AKA the “FOREX”

The Foreign Exchange Market Goods produced within a country must be paid for with that country’s currency International transactions require a market Foreign exchange market—market where currencies can be exchanged for each other This market determines exchange rates—the prices at which currencies trade

Understanding Exchange Rates As of 4PM, April 16, 2015, US$1 exchanged for €.93 or US$1.08 exchanged for €1 When a currency becomes more valuable (expensive) in terms of other currencies, it appreciates When a currency’s value falls, it depreciates Exchange rates affect relative price, thus impacting trade

Modeling Foreign Exchange Rates FOREX is governed by supply and demand Let’s graph the Foreign Exchange Market for the US dollar… Demand slopes downward because higher price means less money demanded (i.e., higher priced American products would mean fewer European purchasers) Supply slopes upward because higher price means greater willingness to supply (i.e., relatively cheaper European goods will cause Americans to put more dollars on the market to exchange)

Equilibrium Exchange Rate Rate at which quantity demanded of a currency = quantity supplied Demand & Supply shifts can cause the exchange rate to appreciate or depreciate Any change in Financial account creates an equal and opposite reaction in the current account, maintaining CA + FA = 0 Movements in the exchange rate ensure that FA and CA offset one another Summary: An increase in capital flows into the US leads to a stronger dollar, which then creates a decrease in US net exports A decrease in capital flow into the US leads to a weaker dollar, which then creates an increase in US net exports

Inflation & Real Exchange Rate Appreciation/depreciation can be exaggerated due to differences in inflation rates Real exchange rates: exchange rates adjusted for international differences in aggregate price levels Real XR = XR (X per Y) ● CPI Y /CPI X (i.e., Mexican pesos per $1U.S. X CPI US /CPI Mex ) Current account responds only to changes in Real XR, not nominal

Ex: Suppose that the exchange rate we are looking at is the number of Mexican pesos per US dollar. Let CPI US and CPI MEX be indexes of the aggregate price levels in the United States and Mexico, respectively. Ex. 1: There is no difference in aggregate price levels between the US and Mexico in the base year. Real exchange rate = 12.5 x (100/100) = 12.5 pesos per dollar Ex. 2: Suppose the Mexican economy has suffered 10% aggregate inflation and CPI MEX = 110 Real exchange rate = 12.5 x (100/110) = 11.4 pesos per dollar So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each US dollar will buy fewer pesos and thus fewer Mexican goods. (To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate.)

Purchasing Power Parity PPP is the nominal exchange rate at which a given basket of goods would cost the same in two countries Comparing PPP to XR over time reveals the impact of inflation The relationship between PPP and exchange rate reveals the relative cost of living in each country

Key Concepts When a country’s currency appreciates, their exports become more expensive, exports fall and imports rise When a country’s currency depreciates, their exports become less expensive, exports rise and imports fall