1. What is the role of the foreign exchange market and the exchange rate? 2. What is the importance of real exchange rates and their role in the current account?

1.Foreign Exchange Market: 2.Exchange Rates: 3.Appreciate: 4.Depreciate: US $JP ¥€ $ ¥ €

1.Foreign Exchange Market: market where foreign currencies are traded 2.Exchange Rates: one nation’s currency in terms of another nation’s currency 3.Appreciate: gains in value 4.Depreciate: loses value US $JP ¥€ $ ¥ €

The role of exchange rate: ensures that the balance of payments current account and financial account balance. 1. Scenario: you are vacationing in Mexico. You want to buy a t-shirt at a market & the price is Mexican pesos. You have U.S. dollars, but you must pay the Mexican shirt manufacturer in pesos. How do you do it? 2. How many Mexican pesos does one U.S. dollar fetch at the foreign exchange counter? Find it on your exchange rate app on your phone. 3. How many pesos would it take to buy one dollar? 4. So how much does the shirt cost in USD? 5. Exchange rate = price of ne nation’s currency in another nation’s currency. Prices change based upon the forces of ___________ and ______________. 6. For example, in late April 2010, it took 12.1 pesos to buy 1 U.S. dollar. This means that if you were in Mexico that month, your dollar would have been able to purchase fewer pesos. What about now? What has the peso done against the USD? 7. When a currency will purchase more of another currency, it has __________in value. 8. When a currency will purchase less of another currency it has ______________ against in value.

The role of exchange rate: ensures that the balance of payments current account and financial account balance. 1. Scenario: you are vacationing in Mexico. You want to buy a t-shirt at a market & the price is Mexican pesos. You have U.S. dollars, but you must pay the Mexican shirt manufacturer in pesos. How do you do it? You must exchange your dollars for pesos in the foreign exchange market. 2. How many Mexican pesos does one U.S. dollar fetch at the foreign exchange counter? Find it on your exchange rate app on your phone. 1USD = to Pesos 3. How many pesos would it take to buy one dollar? So how much does the shirt cost in USD? / = $14.47 USD 5. Exchange rate = price of ne nation’s currency in another nation’s currency. Prices change based upon the forces of supply and demand. For example, in late April 2010, it took 12.1 pesos to buy 1 U.S. dollar. This means that if you were in Mexico that month, your dollar would have been able to purchase fewer pesos. 6. When a currency will purchase more of another currency, it has has appreciated in value. 7. When a currency will purchase less of another currency it has depreciated against in value.

FOREX follows laws of supply & demand Equilibrium Exchange Rate An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in U.S. net exports. A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in U.S. net exports. An easy way to remember how to properly label a foreign exchange graph’s x and y axes is to think “bottom bottom.” Whichever currency is on the x-axis (bottom) goes underneath the other currency on the vertical axis. (Price of USD in Euros)

The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. If you want euros, you demand them. To acquire euros, you must supply USD to the exchange market. So when you demand more euros, you must supply more dollars. The unit on the x-axis is the quantity of U.S. dollars supplied and demanded. The units on the y-axis is the price of U.S. dollars, measured in euros per dollar. 1. Why does the Demand for Dollars slope downward? 2. Why does the Supply of Dollars slope upward? 3. Scenario: Suppose the demand for U.S. dollars increases. European consumers have more money to spend and some of that additional income is being spent on financial investments in America. The payments from those European citizens will flow into the U.S. financial account. Where does the demand curve shift? What happens to the value of the USD? What will happen to the purchase of goods and services from Europe?

The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. If you want euros, you demand them. To acquire euros, you must supply USD to the exchange market. So when you demand more euros, you must supply more dollars. The unit on the x-axis is the quantity of U.S. dollars supplied and demanded. The units on the y-axis is the price of U.S. dollars, measured in euros per dollar. 1. Why does the Demand for Dollars slope downward? As the price of a dollar falls (its value depreciates against the Euro) it takes fewer euros to buy one dollar. Consumers in Europe will find U.S. goods to be less expensive because the dollar is weaker. U.S. exports to Europe will rise, and more dollars will be demanded to pay for those goods. 2. Why does the Supply of Dollars slope upward? As the price of a dollar rises (its value appreciates against the Euro) one dollar buys more euros. Consumers in the U.S. will find European-made goods to be less expensive. U.S. imports from Europe will rise, and more dollars will be supplied to pay for those goods. 3. Scenario: Suppose the demand for U.S. dollars increases. Maybe European consumers have more money to spend and some of that additional income is being spent on financial investments in America. The payments from those European citizens will flow into the U.S. financial account. Where does the demand curve shift? What happens to the value of the USD? What will happen to the purchase of goods and services from Europe? As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. It will now cost more euros to buy one U.S. dollar. Because the U.S. dollar has appreciated against the euro, American consumers will increase purchases of goods and services from Europe. More U.S. dollars will be supplied and will flow out of the U.S. current account.

Real Exchange Rates: exchange rates adjusted for aggregate price levels (inflation). Nominal Exchange Rates: unadjusted for aggregate price levels (inflation). T hen the real exchange rate between the Mexican peso and the U.S. dollar is defined as: Real exchange rate = Mexican pesos per U.S. dollar *(PUS/PMex) To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate. Example 1: There is no difference in aggregate price levels between the US and Mexico in the base year. Real exchange rate = 12.5*(100/100) = 12.5 pesos per dollar Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and PMex=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.

Purchasing Power Parity (PPP): The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Suppose, for example, that a basket of goods and services that costs $100 in the United States costs 1,000 pesos in Mexico. Then the purchasing power parity is 10 pesos per U.S. dollar: at that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries. Big Mac Index: chart-17 chart-17 urce/4.htmhttp://images.businessweek.com/ss/06/05/what_things_cost/so urce/4.htm

 Module Review Questions p. 429 – 430  Read Module 43