Session 8 Exchange Rates Disclaimer: The views expressed are those of the presenters and do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System. Teks

Session 8 Exchange Rates

Disclaimer: The views expressed are those of the presenters and do not necessarily reflect those of the Federal Reserve Bank of Dallas or the Federal Reserve System.

TEKS

• Economics. The student understands the reasons for international trade and its importance to the United States and the global economy. The student is expected to:

(C) analyze the impact of U.S. imports and exports on the United States and its trading partners.

• Economics. The student understands the issues of free trade and the effects of trade barriers. The student is expected to:

(C) analyze the effects of changes in exchange rates on imports and exports.

Teaching the Terms

• Exchange rates
• Appreciate
• Depreciate
• Purchasing power parity
• Nominal values
• Real values

Foreign Exchange Market

• Derived demand
• Currencies are bought and sold
• Largest financial market in the world
• Operates 24 hours a day

Nominal Exchange Rates

• Rate at which the currency of one country can be exchanged for the currency of another country
• Depreciate = Weaken = Lose value
• Appreciate = Strengthen = Gain value

Exchange Rates

• One exchange rate is the reciprocal of another exchange rate
• If €1 = $2.00, then $1 = €0.50
• As the exchange rate fluctuates, the value (or strength) of each currency is affected
• When one currency strengthens, the other weakens

Weakening Dollar / Strengthening Euro

Value of

• $1 = €1.00 (or €1 = $1.00)

U.S. dollar

• $1 = €0.67 (or €1 = $1.50)

Falling

• $1 = €0.50 (or €1 = $2.00)

Weakening Euro / Strengthening Dollar

Value of

• €1 = $2.00 ($1 = €0.50)

Euro

• €1 = $1.50 ($1 = €0.67)

Falling

• €1 = $1.00 ($1 = €1.00)

Exchange Rates in the Short Run

• Model with supply and demand graph
• Quantity of dollars
• Price of a dollar in a foreign currency
• Factors affecting supply of dollars
• American purchase of goods and services produced abroad
• American investment in foreign assets
• Factors affecting demand for dollars
• Foreign purchase of American goods and services
• Foreign investment in American assets

Number of Euros per Dollar

Quantity of Dollars Traded

S1

D1

1

S2

2

Increasing supply of dollars

Leads to a falling price (value)

1

2

Number of Euros per Dollar

Quantity of Dollars Traded

S1

D1

1

D2

2

Increasing demand for dollars

Leads to a rising price (value)

1

2

A stronger U.S. dollar means …

U.S. can buy foreign goods more cheaply and U.S. imports will increase

Foreigners find U.S. goods more expensive and U.S. exports fall

A weaker U.S. dollar means …

Foreigners can buy American goods more cheaply and U.S. exports will increase

Foreigner goods become more expensive for U.S. residents and U.S. imports fall

Exchange Rates in the Long Run

• Law of one price

Identical items should sell for the same price

• Purchasing power parity (PPP)

One unit of domestic currency will buy the same basket of goods anywhere in the world

• PPP implies that the real exchange rate will always be 1

Exchange Rates in the Long Run

• Real exchange rate

Rate at which the goods and services of one country can be exchanged for the goods and services of another country

• Real exchange rate =

Dollar price of domestic goods

Dollar price of foreign goods

Questions?