AP Economics Unit 6

Exchange rates

Price of one currency relative to another currency

Exports

Goods and services leaving a country

Imports

Goods entering a country

Each country must be paid in their

Own currency

The buyer ( ) must exchange their currency for that of the sellers ( )

1.Importer

2.Exporter

How many currencies do we see for 2 countries in the FOREX market

Only look at 2 currencies

Depreciation

The loss of value of a country’s currency with respect to a foreign currency

-More units of dollars are needed to buy a single unit of the other currency

-Dollar is said to be weaker

Appreciation

The increase of value if a country’s currency with respect to a foreign currency

-Fewer units of dollars are needed to buy a single unit of the other currency

-The dollar is said to be stronger

When the United States dollar appreciates against the euro, what will most likely happen

-United States tourists will pay fewer dollars for trips to Europe

Who demands dollars

Foreigners demand dollars

Demand for dollars

There is an inverse relationship between the exchange rate (price) and quantity demanded

Supply of dollars

There is a direct relationship between the exchange rate (price) and the quantity supplied

What happens to exchange rates when there’s shortages

The exchange rate will rise

What happens to exchange rates when there’s surpluses

Exchange rate will fall

If you demand one currency, you must

Supply your currency

The value of a country’s currency will tend to appreciate if

Demand for the country’s exports increases

The value of a country’s currency will tend to depreciate if

Demand for the country’s exports decreases

What are the FOREX shifters?

• Change in Tastes

• Changes in Relative Incomes (resulting in more imports)

• Change in Relative price level (resulting in more imports)

• Changes in relative Interest rates

Changes in tastes example

Ex: British tourists flock to the U.S

-Demand for U.S dollar increases

-supply of British ounces increases

Pound- depreciates

Dollar- appreciates

What shifter of the foreign exchange market are double shifters

• Changes in price level

• Changes in interest rate

Tariff

A tax on imports

Quotas

A limit on the quantity of imports

If the exchange rate between the U.S dollar and the British pound changed from 2 per 1 to 3 per 1 and domestic prices in both countries stayed the same, then the United States dollar would

Depreciate, making United States imports from Britain more expensive

An appreciation of the U.S dollar on the FOREX market could be caused by a decrease in

The United States consumer price index (CPI)

What can cause the United States dollar to depreciate relative to the Euro

An increase in household income in the United States

What will likely occur following the depreciation of the U.S dollar

United States exports will increase

Fixed exchange rate

The government actively manages the country’s currency

Floating exchange rate

The market determines the value of a country’s currency

Why would some governments attempt to depreciate their country’s currency?

In order to promote exports

Under a flexible exchange rate system, the Indian rupee will appreciate against the Japanese Yen when

Real interest rates in India increase relative to those in Japan

What happens to exports when there’s appreciation

Net exports will decrease

What happens to net exports if depreciation happens?

Net exports increase

What graph is used to shoe the change in interest rates and the effect on the value of a currency

The loanable funds graph

What happens when saving increases

• Supply for loans goes up

• Real interest rate goes down

• Net Capital Outflow goes up

• Supply for dollars goes up

• Value of dollars goes down

What happens when investment increases

• Demand for loans goes up

• Real interest rate goes up

• Net Capital Outflow goes down

• Supply of dollars goes down

• Value of dollar goes up

High interest rates attract

Foreign currency

Net Exports (XN)

Exports-Imports

Trade surplus

Exporting more than is imported

Trade deficit (trade gap)

Exporting less than is importing

What does balance of trade (BOP) include

Only goods and services but balance of payments considers ALL international transactions

Balance of Payment (BOP)

Summary a country’s international trade

-Summary is within a given year prepared in the domestic country’s currency

What 2 accounts make up the balance of payments (BOP)

• Current account (CA)

• Capital and financial account (CFA)

What makes up the current account

• Trades in Goods and Services (Net Exports)

• Investment Income

• Net Transfers

Trades in Goods and Services (Net Exports)-

Difference between a nations exports of goods and services and its imports of goods and services

Ex: Toys imported from China, US cars exported to Mexico

Investment Income

Income from the factors of production including payments made to foreign investors

Ex: Money earned by Japanese cars produce in the U.S

Net Transfers

Money flows from the private or public sectors

Ex: donations, aids and grants, official assistance, and remittance

Capital and Financial Account (CFA)

Measures the purchase and sale of financial assets abroad. Purchases of thins that continue to earn money

-Ex: A Korean company buys a factory in Ohio

-An American buys a Japanese government bond

-Foreign Direct Investment

Net Capital Outflow

The difference between the purchase of foreign assets and domestic assets purchased by foreigners

Financial account surplus inflow and outflow

Inflow > Outflow

Financial account deficit inflow and outflow

Inflow < Outflow

Foreign Direct Investment

When a foreign company buys business in a different country

Balance of Payments equation

CA + CFA = 0

What must the current account (CA) and the financial count (CFA) do

They must balance out

Why do CA and CFA eventually balance out?

Money that leaves a country must come back as either a foreign purchase of goods/ services (exports) or foreign purchases of financial assets.

U.S income increase relative to other counties. Does the balance of payments move toward a deficit or a surplus?

• U.S citizens have more disposable income

• Americans import more

• Net Exports decrease

• The current account balance decreased and moves toward a deficit

If the U.S dollar depreciates relative to other countries does the balance of payments move toward a deficit or a surplus

• U.S exports become more desirable

• America exports more

• Net exports (Xn) increases

• The current account balance increases and moves toward a surplus

A country have an increased surplus in its balance of trade as a result of

Declining imports and rising exports

What is the difference between appreciation and depreciation

Appreciation increase of value of a countries currency while depreciation is the loss of value of a countries currency

Why can’t two currencies both appreciate relative to each other at the same time

They can’t both appreciate to each other at the time because the exchange rate are a relative value which means that if one decreases the the other must increase and vice versa

Assume now it takes 100 yen to purchase 1 U.S dollar instead of 120 yen. Which currency appreciated and which currency depreciated.

The Japanese Yen appreciated and the U.S dollar depreciated

If 1 U.S dollar equals 19 Mexican pesos, 1 peso equals how many dollars?

It equals around 0.0526 U.S dollars

Why is supply downward sloping

Because the price level is increasing

Why is supply upward sloping

Because the exchange rate is increasing

Which shifters shift both the demand and the supply of a currency at the same time

• Relative inflation

• Changes in expected future exchange rates