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

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 × P US /P Mex

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 Big Mac Index Big Mac Index  Link to NBC  Link to NBC Link to NBC Link to NBC

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