Foreign Exchange (aka. FOREX) Exchange Rate = Relative Price of Currencies Copyright ACDC Leadership 2015

I want a pallet of Mexican Avocados. What do I have to do to get one? Why? Don’t ask questions...

FOREX Supply and Demand Simplified Imagine a huge bucket with all the different currencies from every country This is the Foreign Exchange Market! Just like at a product market, you can’t take things without paying. If you demand one currency, you must supply your currency. Ex: If Canadians what Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase. Copyright ACDC Leadership 2015

Exchange Rates In the FOREX market we only look at two countries/currencies at a time Ex: US Dollars and Euros We examine the price of one currency in terms of the other currency. Ex: $3 = €2 The Exchange Rate depends on which currency you are converting. The price of one US Dollar in terms of Euros is 1 Dollar = €2/$3 = €.66 The price of one Euro in terms of Dollars is 1 Euro = $3/€2= $1.5 Copyright ACDC Leadership 2015

What happens if you need more dollars to buy one euro (the price for a euro increases)? Ex: From $3=€2 to $6=€2 The U.S. Dollar DEPRECIATES relative to the Euro. 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. The dollar is said to be “Weaker” Copyright ACDC Leadership 2015

What happens if you need less dollar to buy one euro (the price for a euro decreases)? Ex: From $3= €2 to $1= €2 The U.S. Dollar APPRECIATES relative to the euro. Appreciation- The increase of value of a country's currency with respect to a foreign currency Less units of dollars are needed to buy a single unit of the other currency. The dollar is said to be “Stronger” Copyright ACDC Leadership 2015

$ D1D1 S1S1 Euros Quantity of Euros er 1 S er e D € $ Dollars Quantity of Dollars er 1 S er e D € What happens if Europeans prefer vacationing in the United States? The Dollar APPRECIATES The Euro DEPRECIATES Copyright ACDC Leadership 2015

Flexible Exchange Rates Determinants of exchange rates Factors that shift demand/supply –Changes in tastes –Relative income changes –Relative price-level changes Purchasing-power-parity theory –Relative interest rates –Relative expected returns on assets –Speculation 38-8

Change in Tastes Vs.

Change in Relative Income

Change in Relative Price Level

Change in Relative Interest Rates Change in Relative Expected Returns on Investment

Currency Speculation Self- fulfilling prophecy

Pesos What will happen to the international value of the Mexican peso if there is high inflation in Mexico? The demand for pesos will decrease since Mexico's trading partners will not want to purchase higher priced Mexican products. The supply will increase as Mexicans look to buy lower priced imports. The peso DEPRECIATES

Practice For each of the following examples, identify what will happen to the value of US Dollars and Japanese Yen. 1.American tourists increase visits to Japan. 2.The US government significantly decreases personal income tax. 3.Inflation in the Japan rises significantly faster than in the US. 4.Japan has a large budget deficit that increases Japanese interest rates. 5.Japan places high tariffs on all US imports. 6.The US suffers a larger recession. 7.The US Federal Reserve sells bonds at high interest rates. How do these scenarios affect exports and imports?

Practice 16 Shifter Value of Dollar ($) Value of Yen (¥ ) Copyright ACDC Leadership 2015

Practice 17 Shifter Value of Dollar ($) Value of Yen (¥ ) 1 Tastes(S↑) Depreciates(D↑) Appreciates 2 Income(S↑) Depreciates(D↑) Appreciates 3 Price Level(D↑) Appreciates(S↑) Depreciates 4 Interest Rate(S↑) Depreciates(D↑) Appreciates 5 Regulation(D↓) Depreciates(S↓) Appreciates 6 Income (S↓)Appreciates(D↓) Depreciates 7 Interest Rate(D↑) Appreciates(S↑) Depreciates Copyright ACDC Leadership 2015 Scenarios 1, 2, and 4 will increase US exports because US products are now relatively “cheaper”

2008 Audit Exam

High interest rates attract foreign currency 2008 Audit Exam

2010 FRQ #3 Copyright ACDC Leadership 2015

2010 FRQ #3 Copyright ACDC Leadership 2015

Flexible Exchange Rates Pro - Eliminates balance of payments deficit or surplus –Large imports from Mexico increase demand for the peso, causing it to appreciate, making Mexican goods more expensive and less likely to be imported

Flexible Exchange Rates Disadvantages of flexible exchange rates? –Volatility –Uncertainty and diminished trade –Terms-of-trade changes –Instability Depreciation of dollar = more exports = higher prices (inflation) Appreciation of dollar = more imports/less exports = more unemployment

Exchange Rate Regimes Flexible Exchange Rate- The market determines the value of the country’s currency Fixed Exchange Rate- The government actively manages the country’s currency Some governments attempt to depreciate their country’s currency in order to promote exports Copyright ACDC Leadership 2015

Fixed Exchange Rates Government intervention –Alter Supply/Demand Use of reserves (show on graph) –Selling pounds = transfer of assets Trade policies – tariffs, subsidies Exchange controls and rationing –Distorted trade lessens advantages –Favoritism to certain importers –Restricted choice for consumers –Black markets – LEVIS! 38-25

Macroeconomic Adjustments to maintain fixed exchange rates Use Monetary/Fiscal Policy –Trade deficit with Britain –Reduce demand for British Pounds by undertaking contractionary policy, reducing American incomes and thus imports of British goods –The cost? –Recession.

Exchange Rate Systems Gold standard –Fixed exchange rate system Bretton Woods –Fixed exchange rate system indirectly tied to gold –International Monetary Fund Managed float 1971-present 38-28

Managed Float Dependence on foreign exchange markets Occasional intervention (IMF) –Tsunami I n support of managed float –Track Record Concerns with managed float –Volatility –Manipulation 38-29

5 Key Graphs Copyright ACDC Leadership 2015

Macro Review Copyright ACDC Leadership 2015