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Module The Foreign Exchange Market KRUGMAN'S MACROECONOMICS for AP* 42 Margaret Ray and David Anderson

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Housekeeping Housekeeping Read modules 43-44 Test - Friday 5/2 – AP 5 Test – Monday 5/5 – AP 3

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Do Now Do Now How do foreign currency exchange rates impact you?

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What you will learn in this Module : The role of the foreign exchange market and the exchange rate Determinants of FX rate changes The importance of real exchange rates and their role in the current account

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What is an exchange rate? What is an exchange rate? Price of one currency in terms of units of another currency. Example: Activity 53 USD 1.4 = ₤ 1.00 or…. ₤ 0.71 = USD 1.00

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Activity # 53 – Part A Activity # 53 – Part A Convert foreign prices to USD. Which currencies appreciated vs. the USD? Which depreciated? Also do 7 & 8.

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The Equilibrium Exchange Rate The Equilibrium Exchange Rate FOREX follows laws of supply & demand Equilibrium Exchange Rate

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Figure 42.2 An Increase in the Demand for U.S. Dollars Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

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Determinants of FX rates Determinants of FX rates Current account flows (X-M) Capital flows (real interest rates, business opportunities, political)

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Two Ways to Look at FX Markets Two Ways to Look at FX Markets Activity 53 - # 9 – page 307 Germany & US Trade

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Activity 53.3 – 53.5 Activity 53.3 – 53.5 Graph changes in FX markets using both approaches.

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Inflation and Real Exchange Rates Inflation and Real Exchange Rates Real exchange rate = current rate * change in relative price indexes ( FX rate currency A / 1.00 currency B) * (price index B/ price index A) Example 1 – US vs. Mexico. Assume no inflation, so price level index equals 100 in both countries: The real exchange rate = 12.5*(100/100) = 12.5 pesos per dollar

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Inflation and Real Exchange Rates Inflation and Real Exchange Rates Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and price index Mex=110. Real exchange rate = 12.5*(100/110) = 11.4 pesos per dollar. So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods.

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Why are real exchange rates important? Why are real exchange rates important? ???????

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Exercise: Exchange rates and inflation Exercise: Exchange rates and inflation Do # 10 a, b, c and d

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Housekeeping Housekeeping Read modules 43-46. Focus on 43 and 44. Test – Postponed until after AP exam. Monday - brief review of Economic Growth concepts (Section 7). Practice tests and reviews thru 5/14.

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Purchasing Power Parity Purchasing Power Parity Purchasing Power Parity (PPP): nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Big Mac Index Nominal Exchange Rates and PPP

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Summary Summary FX rates are the price of foreign currency Currencies appreciate or depreciate. Shifts in FX supply and demand result from current account or capital account flows. Current account = trade Capital account = interest rates, animal spirits.

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Summary 2 Summary 2 Real exchange rates reflect changes in nominal FX rates adjusted by relative changes in the price level. Real exchange rates drive the current account. Purchasing power parity is an exchange rate that equalizes the cost of the same basket of goods across all countries. Helps compare economies. Identifies under or overvalued currencies.

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Exit ticket / Homework Exit ticket / Homework FRQs 2009 and 2010

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Exchange Rates Lecture notes 8 Instructor: MELTEM INCE.

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