1. FOREIGN CURRENCY AND FOREIGN EXCHANGE SIMULATION & OVERVIEW International Trade

2. Foreign Exchange Rates (AKA FX or forex) What are exchange rates?  The price of a currency in terms of another - the rate at which one currency can be exchanged for another (multiply foreign price by exchange rate to calculate)  Ex. If $2= 1euro, $1 =.5 euro or if $1 = 10 pesos, $10 = 1 peso Why do exchange rates exist?  Because people have a demand for other currencies. What is the demand?  People have a demand for other currencies because they have a demand for goods & services that can be purchased with that currency.  For example, in our simulation, you demanded candy and therefore you demanded ‘bucks’ with which to purchase the candy

3. Foreign Exchange Rates Some nations fix their rates and others are allowed to “float” with the forces of supply and demand  Fixed Rate of exchange stays the same; in past basis was gold (set by central bank - rarely works)  Gold Standard was used as global exchange rate prior to WWI  Floating Rate: based on supply and demand for each currency (Currently using “managed float” in US)  Rates determined in foreign currency market through Supply and Demand IMF (International Monetary Fund) helps regulate monetary stability and promote foreign trade

4. Assumptions related to Exchange Rates Determinants of Exchange Rates If the demand for a nation’s currency increases (all else equal), that currency will appreciate. If Demand declines, it will depreciate. If the supply of a nation’s currency increases, that currency will depreciate. If supply decreases, that currency will appreciate If a nation’s currency appreciates, some foreign currency depreciates relative to it. Tastes Income Price Level Interest Rates/Speculation Factors that change Supply & Demand and thus alter the exchange rate

5. Appreciation and Depreciation Appreciation (strong dollar)  dollar buys more of another currency, resulting in less expensive imports and more expensive exports Depreciation (weak dollar)  dollar buys less of another currency, resulting in more expensive imports and less expensive exports

6. Tastes Factors that change Supply & Demand and thus alter the exchange rate When domestic consumers build a strong preference for foreign produced goods and services, the demand for those currencies increases and the dollar depreciates  Ex: Japanese autos gain popularity in US (Yen appreciates, USD depreciates) If foreign consumers increase their demand for U.S.- made goods, the dollar appreciates.  Ex: European tourists flock to the US (USD appreciates; Euro depreciates)

7. Income Factors that change Supply & Demand and thus alter the exchange rate When one nation’s macroeconomy is strong and incomes are rising, ceteris paribus, demand for all goods increases, domestically and abroad  Ex: if Europeans are enjoying economic growth and the US is in recession, the relative buying power of European Citizens is growing. They will increase their consumption of domestic and US made goods. (demand for USD increases, USD appreciates)  Ex: England encounters a recession, reducing its imports, while US real output and real income surge, increasing US imports (British pound appreciates, USD depreciates.

8. Prices (Inflation) Factors that change Supply & Demand and thus alter the exchange rate If one nations’ price level is rising faster than that of another nation, consumers seek the goods that are relatively less expensive.  Switzerland experiences a 3% inflation rate compared to Canada’s 10% rate (Swiss franc appreciates; Canadian dollar depreciates).  If European inflation is higher than inflation in the US, American-made goods are a relative bargain to German consumers and the dollar appreciates. (Another reason for the Fed to keep inflationary pressure low!)

9. Interest Rates/Speculation Factors that change Supply & Demand and thus alter the exchange rate Foreign currency is traded as an asset and investors seek to profit from buying currency at a low rate and selling it at a high rate  Ex: If it appears that future US interest rates will fall relative to the rates in Japan, the Yen begins to look like a great investment (speculators increase demand for Japanese assets, thus appreciating the Yen and depreciating USDs)  Ex: Currency traders believe South Korea will have much greater inflation than Taiwan (South Korea won depreciates; Taiwan dollar appreciates)  Ex: Currency traders think Finland’s interest rates will plummet relative to Denmark’s rates (Finland’s markka depreciates; Denmark’s Krone appreciates)