# MODULE 42: The Foreign Exchange Market (FOREX) Duffka School of Economics

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1 MODULE 42: The Foreign Exchange Market (FOREX)

2 Key Economic Concepts Foreign currencies are exchanged because foreign goods and services are exchanged. The market for a currency (like the U.S. dollar) operates with the forces of supply and demand. When the dollar can buy more of a foreign currency (like the euro), it is said that the dollar has appreciated in value, or it has become stronger against the euro. When the dollar can buy less of a foreign currency (like the euro), it is said that the dollar has depreciated in value, or it has become weaker against the euro. Movements in the exchange rate ensure that changes in the financial account(capital account) and in the current account offset. The real exchange rate is the nominal exchange rate adjusted for international differences in aggregate price levels (inflation).

3 Module Layout I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity

4 I. The Role of the Exchange Rate A. Understanding Exchange Rates The exchange rate is a price of one currency to use another currency. EXAMPLE: April 2010, 12.1 pesos to buy 1 U.S. dollar. June 2010, 12.5 pesos to buy 1 U.S, dollar The dollar was more expensive (measured in pesos per dollar) in June 2010 than it was two months earlier. Economists would say that the dollar has appreciated in value against the peso because it has become more expensive. In other words: the peso has depreciated in against the dollar.

5 I. The Role of the Exchange Rate A. Understanding Exchange Rates The exchange rate is a price of one currency to use another currency. EXAMPLE: 1999 \$0.85 to buy \$1.58 to buy \$1.31 to buy 1 Depreciated From the value of the dollar compared to the Euro From the value of the dollar compared to the Euro Appreciated From the value of the Euro compared to the dollar Appreciated From the value of the Euro compared to the dollar Depreciated

6 Practice Question #1

7 Practice Question #1 1. When the U.S. dollar buys more Japanese yen, the U.S. dollar has, I. become more valuable in terms of the yen. II. appreciated. III. depreciated a. I only b. II only c. III only d. I and II only e. I and III only

8 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. Buying a German product: Demand Euros (increase demand for Euros)=Euro appreciation Supply Dollars (increase the supply of dollars)=dollar depreciation

9 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. Buying a German product with dollars: Demand Euros (increase demand for Euros)=Euro appreciation Supply Dollars (increase the supply of dollars)=dollar depreciation RESULT: Dollar depreciated Euro appreciated It takes less Euros to buy dollars. upad Graph: Y-axis-Euros per DOLLAR X-axis-Quantity of DOLLARS DOLLAR supply is increased to buy German product. 0.85

10 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. Buying an American made product with euros: Demand Dollars (increase demand for dollars)=dollar appreciation Supply Euros (increase the supply of euros)=euro depreciation

11 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate Why does the Demand for dollars slope downward? As the price of a dollar falls (its value depreciates) it takes fewer pesos to buy one dollar. Consumers in Mexico will find U.S. goods to be less expensive. U.S. exports to Mexico will rise, and more dollars will be demanded to pay for those goods. Why does the Supply of Dollars slope upward? As the price of a dollar rises (its value appreciates) one dollar buys more pesos. Consumers in the U.S. will find Mexican-made goods to be less expensive. U.S. imports from Mexico will rise, and more dollars will be supplied to pay for those goods.

12 Practice Question

13 Practice Question #5 5. Which of the following will decrease the supply of U. S. dollars in the foreign exchange market? a. U.S. residents increase their travel abroad. b. U.S. consumers demand fewer imports. c. Foreigners increase their demand for U.S. goods. d. Foreigners increase their travel to the United States. e. Foreign investors see increased investment opportunities in the United States.

14 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate Summary: 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.

15 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level (inflation) in those nations. Economists calculate real exchange rates, exchange rates adjusted for international differences in aggregate price levels.

16 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level (inflation) in those nations. Economists calculate real exchange rates, exchange rates adjusted for international differences in aggregate price levels.

17 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level (inflation) in those nations. Economists calculate real exchange rates, exchange rates adjusted for international differences in aggregate price levels.

18 Practice Question

19 Practice Question #3 3. What happens to the real exchange rate between the euro and the U.S.dollar (expressed as euros per dollar) if the aggregate price levels in Europe and the United States both fall? It a. is unaffected. b. increases. c. decreases. d. may increase, decrease, or stay the same. e. cannot be calculated.

20 Practice Question

21 Practice Question #4 4. Which of the following would cause the real exchange rate between pesos and U.S. dollars (in terms of pesos per dollar) to decrease? a. an increase in net capital flows from Mexico to the United States b. an increase in the real interest rate in Mexico relative to the United States c. a doubling of prices in both Mexico and the United States d. a decrease in oil exports from Mexico to the United States e. an increase in the balance of payments on the current account in the United States

22 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity The nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Example: 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.

23 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity The Big Mac Index The price, in dollars, to purchase a Big Mac in all the countries listed to the right.

