Exchange Rates

Georgia Council on Economic Education w w w. g c e e. o r g

Why do we have currency exchange? In a foreign exchange market, various national currencies are exchanged for one another so that international trade can take place. Germans want euros, Mexicans want pesos, and the Japanese want yen when they sell their products

Appreciation v. Depreciation Appreciation –The value of one currency rises relative to another currency –So, if the dollar appreciates relative to the yen, each dollar will be able to buy more yen Thus we will be able to buy more Japanese products Depreciation –The value of one currency falls relative to another currency –So, if the dollar depreciates relative to the yen, each dollar will be able to buy fewer yen Thus, we will be able to buy fewer Japanese products

Exchange Rates Why do they fluctuate?

Relative Rate Interest rates Relative Economic health Foreign trade Official interventions Shocks and speculation Relative Price Level Relative National Income What causes the value of a currency to appreciate or depreciate?

What causes the value of a currency to appreciate or depreciate? Safe Haven

Afghanistan 14% Argentina11.38% Belarus 10 % 9.6% inflation 8.4% inflation 10% inflation Interest Rate Just because interest rates are high doesn’t mean that’s where we will automatically invest. For example…

A rising US currency makes dollar-priced crude more expensive for foreign buyers and therefore tends to dampen demand. The dollar was stronger due to speculation that the European Central Bank will cut interest rates again in May.

What causes the supply and demand for currency to change? 2. The price level in one country relative to another country’s. 3. The real interest rate in one country relative to the real interest rate in another country for the purchase of interest-bearing instruments. 4. The purchase of real assets from another country. 1.Safe haven.

Assume that the United States and France are the only two countries in the world and that exchange rates between the two countries are flexible. Assume that there is an increase in the U.S. demand for French goods. Explain how this increase in demand will affect each of the following. (i) The supply of dollars (ii) The international value of the dollar

S D Currency doesn’t flow this way S D Dollar Euro dollar Euro S1 P Q P Q P1 P Q Q1 D1 P Q P1 Q1 SupplySupply buy PayPay French goods

Assume that there is an increase in real interest rates in the U.S., but not in France. Explain how this increase in interest rates will affect each of the following: (i) The international value of the dollar in the foreign exchange market (ii) The quantity of dollars supplied in the foreign exchange market

Increase in interest rates in U.S. relative to France. If you lived in France, where would you like to invest your hard-earned money? S D P QEuro S1 SupplySupply In the U.S. How do you do it? Go through the-- P1 Q1 S D P QDollar D1 Q1 P1 Buy Dollars INVESTINVEST Receive higher interest rate

Practice FRQ The exchange rate between the Canadian dollar and other currencies has been free to fluctuate since the mid-1960s. For each of the following (in some cases hypothetical) events, indicate whether the value of the Canadian dollar in terms of the U.S. dollar will tend to appreciate, depreciate or remain unchanged. Explain your answer. Use a supply and demand graph to illustrate each situation. (A) Montreal hosts the Olympics. (B) The rate of inflation in Canada increases relative to the U.S. inflation rate. (C) Investors in Quebec purchase substantial real estate in nearby New England and New York. (D) A consortium of U.S. oil companies constructs a pipeline in Canada to transport natural gas to the United States. (E) Interest rates rise in the U.S. relative to interest rates in Canada.

Answers (A) Montreal hosts the Olympics. –Demand shifts right; Appreciate. Visitors exchange their currency for Canadian dollars (B) The rate of inflation in Canada increases relative to the U.S. inflation rate. –Supply shifts right; Depreciate. U.S. goods become relatively cheaper, stimulating imports by Canadians and reducing Canadian exports to the U.S (C) Investors in Quebec purchase substantial real estate in nearby New England and NY. –Supply shifts right; Depreciate. Outflow of investment funds requires U.S. dollars (D) A consortium of U.S. oil companies constructs a pipeline in Canada to transport natural gas to the United States. –Demand shifts right; Appreciate. investment funds shift from the U.S. to Canada. (E) Interest rates rise in the U.S. relative to interest rates in Canada. –Supply shifts right; Depreciate. The U.S. should attract Canadian investment funds