1 Chapter 9 How Exchange Rates are Determined ©2000 South-Western College Publishing

2 Exchange Rate The number of units of foreign currency that can be acquired with one unit of domestic money

3 Foreign Currency (Money) Supplies of foreign exchange

4 Appreciated means... When a currency has increased in value relative to another currency

5 Depreciated means... When a currency has decreased in value relative to another currency

6 U.S. dollar price of foreign goods = Foreign price of foreign goods (9.1) Exchange rate

7 Foreign Exchange Market The market for buying and selling the different currencies of the world

8 Yen Price of Exchange Rate Dollar Price of Japanese Auto (1) (2) (1)/(2) 2,000,000 Yen $1 = 150 Yen $13,333 2,000,000 Yen $1 = 100 Yen $20,000 2,000,000 Yen $1 = 50 Yen $40,000 How Movements in the Exchange Rate Affect the Dollar Price of Foreign Goods

9 Demand for dollars = F(foreign demand for U.S. goods, services, and securities) (9.2) +

10 Quantity demanded of dollars/month = F(Exchange rate) (9.3) –

11 Foreign Exchange Market Exhibit 9-1 Rest of the World United States U.S. Purchases (Demand) Foreign Goods, Services, and Securities Foreign Purchases (Demand)U.S. Goods, Services, and Securities U.S. Supplies Dollars as U.S. Demands Yen to Pay Foreigners Foreigners Supply Yen as Foreigners Demand Dollars to Pay U.S.

12 Dollar price of U.S. goods (9.4) × Exchange rate Yen (foreign) price of U.S. goods =

13 Since $1 = 100 yen and $1 = 1.5 marks, then 100 yen = 1.5 marks. If 100 yen = 1.5 marks, we can find how much 1 yen is worth by dividing both sides of the equation by 100 to arrive at 1 yen =.015 marks. 100/100 yen = 1.5/100 marks This is the marks/yen exchange rate. We can find out how much 1 mark is worth by dividing both sides of the equation by 1.5 to arrive at 1 mark = 67 yen. 1.5/1.5 marks = 100/1.5 yen

14 If an IBM Computer costs $1,500 and the yen /dollar exchange rate is 100, then in Japan, assuming transportation costs are zero, the computer will cost 1,500  100 yen 150,000 yen If the exchange rate appreciates to 150, then the computer will cost 1,500  150 yen 225,000 yen

15 Supply of dollars = F(U.S. demand for foreign goods, services, and securities) + (9.5)

16 Quantity supplied of dollars/month = F (exchange rate) + (9.6)

17 A Yen/ Dollar Quantity of Dollars / Month 100 Supply of Dollars Demand for Dollars The Market for Dollars Exhibit 9-2

18 Yen/Dollar Exchange Rate Quantity of Dollars / Month 50 Supply of Dollars Changes in the Exchange Rate Exhibit Supply of Dollars after Rise in U.S. Income A B Demand for Dollars

19 B Yen/Dollar Exchange Rate Quantity of Dollars / Month 50 Supply of Dollars Changes in the Exchange Rate Exhibit 9-4 Demand for Dollars After Rise in U.S. Prices Demand for Dollars A 100

20 Balance of Payments The record of transactions between the United States and its trading partners in the rest of the world over a particular period of time

21 Credit In the balance of payments, any item that results in a payment by foreigners to Americans

22 Merchandise Exports Foreign purchases of U.S. exports

23 Debit In the balance of payments, any transaction that results in a payment to foreigners by Americans

24 Merchandise Imports U.S. purchases of foreign goods

25 Current Account Transactions that involve currently produced goods and services, including the balance of goods and services and net unilateral transfers

26 Account Component Receipts Payments Balance Use of $ Sources of $ by Foreigners by foreigners Current (2) Merchandise Exports +400 (4) Balance of Trade (3) Merchandise Imports -$600 (2) + (3) = -$200 (5) Net Exports of Services +500 (6) Balance on Goods and Services: (4) + (5) = -$150 Net Exports (7) Net Unilateral Transfers -$30 (1) Balance on Current Account (6) + (7) = $180 Capital (9) Capital Inflows +$280 (8) Balance on (10) Capital Outflows -$100 Capital Account: (9) + (10) = $180 Total Uses Total Sources Balance of Payments +$730 -$730 (1) + (8) = 0 Exhibit 9-5

27 Net Transfer Payments In the current account, the net amount of government aid to foreigners plus private charitable relief

28 Trade Balance The difference between merchandise exports and imports

29 Trade Deficit When merchandise imports are greater than exports

30 Trade Surplus When merchandise exports are greater than imports

31 Balance of Goods and Services Net exports of services plus the trade balance

32 European Currency Unit (ECU) A unit of account made up of a weighted basket of currencies of the countries in the European Monetary System

33 Balance on Current Account The balance of goods and services plus net unilateral transfers

34 Capital Account The financial flow of funds and securities between the United States and the rest of the world

35 Capital Inflows Purchases of U.S. financial securities by foreigners and borrowing from foreign sources by U.S. firms and residents

36 Net Capital Inflow Capital inflows minus capital outflows

37 Devaluation Devaluation occurs when a country increases the units of currency that equal one ounce of gold under a fixed exchange rate system

38 200% 150% 100% 50% 0% Weighted Average Exchange Value of the U.S. Dollar: March, 1973 = 100 Recessions 1975