Exchange RatesGraphing Currency Movements

• Nominal exchange rate- rate you can exchange (swap) currency – Example: Swap Dollars for Euros => Give $1.16 dollars to receive €1.0 Euro

• Real exchange rate- rate you can trade actual goods & services between countries (after swapping currencies)

– Purchasing Power Parity is when real exchange rate = 1 • Called “law of one price” (buy the same good at same effective price)

Exchange Rates

3) Buy I-phone in Japan

1) I-Phone cost $600 in USA

2) You swap Dollars for Yen

If you break even => real exchange rate = 1

2 Types of Exchange Rates

• FIXED exchange rates – a set relationship between a currency value expressed in a precious asset (gold)– Example: Belize Dollar “pegged” to U.S. dollar at 2 B.D. to 1 U.S.D.

• A Gold Standard would make all exchange rates A Gold Standard would make all exchange rates fixedfixed

• FLOATING exchange rates – free market rates- free market rates- supplysupply & & demanddemand determine exchange rates determine exchange rates– Example:Example: almost all major currenciesalmost all major currencies

AD Shifts & Exchange Rates

• Appreciation = increase in value of currency – Dollar appreciates => (NX↓ ) (Imports cheaper & Exports more expensive)

– AD shifts left & larger Trade Deficit (NX)

• Depreciation = decrease in value of currency – Dollar depreciates => (NX↑ ) (Imports more expensive & Exports cheaper)

– AD shifts right & smaller Trade Deficit (NX)

Dollar Price of a Euro

Qty of Euros

D1

S1

----------------------------

1.08 $

Q1

Graphing Exchange Rates

This label determines the marketyou are graphing:

Market for US dollars Priced in Euros

Market for Euros

1) Currency are priced in other currencies2) All FX trades are executed in the market for

foreign exchangeHint: pretend a “house of foreign exchange” is located on a

remote island where all currency is exchanged….

House of

ForeignExchange

Euro Depreciates!

1.40 => 1.07 Dollars to Euro

Determinants of Exchange RatesDeterminants of Exchange Rates

1. Changes in Consumer Tastes2. Relative Income Changes3. Relative Price Level Changes

“Purchasing Power Parity Theory”

4. Relative Real Interest Rates5. Speculation & Investment

U.S. Income Rises

Demand Imports

DemandForeign Currency

Products should costthe same in real terms

in each country