Economics: Currency Exchange and Market Dynamics

Real Exchange Rate Formula

  • The formula for calculating the real exchange rate (in target currency per US dollar) is:
    • RER = E \times \frac{CPI{US}}{CPI{target}}
    • Where:
    • RER = Real exchange rate
    • E = Nominal exchange rate
    • CPI_{US} = Consumer Price Index of the US
    • CPI_{target} = Consumer Price Index of the target nation

Impact of NAFTA

  • NAFTA (North American Free Trade Agreement) created a trading zone among the US, Canada, and Mexico.
  • Major effects:
    • Increased competition and decreased manufacturing costs due to cheaper labor in Mexico.
    • This resulted in an influx of jobs moving to Mexico, where tariffs were eliminated.
  • Ross Perot's comment about the 'giant sucking sound' relates to US jobs moving to Mexico because of labor cost differences.

Understanding Purchasing Power

  • Purchasing power refers to the actual value of currency in terms of the goods and services it can buy, unaffected by the nominal exchange rate.
  • Example:
    • If a can of Coke costs $2 in the US and €1.50 in the EU:
    • You can buy a Coke for the same purchasing power regardless of location.

Foreign Exchange Market (Forex) Graph

  • Graph Setup:
    • Y-axis: Exchange rate (currency per US dollar)
    • X-axis: Quantity of US dollars (USD)
  • Demand for US Dollars (DUSD):
    • Driven by entities needing USD, including:
    • Tourists
    • Foreign investors
    • Importers
  • Supply of US Dollars (SUSD):
    • Entities willing to exchange USD for foreign currencies (like euros).

Equilibrium in Forex Market

  • The equilibrium point occurs where the demand and supply curves intersect, labeled as:
    • Price: Exchange rate at that equilibrium
    • Quantity: Quantity of USD at that exchange rate
  • Example:
    • If the equilibrium exchange rate is €0.95 per dollar, both the demand and supply are satisfied at this rate.

Balancing Current Account and Capital Account

  • Current Account (CA) and Capital Account (CFA) must balance:
    • CA represents trade in goods and services.
    • Example: Europeans buying $2 trillion in US goods and assets versus Americans buying $2 trillion in European goods and assets.
    • Any imbalance would indicate a disequilibrium in exchange rates.

Supply and Demand Shifts in Currency

  • Graphs to Memorize:
    1. Demand Increase → Shift right, equilibrium exchange rate rises.
    2. Demand Decrease → Shift left, equilibrium exchange rate falls.
    3. Supply Increase → Supply curve shifts right, decreases exchange rate.
    4. Supply Decrease → Supply curve shifts left, increases exchange rate.

Effects of Demand Changes

  • Increase in Demand for US Currency:
    • Results in a currency shortage, pushing exchange rate up (appreciation of the US dollar).
  • Decrease in Demand for US Currency:
    • Causes excess supply, reducing the exchange rate (depreciation of the US dollar).

Effects of Supply Changes

  • Increase in Supply of Euros:
    • Leads to a decrease in euro's exchange rate, indicating depreciation.
  • Decrease in Supply of Euros:
    • Results in an increase in euro's exchange rate, signifying appreciation.