24 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity The Big Mac Index The price, in dollars, to purchase a Big Mac in all the countries listed to the right.

25 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity-ten most expensive cities

26 Practice Question

27 Practice Question #2 2. The nominal exchange rate at which a given basket of goods and services would cost the same in each country describes a. the international consumer price index (ICPI). b. appreciation. c. depreciation. d. purchasing power parity. e. the balance of payments on the current account.

28 I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate C. Inflation and Real Exchange Rates D. Purchasing Power Parity Questions?

29 APE U6 L3 A53 Figure 53.1 Cost in foreign currency US dollars Cost in US dollars of foreign currency May August May August British pound Canadian dollar European euro Swedish krona Japanese yen peso PARTMexican A: August May 1. A dinner for two that costs 500 pesos \$55.05 \$ A hotel room that costs 30,000 yen \$ \$ \$73, \$77, \$2.82 \$ A BMW that costs 85,000 euros 4. A pound of swedish meatballs that costs 30 krona 5. A pair of pants that costs 72 pounds in London 6. A leather jacket that costs 1,800 Canadian dollars \$ \$1, \$ \$1,134.00

30 APE U6 L3 A53 An American meal that cost \$60 #7 & 8 May August DOLLAR Appreciate Depreciate (strengthen) (weaken) British pound Canadian dollar European euro Swedish krona Japanese yen X Mexican peso X X X X X

31 APE U6 L3 A53 S S1 D Qty of US Dollars US Dollar/Euro Exchange Rate Euro/US Dollar Exchange Rate Figure 53.2: Prices of US Goods Increase S D1 D Qty of Euros Rationale: Americans will demand less expensive German goods, thereby increasing the demand for euros and supplying more dollars to the foreign exchange market. The US dollar depreciates. The euro appreciates.

32 APE U6 L3 A 53 S D1 D Qty of US Dollars US /Canadian Dollar Exchange Rate Canadian/US Dollar Exchange Rate Figure 53.3: Interest Rates in the US Increase S S1 D Qty of Canadian Dollars Rationale: Canadian investors will demand US dollars to purchase US investments, causing the US dollar to appreciate. The supply of Canadian dollars will increase because Canadians are trading Canadian dollars for US dollars. The Canadian dollar will depreciate.

33 APE U6 L3 A 53 S D1 D Qty of Pesos Peso/Euro Exchange Rate Euro/Peso Exchange Rate Figure 53.4: French Tourists Visit Mexico S S1 D Qty of Euros Rationale: The demand for pesos increases to pay for the beach vacations. The supply of euros increases because the French are exchanging euros for Mexican pesos. The Mexican peso is appreciating, and the euro is depreciating.

34 APE U6 L3 A 53 S S1 US Dollar/Yen Exchange Rate Yen/US Dollar Exchange Rate Figure 53.5: US Children Want Videos Produced in Japan S D1 D Qty of US Dollars D Qty of Yen Rationale: Demand for Japancse Yen increases as US children buy more Japanese video games; the supply of dollars to the exchange market increases. The US dollar depreciates. The yen appreciates.

35 APE U6 L2 A51 Barriers to Trade PART A: Quotas Price 1. Effects of quota removal on domestic price, production and the amount of imports. The domestic supply and total supply curves on the graph are without any barriers to trade imposed. Be sure to show on the graph the supply curve with the quota. Domestic Supply Total Supply w/ quota P Total Supply P2 P1 Domestic Demand Q3 Q Q2 Q1 Quantity An import ban the eq price would be P and eq quantity would be Q with domestic production only. If a partial quota, S curve labeled TS w/ Quota would be the relevant curve. P2 & Q2. Quota = (Q2-Q3) Domestic production will be Q3. Removing the Q & moving to free trade eq, the domestic consumers will pay P1 and purchase Q1. Removal of a quota has led to a decrease in P and an increase in the quantity consumed. In this case, there will be zero domestic production under free trade.

36 APE U6 L2 A51 Barriers to Trade Part A: Quotas 2. Write a paragraph summarizing the advantages and disadvantages of a quota to the domestic economy. Be sure to discuss the impact on domestic consumers, domestic producers and foreign producers. Advantages: Disadvantages: The domestic industry will be able to: Consumers: *produce more *cannot consume as much *receive a higher price *employment is greater *pay a higher price Foreign Producers: *receive a higher price but produce less with a quota than under free trade 3. If a quota is imposed, explain the methods people would use to circumvent the effects of the quota: An underground market may develop for the commodity. Foreign firms may open factories or assembly plants in the domestic nation and produce the commodity there so that production won t be subject to the quota.

