1. The Foreign Exchange Market
The Supply and Demand for Currencies

2. Foreign Exchange Markets and Chuck E. Cheese’s
Chuck E. Cheese’s does not accept cash for their games (including the ever-popular “Whack-a-Mole”), only tokens.
You get 4 tokens for every $1, and “Whack-a-Mole” costs 4 tokens.
How many games would you play?
What would happen to how much “Whack-a-Mole” you played if Chuck E. Cheese’s changed their rate to 10 tokens/$1?
The dollar is “strong” (it has “appreciated”) and buys more of Chuck E. Cheese’s stuff.
What would happen to how much “Whack-a-Mole” you played if Chuck E. Cheese’s changed their rate to 2 tokens/$1?
The dollar is “weak” (it has “depreciated”) and buys less of Chuck E. Cheese’s stuff.

3. Foreign Exchange Markets and Chuck E. Cheese’s
U.S. dollars and foreign currencies are like tokens and games of “Whack-a-Mole.”
Note:
You need tokens to play “Whack-a-Mole.
And you (ultimately) need pay Sony in yen to buy a PS4.
When tokens become “cheap” (when the dollar is “strong”, when it has “appreciated”) you play more Whack-a-Mole.
When yen are “cheap,” Americans buy more PS4s.
When tokens become “expensive” (when the dollar is “weak”, when it has “depreciated”) you play less Whack-a-Mole.
When yen are “expensive,” Americans buy fewer PS4s.
Therefore, there is a supply-and-demand market for world currencies, similar to other markets. This “foreign exchange market” (FOREX) has important consequences for the macroeconomy.

4. Exchange Rates: Buying a PS4 in Two Different Months
Let’s say you travel to Tokyo, Japan to buy the newest PS4 fresh off of the assembly line. You have dollars in your pocket, but they are not terribly useful to the vendor in Tokyo. The price of the PS4 is 40,000 yen. How much will the PS4 cost you (in dollars)…
… in early June, 2015 (exchange rate was $1 = 125 yen)?
… in early July, 2016 (exchange rate was $1 = 100 yen)?
What happened to the price of the PS4 (in dollars) from June, to July, 2016?
What happened to the value of the dollar, relative to the yen?
What happened to the value of the yen, relative to the dollar?
Therefore, the exchange rate is just a price. How many yen will my 1 dollar buy?
And that exchange rate affects the prices of foreign goods, which in turn affects the behavior of consumers and investors.

5. Graphing the Foreign Exchange Market in Equilibrium
When graphing the market for a currency, remember:
The x-axis is the quantity of the currency supplied and demanded
The y-axis is the price of the currency in question, measured in the amount of the other currency.
In this example, this is the market for dollars in euros.
When labeling the graph, remember: What goes below, goes below (so this is the market for dollars).

6. An Increase in Demand for U.S. Dollars
What would cause this?
What would the effects be?

7. Balance of Payments and Foreign Exchange
Remember, the Financial Account and Current Account always sum to zero.
So what happens when foreign investors send more money to the U.S. (capital inflows)?
What happens to the value of the dollar, consumer behavior, and the resulting balance of the Current Account?
Payments From
Payments To
Net 1
Sales/purchases of goods and services 2
Factor Income 3
Transfers
Current Account ( ) 4
Official asset purchases/sales 5
Private sales and purchases of assets
Financial Account
(4 + 5)
Total
Current Account
Financial Account
The foreign exchange market helps insure that the current account and the financial account sum to 0.

8. Real Exchange Rates
Foreign exchange markets (FOREX) use the Real Exchange Rate, not the Nominal Exchange Rate.
The Real Exchange Rate takes into account the price level in each country.
That way, domestic inflation doesn’t make a country’s goods “more expensive.”
For example, what if rampant inflation hits Japan?
PJ = aggregate price level in Japan, PUS = aggregate price level in the U.S.
Real Exchange Rate = Japanese yen per U.S. dollar x (PUS / PJ)
Example 1: There is no difference in aggregate price levels in the U.S. and Japan
Real Exchange rate = Yen per dollar x (PUS / PJ) = 100 x (100/100) = 100
40,000 yen PS4 = 40,000 yen/100 yen per dollar = $400
Example 2: Suppose the Japanese economy suffers 10% inflation, therefore PJ = The Nominal Exchange Rate also adjusts to 110 yen per dollar.
Real Exchange rate = 110 x (100/110) = 100 yen per dollar
44,000 yen PS4 (with 10% inflation) = 44,000 yen/110 yen per dollar = $400