Exchange Rates and the International Money Markets

Exchange Rates and the International Money Markets

Exchange Rates and the International Money Market Copy down these definitions: Net exports (Xn)- the value of a nations total exports(x) minus imports(m). Xn=X-M Price level- The average of all prices of all goods or services in an economy- increase PL increase inflation Bond- a loan from the people or other governments to pay for government spending- repaid with interest Real interest rates- interest rates adjusted to inflation. Higher interest rates= more investments in govt bonds

Welcome to Economics! Grading FRQs today- please don t start until I tell you to. Important things to know: Test onwednesday. Covers PPC, CA, S&D, FOREX(today) After School Study Session- Tuesday from 2:45-3:45. or Wednesday Morning 6am FOREX FRQ on Thursday (major grade)

Factors that Influence Net Exports (X-M) Foreign incomes demand for U.S. exports Xn Foreign incomes demand for U.S. exports Xn Foreign tariffs on U.S. goods price of U.S. exports X Xn tariffs on U.S. goods price of U.S. exports X Xn

U.S. dollars must be used to purchase U.S. goods, services and assets (ex. bonds) (Creates a for $) To buy U.S. goods, services and assets, foreign consumers must their own currency to obtain (demand) U.S. dollars. demand for $ creates supply of foreign currency.

Foreign currencies must be used to purchase foreign goods, services and assets. ( for foreign currencies) To buy foreign goods,etc., U.S. consumers must U.S. dollars to obtain (demand) foreign currencies. demand for foreign currency creates supply of $.

1 Dollar = 2 Yen What is the Yen price of a $100 TV purchased in the U.S.? What is the Dollar price of a 200 Yen TV purchased in Japan?

1 Dollar = 2 Yen 1 Dollar = 4 Yen What is the Yen price of a $100 TV purchased in the U.S.? What is the Dollar price of a 200 Yen TV purchased in Japan?

1 Dollar = 1 Yen 1 Dollar = 2 Yen 1 Dollar = 4 Yen Appreciate: in value relative to other currency. Depreciate: in value relative to other currency

Get out your notes from yesterday and your graph paper (from yesterday) Be ready to start when the bell rings Remember the afterschool study session today and the before school study session tomorrow. STUDY TONIGHT!!!

American consumers give up dollars to get Japanese currency; therefore, Japanese goods seem. cheaper X M Xn Japanese consumers give up of their currency to get American currency; therefore, American goods seem. more expensive X M Xn

American consumers give up dollars to get Japanese currency; therefore, Japanese goods seem. more expensive X M Xn Japanese consumers give up of their currency to get American currency; therefore, American goods seem. cheaper X M Xn

Exchange Rates The price of a currency in terms of another currency Exchange rates are based on supply and demand in international currency markets (foreign exchange markets). A demand for one currency creates a supply of the other currency. If a currency appreciates relative to another currency, the other currency depreciates.

Foreign currency price of $ dollar price of foreign currency Foreign Exchange Market FC/$ Market for the U.S. $ $/FC Market for Foreign Currency S $ S FC P 1 P 1 D $ D FC Q 1 Q $ Equilibrium exchange rate Quantity of $ Supplied/demanded Q 1 Q FC Equilibrium exchange rate Quantity of $ Supplied/demanded

Americans increase their demand for European goods $ / Euros Market for Euros Market for $ S Euros Euros/ $ S$ P2 P P S$ 2 D Euros2 D Euros P 2 D $ Q Q 2 Q Q 2 Q of Euros Q of $ Euro: appreciates Dollar: depreciates

Interest rates in the U.S. rise. $ / Euros Market for Euros Market for $ Euros / $ S Euros S $ P S Euros2 P 2 P P 2 D Euros D $2 D $ Q Q 2 Euro: Depreciates Q Q 2 Q of Euros Q of $ Appreciates Dollar:

The U.S. price level increases. Japanese Perspective $ / Yen Market for Japanese Yen Market for $ S Yen2 Yen / $ S $ P 2 P S Yen P Q 2 Q D Yen D D $ $2 Q of Yen Q 2 Q Q of $ Yen: appreciates depreciates Dollar: P 2

The U.S. price level increases. U.S. perspective: $ / Yen Market for Japanese Yen Market for $ Yen / $ P 2 P S Yen D Yen2 P P 2 S $ S $2 D Yen D $ Q Q 2 Q of Yen Q Q 2 Q of $ Yen: appreciates depreciates Dollar:

