Confidential and Proprietary – Not for Distribution The Foreign Currency Market AP Annual Conference 2012 Orlando, Florida 1 Arthur Raymond Chief Reader,

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Confidential and Proprietary – Not for Distribution The Foreign Currency Market AP Annual Conference 2012 Orlando, Florida 1 Arthur Raymond Chief Reader, AP Macroeconomics Muhlenberg College Allentown, PA

The Foreign Currency Market Proper Labeling of the Axes of the foreign currency market diagram The slopes of the demand and supply curves for foreign currency Shifts of the demand and supply curves for foreign currency 2

Labeling the Axes The diagram below shows supply and demand in the auto market. 3 S cars D cars

Labeling the Axes What is the label on the horizontal axis of the diagram for the auto market? The quantity of cars What is the label on the vertical axis of the diagram for the auto market? The price of one car: $/1car 4

Labeling the Axes The diagram below shows supply and demand for Euros in the foreign currency market. 5 S€S€ D€D€

Labeling the Axes What is the label on the horizontal axis? The quantity of Euros What is the label on the vertical axis? The price of one Euro If it’s the dollar-euro market, then it’s the number of dollars to buy one Euro, i.e., $1.25/1€ 6

Labeling the Axes The diagram below shows supply and demand for dollars on the foreign currency market. 7 S$S$ D$D$

Labeling the Axes What is the label on the horizontal axis? The quantity of dollars What is the label on the vertical axis? The price of one dollar If it’s the dollar-euro market, then it’s the number of Euros to buy one dollar, €/$, i.e., €0.80/ $1 8

Labeling the Axes The diagram below shows the supply and demand for Yen in the foreign currency market. 9 S¥S¥ D ¥

Labeling the Axes What is the label on the horizontal axis? Quantity of Yen What is the label on the vertical axis if it’s the Euro-Yen market? Euro per Yen, €/¥1, i.e, €.0103/¥1 10

Labeling the Axes In the foreign currency market, the vertical axis is the price of one unit of the currency on the horizontal axis. 11

Slopes of Supply and Demand Curves for Currency 12 S$S$ D$D$ €/$ Q$Q$ Dollar-Euro Market

Supply and Demand Curves for Currency The demand for the dollar on the dollar-euro market is due to the European demand for US goods, services, and financial assets. 13

Supply and Demand Curves for Currency The supply of the dollar on the Dollar-Euro market is due to US demand for European goods, services, and financial assets. 14

Shifts of the Demand and Supply Curves for Currency Shifts of the Supply or Demand Curves for Currency Produce Appreciation or Depreciation of a Currency (with floating exchange rates). 15

Shifts of the Demand and Supply Curves for Currency Sources of shifts in currency demand and supply curves Changes in price levels Changes in real interest rates Changes in real income 16

Shifts of the Demand and Supply Curves for Currency 1.(a) Explain the effect of a decrease in the US price level on the demand for the Japanese Yen. A decrease in the US Price level will decrease the demand for Japanese goods and services and increase the demand for US goods and services, so there will be a decrease in the demand for the Japanese Yen. 17

Shifts of the Demand and Supply Curves for Currency (b) Use a properly labeled graph of the foreign exchange market for the Japanese Yen to show the effect of the change in demand for the Japanese Yen described in part (a) on the dollar value of the Yen. 18

Shifts of the Demand and Supply Curves for Currency 19 Q¥Q¥ $/¥ D¥D¥ S¥S¥ ($/¥) 1 D’ ¥ ($/¥) 2

Shifts of the Demand and Supply Curves for Currency (From 2007 Macroeconomics Exam, Form B) Assume that the interest rate in both the United States and the European Union equals 4.5 percent. a) Assume that the real interest rate in the United States falls to 3.75 percent. (ii) Using a correctly labeled graph of the foreign exchange market for the euro, show how the value of the euro would change relative to the United States dollar in a flexible exchange rate system. 20

Shifts of the Demand and Supply Curves for Currency 21 Q€Q€ $/€ S€S€ D€D€ D’ € S’ € ($/€) 1 ($/€) 2

Shifts of the Demand and Supply Curves for Currency (From 2012 AP Macroeconomics Exam) (c) Suppose Rankinland has a current account deficit. Rankinland’s currency is called the bera. (i) What will initially happen to the current account deficit in Rankinland solely due to the change in the real GDP from part (b)(iv) ? Explain. (ii) What will happen to the international value of the bera solely due to the change in the real GDP from part (b)(iv) ? Explain. (Real GDP Increases) 22

Shifts of the Demand and Supply Curves for Currency An increase in Real GDP increases Rankinland’s imports, which increases the supply of the bera on the foreign exchange market. An increase in the supply of the bera will cause a decrease in the value of the bera. 23

Shifts of the Demand and Supply Curves for Currency 24 QbQb $/b SbSb DbDb S’ b ($/b) 1 ($/b) 2