LO4 - Exchange Rates

Economics

What is an exchange rate? (with example)

• Is the value of one currency in terms of another.

• E.g. → €1 = $1.17 (The value of €1 = $1.17)

What is currency appreciation? (example)

Is when a currency increases in value relative to another.

• Value of €1 increasing from $1.15 → $1.17

What is currency depreciation?

Is when a currency falls in value relative to another.

• €1 falling from $0.76 → $0.67 (Euro depreciation)

Why do Americans demand euros? (2)

To buy European;

• Goods & services

• Financial assets (like → shares, property, bonds)

→ This is because European goods are sold in (€), they would need to convert their ($) to be able to obtain them.

What happens to demand for euros when the euro appreciates? (4)

• EU goods become more expensive for Americans

• Demand for EU goods falls

• Demand for euros falls

• Demand curve shifts left

What happens when the euro depreciates? (4)

• EU goods become cheaper for Americans

• Demand for EU goods rises

• Demand for euros rises

• Demand curve shifts right

Why do Europeans supply euros? (2)

To buy American;

• Goods & services

• Financial assets (like → shares, property, bonds)

→ This is because American goods are only sold in ($), they would need to convert their (€) to be able to obtain them.

What happens to supply of euros when the euro appreciates? (4)

• US goods become cheaper

• Europeans buy more US goods

• Supply of euros increases

• Supply curve shifts right

What happens when the euro depreciates? (4)

• US goods become more expensive

• Europeans buy fewer US goods

• Supply of euros decreases

• Supply curve shifts left

What happens when the euro (€) appreciates? (6)

• EU exports ↓

• EU imports ↑

• American tourists find EU more expensive

• EU tourists find US cheaper

• Demand for euros ↓

• Supply of euros ↑

What happens when the euro depreciates? (6)

• EU exports ↑

• EU imports ↓

• American tourists find EU cheaper

• EU tourists find US more expensive

• Demand for euros ↑

• Supply of euros ↓

Convert £50,000 to USD at GBP/USD = 1.23516

£1 = $1.23516

£50,000 = ?

£50,000 × 1.23516 = $61,758

NOTE

(since the requested figure is on the opposite side of the exchange rate → you x the 2, if it was on the same side you divide) you can determine this based on the way the 2 currencies are formatted “GBP/USD” & what was requested £50,000. If the currency was written in this way USD/GBP → that means both figures would be on the same side)

Convert JPY 21,000,000 to EUR at EUR/JPY = 160.216

JPY 1 = €160.216

? = JPY 21,000,000

21,000,000 ÷ 160.216 = €131,073.05

Convert £2,369 to EUR at June 2022 rate 0.85

£2,369 ÷ 0.85 = €2,787.05

Convert £2,369 to EUR at August 2022 rate 0.84

£2,369 ÷ 0.84 = €2,820.23

What are the factors affecting exchange rates: (4)

• Interest rate differentials

• Inflation differentials

• Income differentials

• Speculations

How do interest rate differentials affect exchange rates? (2)

• Higher interest rates → attract investors → demand for currency ↑ → currency appreciates

• Lower interest rates → investors leave → currency supply ↑ → currency depreciates

How do inflation differentials affect exchange rates? (2)

• Higher inflation → exports expensive → demand for currency ↓ → depreciation

• Lower inflation → exports affordable & countries compete for it → demand for currency ↑ → appreciation

How do income differentials affect exchange rates?

• Higher domestic income → more imports → supply of domestic currency ↑ → depreciation

How does speculation affect exchange rates?

• If traders expect a currency to weaken → they sell it → supply ↑ → depreciation

• If they expect it to strengthen → they buy it → demand ↑ → appreciation

If EUR/USD falls from 1.14 to 1.12, has the euro appreciated or depreciated?

The euro has depreciated (it now buys fewer dollars).

How does a weaker euro affect Irish tourism?

• Ireland becomes cheaper for US tourists → tourism increases

• Irish tourists find the US more expensive → tourism decreases