Macro Project 2 Important Final Assignment $ Any Takers?

Handout MACRO #18P

Exchange Rates

Just Between Friends

Foreign currency is the money of other countries, in any form and is exchanged in the foreign exchange market, like any other good. The price of one nation’s currency in terms of another currency is the nominal exchange rate.

Movements in one currency against another currency are referred to as either appreciation or depreciation. Appreciation means that the value of one currency rises against another currency and depreciation means that the value of one currency drops against another. Appreciation of the dollar means that more of a foreign currency is need to buy it while depreciation means less of a foreign currency is needed to buy it. Another way to think of it is that when the dollar appreciates it buys more foreign currency, and when the dollar depreciates, it buys less foreign currency. Automatically, when one currency appreciates, the other depreciates.

Your purchasing power is really affected by fluctuations in currency rates. Let’s say you go to Italy and you want to buy some shoes. You take $400 with you to spend. Shoes cost €100 (euros).

	Exchange Rate	Other Way Exchange Rate	Price in Dollars	Price in Euros	Effect on You
Original	$1 = €1/2	€1 = $2	$200	€100	You can buy 2 pairs of shoes
Dollar Appreciates (Worth More)	$1 = €1 (Buys more euros)	€1 = $1 (Buys fewer dollars)	$100	€100	$100 cheaper so you can buy 4 pairs of shoes
Dollar Depreciates (Worth Less)	$1 = €1/4 (Buys fewer euros)	€1 = $4 (Buys more dollars)	$400	€100	$200 more expensive so you can only buy 1 pair of shoes

As the dollar appreciates, foreign goods become cheaper, and if the dollar depreciates, foreign goods become more expensive. When the dollar appreciates, foreigners cut back on their purchases of American goods, and exports will decrease and imports will increase as Americans purchase more of the now cheaper foreign goods. If the dollar depreciates, exports will increase and imports decrease, as American and foreign consumers turn away from the relatively higher priced foreign goods toward the now bargain American goods.

In the foreign exchange market, supply and demand determine the price of currency or the nominal exchange rate. But in this market, when you have one currency, let’s say dollars, and you want to exchange them for euros, you are at the same time supplying dollars and demanding euros. So factors that affect the demand for a countries currency will also affect the supply of the currency.

The quantity demanded of a currency will depend on its exchange rate. If the exchange rate rises, less quantity will be demanded and if the exchange rate falls, more will be demanded. This is represented by movements along the demand curve for currency.

SHAPE \* MERGEFORMAT

The quantity demanded of currency will be determined by two things – the exports effect and the expected profit effect. The exports effects shows how when the exchange rate is low, US exports are cheaper than foreign goods. With cheaper US exports, foreigners want to buy more US goods which are priced in dollars. So in order to pay for the increased quantity of US goods, a higher quantity of dollar currency is demanded. Conversely, if the exchange rate rises, US exports are more expensive, foreigners want to buy less US goods, and so they don’t require as many US dollars to pay for them.

The expected profits effect comes from the speculative buying and selling of currencies by currency traders. Traders wish to buy a currency when the exchange rate is low so they can sell the currency when the rate rises in the future and make a profit. Thus the quantity demanded of a currency will be higher when the exchange rate is low. Conversely, when the exchange rate is high, if traders bought the currency now, they would more likely make a loss, so the quantity demanded is low.

Changes in the demand for currency will depend on:

· World demand for US exports. An increase in world demand for US exports (for reasons other than the exchange rate like changes in foreign real national income) means foreigners will need more US dollars to pay for the higher exports. The demand curve for US dollars will shift out and to the right and the equilibrium exchange rate will increase.

SHAPE \* MERGEFORMAT A decrease in world demand for US exports will work just the opposite and shift the demand for US dollars in to the left.

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· The differential between US interest rates and foreign interest rates. Since the market for loanable funds is a world market, when US real interest rates are higher than the world interest rate, investors will want to invest in financial assets in the US which are priced in dollars. The demand curve will shift out to the right, resulting in a higher exchange rate. Obviously, if the interest rate differential between the US and the world is negative, meaning that interest rates are lower in the US, the demand for US dollars to buy US financial assets will decrease and the demand curve will shift left.

· The expected U.S. exchange rate. If the exchange rate for the US dollar is expected to increase, traders could expect to make a profit by buying US dollars today and selling them in the future for a higher price. So the demand for US dollars today would increase. If the exchange rate was expected to fall in the future, the demand for dollars today would decrease. Note that an increase in the US exchange rate would mean a fall in the foreign currency exchange rate.

The quantity supplied of currency will also be determined by two things – the imports effect and the expected profit effect. The imports effects shows how when the exchange rate is high, US goods are more expensive than foreign goods. With cheaper foreign imports, American consumers want to buy more foreign goods which are priced in foreign currencies. A higher quantity of US dollar currency is offered to buy foreign currencies to pay for the increased imports. Conversely, if the exchange rate drops, US exports are cheaper, US consumers want to buy less imports, and so they don’t require as many US dollars to pay for foreign currency.

The expected profits effect works just the opposite as for demand. Traders wish to sell a currency when the exchange rate is high to reap a profit. Thus the quantity supplied of a currency will be higher when the exchange rate is high. Conversely, when the exchange rate is low, traders are more likely make a loss, so the quantity supplied is smaller.

Changes in the supply of currency will depend on:

· US demand for foreign imports. An increase in US demand for foreign imports (for reasons other than the exchange rate like changes in US real national income) will increase the supply of US currency as US consumers will offer more US dollars to pay for the higher imports. The supply curve for US dollars will shift out and to the right and the equilibrium exchange rate will fall.

SHAPE \* MERGEFORMAT A decrease in US demand for foreign imports will work just the opposite and shift the supply of US dollars in to the left.

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· The differential between US interest rates and foreign interest rates. In the opposite direction from demand, when US real interest rates are higher than the world interest rate, US investors will want to invest in fewer foreign financial assets. US investors will not need to offer as many dollars to buy foreign assets, so the supply curve will shift in to the left, resulting in a higher exchange rate. Obviously, if the interest rate differential between the US and the world is negative, meaning that interest rates are lower in the US, the supply of US dollars to buy more profitable foreign financial assets will increase and the supply curve will shift right.

· The expected foreign exchange rate. If the exchange rate for foreign currency is expected to increase, US traders could expect to make a profit by buying foreign currencies today and selling them in the future for a higher price. So the supply of US dollars today would increase to pay for the purchase of foreign currency. If the foreign currency exchange rate was expected to fall in the future, the supply of dollars today would decrease as traders backed off their speculative purchasing. Note that an increase in the foreign currency exchange rate would mean a fall in the US exchange rate.

Because in this market, demanding one currency is at the same time supplying another currency , the final impact on exchange rates will depend on both demand and supply changes in response to a factor change.

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