37 APE U6 L2 A51 Barriers to Trade Part B: Tariffs A tariff is a tax on an import. The imposition of a tax increases the cost of each unit, which is represented by a decrease in supply. This would result in an increase in equilibrium price and a decrease in equilibrium quantity. Price Domestic Supply P Total Supply w/ Tariff Tariff=\$T Total Supply PT P1 Domestic Demand Q2 Q The imposition of a tariff causes the total supply to decrease b/c the tariff has caused the price to increase at every level of output. Q2 is the amount of domestic production after the tariff. The tariff is the vertical distance between the Total Supply & the Total Supply w/ Tariff curves indicated by an arrow on the graph. QT Q1 Quantity 5. What is the effect of the tariff on the equilibrium price and quantity for domestic consumers compared with the free trade levels? The equilibrium quantity decreases to QT, and the equilibrium price increases to PT. Note that domestic firms are producing, whereas under the free trade equilibrium price of P, the domestic industry is not producing. How far the curve shifts (how large the tariff is) determines whether domestic firms are producing any output.

38 APE U6 L2 A51 Barriers to Trade Part B: Tariffs 6. What are the similarities between the effects of a quota and those of a tariff? Both a quota and a tariff raise the price and limit the quantity to domestic consumers relative to the free trade equilibrium. Foreign firms produce less under either a quota or a tariff. 7. What is the primary difference between the effects of a quota and those of a tariff? In both cases, the price increases. With a quota, all of the revenue generated by the price increase goes to the producers. With a tariff, the government receives the tax revenue. 8. Suppose a country can impose either a quota that raises the domestic price to P2 as in Figure 51.2 or a tariff that raises the domestic price to P2. Explain whether domestic consumers would prefer a tariff or a quota and why. Domestic consumers would prefer a tariff b/c the domestic government receives the revenue as opposed to the producers (domestic & foreign). Consumers might expect that the overall level of taxes would then decrease. The tariff tax revenue would substitute for other tax revenue.

39 APE U6 L2 A51 Barriers to Trade Part C: Export Subsidies Nations may choose to assist domestic industries by providing subsidies to an industry. The subsidies would lower the costs and permit the industry to sell at a lower price. This assistance is called an EXPORT SUBSIDY because the industry can now compete on the world market and export some of its product to other nations. Price Domestic Supply without Subsidy The equilibrium without subsidy Domestic Supply with Subsidy would result in P1 & Q1 Total Supply without Subsidy Domestic economy would be at Total Supply with Subsidy P1 & Q2. P P1 PS W/ the subsidy to the domestic industry, the equilibrium would result in Ps & Qs. Domestic Demand Q2 Q3 Q Q1 QS Domestic economy would be at Ps & Q3 Quantity A. A completely closed economy (no imports or subsidies)? P&Q B. An open economy (free trade) w/ no export subsidy? P1 & Q1 C. An open economy w/ a domestic export subsidy? Ps & Qs The quantity supplied by foreign producers is (Qs-Q3)

40 APE U6 L2 A51 Barriers to Trade 10. What is the effect of an export subsidy on the equilibrium price and quantity for domestic consumers relative to the free trade equilibrium without a subsidy? The price is lower and the quantity is greater. 11. If an industry receives a subsidy, what will happen at the equilibrium to domestic production and the amount of imports?

41 APE U6 L2 A51 Barriers to Trade Part D: Applications 12. One of the goals of the EU is the elimination of trade barriers among the member nations. If this goal is achieved, which groups of people will benefit and which will not benefit? Consumers who buy the commodity will benefit by having lower prices and a greater quantity of the commodity. Domestic producers of imported commodities will lose since the price will decrease as trade barriers are reduced and domestic producers will produce less at the lower price. A second result of the reduced production is that employment in this industry will decrease. However, the economy will be more efficient, and the standard of living will increase.

42 APE U6 L2 A51 Barriers to Trade 13. Identify the arguments frequently used to impose some types of trade barrier. Discuss the pros and cons of these arguments. Protection of specific industries from foreign competition: An industry may argue that it cannot compete with foreign producers and that this competition will have an impact on wages and employment. The costs to domestic consumers are the higher prices and restricted quantity. Most governments that favor unrestricted trade will offer short-term protection to allow the industry to adjust. National defense and other non-economic considerations: Some industries produce defense items and thus should not be driven out of business by foreign competition. This is a non-economic reason for protecting an industry. The problem with this argument is that the number of industries to which protection is extended may be quite large. The US restricts endangered-species imports for non-economic reasons. Infant industry: Start-up industries argue that, to develop, they need protection from foreign competition. Support for this argument is valid only if the expected future benefits exceed the up-front costs of protectionism. Another argument against infant industry protection is that the industry may never grow up. Wage or Unemployment Protection: With low prices on imports, domestic workers will lose their jobs and unemployment will rise. The economy as a whole benefits from low prices and increased quantity of goods. The government response could be to retrain the affected workers and to provide adequate monetary and fiscal policies to maintain domestic growth and employment.

43 2011 FRQ #2

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