Japanese tourists flock to the U.S. $ / Yen P P 2 Market for Yen Market for $ S Yen D Yen Yen / $ P 2 P S $ D $ Q Q 2 Q of Yen Q Q 2 Q of $ Yen: depreciates appreciates Dollar:

Incomes fall in Europe due to recession. $ / Euros Market for Euros Market for $ Euros / $ S Euros S $ P 2 P P P 2 D Euros D $ Q 2 Q Q of Euros Q 2 Q Q of $ Euros: Appreciates depreciates Dollar:

If exchange rates are allowed to fluctuate freely and the U.S. demand for German marks increases, which of the following will most likely occur? a. Americans will have to pay more for goods made in Germany. b. Germans will find that American goods are getting more expensive. c. The U.S. balance of payments deficit will increase. d. The dollar price of marks will fall. e. The dollar price of German goods will fall.

If the dollar cost of the British pound decreases, U.S. imports from and exports to the U.K. will change in which of the following ways? Imports Increase Increase Increase Decrease Decrease Exports decrease increase no change decrease increase

Assume there is an increase in the U.S. demand for French goods. Explain how this increase in demand will affect each of the following (2000). Use an appropriately labeled foreign exchange graph to depict the change indicated. The supply of dollars The international value of the dollar

Assume that there is an increase in real interest rates in the U.S. but not in France. Explain how this increase in real interest rates will affect each of the following? Use an appropriately labeled foreign exchange market diagram to depict the change indicated. The international value of the dollar in foreign exchange markets The quantity of dollars supplied in foreign exchange markets.

Free Response Question Initially the real interest rates in the U.S. and Japan are equal to 7 percent. The real interest rate in the U.S. increases to 8 percent while the real interest rate in Japan decreases to 6 percent. A. How and why will capital flows be affected by this change in real interest rates? B. Using a correctly labeled graph for the yen market, show and explain how the value of the yen will change relative to the value of the dollar. C. Explain how the change in the value of the yen will affect each of the following in the U.S. i) imports from Japan ii) exports to Japan

Free Response Question Initially the real interest rates in the U.S. and Japan are equal to 7 percent. The real interest rate in the U.S. increases to 8 percent while the real interest rate in Japan decreases to 6 percent. A. How and why will capital flows be affected by this change in real interest rates? Capital inflows to the U.S. from Japan will increase as Japanese investors increase their purchases of U.S. interest bearing Securities (bonds) to receive a higher rate of return (higher interest rate). This will increase capital outflow from Japan. U.S. capital outflows will decrease as U.S. investors reduce their purchases of Japanese bonds due to the lower rate of return (lower interest rate).

Free Response Question Initially the real interest rates in the U.S. and Japan are equal to 7 percent. The real interest rate in the U.S. increases to 8 percent while the real interest rate in Japan decreases to 6 percent. B. Using a correctly labeled graph for the yen market, show and explain how the value of the yen will change relative to the value of the dollar. $/Yen P 1 P 2 Yen Market S Yen1 S Yen2 Q 1 Q 2 D Yen Q Yen D acceptable with different explanation As the supply of Yen increase in order to obtain Dollars to purchase U.S. bonds, the dollar price of the Yen will decrease, thus depreciating the Yen and appreciating the dollar.

Free Response Question Initially the real interest rates in the U.S. and Japan are equal to 7 percent. The real interest rate in the U.S. increases to 8 percent while the real interest rate in Japan decreases to 6 percent. C. Explain how the change in the value of the yen will affect each of the following in the U.S. i) imports from Japan ii) exports to Japan As the Yen depreciates relative to the dollar, Japanese goods will seem cheaper to U.S. consumers as they give up less for the Yen, thus increasing imports from Japan. A depreciated Yen relative to the dollar will make U.S. goods relatively more expensive to Japanese consumers (give up more Yen/dollar), thus U.S. exports to Japan will decrease.

Flows of money to purchase financial and physical assets (stocks, bonds, and real estate) What typically attracts capital flows to a country?

Exchange Rates Online Quiz Unit 3 on website record score on card provided Take notes with you --- not an easy quiz Complete for homework if you do not finish in class. Return to seats for discussion/notes on balance of payments and more board work.

