREX M = Imports, XN = Net Exports ER = Excess Reserves MS = Money Supply nir = Nominal Interest Rate IG = Gross Private Investment D$= Demand for dollars in FOREX X = Exports

Contractionary Monetary Policy to Counteract Inflation w/ reinforcing effect on Net Exports Res. Ratio Disc. Rate Sell Bonds → ER , therefore MS causing nir which leads to IG → → → → = → so AD , resulting in PL and GDPR ,making u% → → → → And now! Because nir either D$ or S$ which causes $ making U.S. goods relatively and foreign goods relatively causing X & M which means XN thereby reinforcing the decrease in AD already caused by the decrease in IG. ← ← → → more expensive cheaper → → → AD = Aggregate Demand PL = Price Level GDPR = Real Gross Domestic Product u% = Unemployment Rate S$ = Supply of Dollars in FOREX M = Imports, XN = Net Exports ER = Excess Reserves MS = Money Supply nir = Nominal Interest Rate IG = Gross Private Investment D$= Demand for dollars in FOREX X = Exports