Monday, April 27 Need big board, marker, cloth, pen and balance of payments and multiplier handouts and new handout today (class set) (calculator handy) See board for schedule of study sessions and tutorials (form your own study group and come in and go over released tests) Updated grade sheet --- Net Export and Exchange Rate quiz grades due no later than Wednesday (zero after Wednesday) AP Gov Test Next Monday morning. Please cover mouth when sneezing/coughing; anti-bacterial hand cleaner available, feel free to use wipes or spray Lysol to clean desks. Protect yourself from germs.

Flows of Money for Anything Between Nations Inpayments (credits) - payments flowing into a nation for goods, services, or real or financial investments (earn supplies of foreign currency reserves) Outpayments (debits) payments flowing out of a nation for goods, services, or real or financial investments in other nations (deplete supplies of foreign currency reserves)

The official record of all transactions made between a nation and all other nations in a year. It includes all inpayments ($ coming in) and outpayments ($ going out)

Balance of Payments Record of inflows and outflows of currency for a nation. Balance of Payments has three parts: Current account(goods, services, returns on previous investments, exchanges between governments.) Includes trade balance (?) on goods and services. Do inpayments of currency match outpayments for goods and services, etc. If not, is there a deficit or surplus? Capital account (flows of financial capital to make current purchases of securities, real estate, etc. Do impayments of currency match outpayments? If not, deficit or surplus? Official reserves: balancing factor Taken together, do the capital and current accounts balance? Overall, do outpayments of currency match inpayments of currency? If deficit occurs (outpayments > inpayments). U.S. reserves in central bank are depleted to make up difference as if an inpayment (inflow) If surplus occurs - (inpayments > outpayments) U.S. reserves in central bank are increased to make up difference as if an outpayment.(outflow) Inpayments EARN supplies of foreign currency; outpayments use up supplies of FC.

The U.S. Balance of Payments, 1999 (in billions) The U.S. Balance of Payments, 1999 (billions) Current Account 1 U.S. goods exports $ +684 2 U.S. goods imports -1030 3 Balance of Trade -346 4 U.S. exports of services +272 5 U.S. imports of service -191 6 Balance on Services +81 7 Balance on goods and services -265 8 Net investment income -18 9 Net Transfers (private and public) -48 10 Balance on Current Account -331 Capital Account 11 Foreign purchases of assets in the U.S. $ +760 12 U.S. purchases of assets abroad -438 13 Balance on capital account +322 Official Reserves Account deficit credit debit deficit 14 Official Reserves $ +9 $ 0

Balance of Payments quiz Unit 3 8-10 minutes max Record score on sheets on front board

2008 FR #2 2. Balance of payments accounts record all of a country s international transactions during a year. (a) Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will each of the following transactions be recorded? (i) A United States resident buys chocolate from Belgium. (ii) A United States manufacturer buys computer equipment from Japan.

2008 FR #2 2. Balance of payments accounts record all of a country s international transactions during a year. (b) How would an increase in the real income in the United States affect the United States current account balance? Explain. (c) Using a correctly labeled graph of the foreign exchange market for the United States dollar, show how an increase in United States firms direct investment in India will affect the value of the United States dollar relative to the Indian currency (the rupee). U.S. investment in India creates a demand for the rupee to make the investment in India, thus creating an in supply of the dollar. The supply of the dollar lowers the rupee price of the $ causing its value to fall (depreciate) while the rupee s value appreciates. 2C. Rupees/ $ 2b. An increase in real incomes will likely result in demand for domestic and foreign goods and services by U.S. consumers. An increase in imports of goods or services will lead to out-payments in the current account, thus moving the current account s balance on goods and services toward a deficit. P 1 P 2 Market for $ S $1 S $2 D $ Q 1 Q 2 Q$

Effects on Net Exports Inflation high in one country or PL increases. Interest rates Recession Foreign incomes

How does a change in real interest rates affect long run economic growth?

Incomes fall in Germany Cause-effect chain of reaction:

Interest rates rise in the U.S (The Net Export Effect)

Explain how each of the following will effect long-run aggregate supply (potential real GDP): A decrease in the labor force participation rate An increase in the government deficit following a reduction in personal income taxes A decrease in the quantity of inputs required to produce a unit of output An increase in the quantity and quality of education An increase in the rate of savings