Please read this to yourself. Ever been out of the country?Ever bought something from another country?When you bought goods/services in that foreign country what currency did you pay with?

• When you buy something from Wal-Mart that was made in another country, Wal-Mart eventually pays for it in the OTHER country’s currency.

• To get the foreign currency to pay for it, Wal-Mart must change their US $ to the OTHER currency. They put their dollars on the ForEx market (they SUPPLY dollars) and they ask for (DEMAND) Euros.

This leads us to:

AP Macroeconomics

Mechanics of Foreign Exchange (FOREX)

Foreign Exchange (FOREX)• The buying and selling of currency

– Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros.

• The exchange rate (e) is determined in the foreign currency markets. – Ex. The current exchange rate is

approximately 99Japanese yen to 1 US dollar

– About a year ago 1 US dollar would’ve bought only 77 yen. Therefore the US dollar has appreciated; the Japanese yen has depreciated

• Simply put. The exchange rate is the price of a currency.

• Do not try to calculate the exact exchange rate

• Scenario—Assume there are only two currencies in the world—the Euro € and the US $

• Americans buy more German cars than ever before

• What does the US auto dealer want to be paid in?• Americans travel to France • What does the person selling French souvenirs

want to be paid in?

• An American has $1,000,000 she/he wants to put in a bank account.

• She wants a HIGH rate of interest because the bank is going to PAY her interest.

• Banks in Germany are PAYING a higher interest rate than banks in the US.

• Where will he deposit his money? In a US bank that PAYS him 2% interest ($20,000 a year) or in a German bank which will pay him 7% interest ($70,000 a year)?

• Right, the German bank so he will demand…• Euros and supply…• US dollars in the ________________ …• Foreign Exchange Market

$/€dollars per one Euro

Q€

S€

D€

e

q

D€1

e1

q1

D€ .: e ↑ & Q€ ↑

.: € appreciates relative to the $

Increase in the Demand of Euros relative to the U.S. dollar

Q$

S$

D$

e

q

S$ .: e (ex. rate) ↓ & Q$ ↑

.: $ depreciates relative to €

S$ 1

e1

q1

Increase in the Supply of U.S. dollars relative to the Euro

€ / $Euros per ONEdollar

Demand $—exports and capital inflowsWhen the US exports goods/services to other countries, they need OUR

dollar to complete the transaction.So they demand OUR moneyThey need to supply theirs.

Supply $—imports and capital outflowsWhen we import goods/services from other countries, we need THEIR

money to complete the transaction.So we demand THEIR money.We need to SUPPLY ours

Tips• Always change the D line on one

currency graph, the S line on the other currency’s graph

• Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer.

• If D on one graph increases, S on the other will also increase

• If D moves to the left, S will move to the left on the other graph.

Changes in Exchange Rates• Exchange rates (e) are a function of

the supply and demand for currency.– An increase in the supply of a currency

will make it cheaper to buy one unit of that currency (that currency has depreciated)

– A decrease in supply of a currency will make it more expensive to buy one unit of that currency (that currency has appreciated)

Changes in Exchange Rates

– An increase in demand for a currency will make it more expensive to buy one unit of that currency (appreciated)

– A decrease in demand for a currency will make it cheaper to buy one unit of that currency (depreciated)

Appreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases (e↑)– Hypothetical: 100 yen used to buy $1.

Now 200 yen buy 1US$.– The dollar is “stronger” because it takes

more yen to buy one dollar

Depreciation• Depreciation of a currency occurs

when the exchange rate of that currency decreases (e↓)– Depreciation of the yen (¥)– 100 dollars used to buy one yen. Now

50 dollars buys one yen. – The yen is weaker because it takes

fewer dollars to buy one yen

Example of Appreciation and Depreciation

• Ex. If more German tourists visit America then the demand of US dollars will…

increase. This will cause the US dollar to appreciate.The supply of the Euro will increase causing the Euro to depreciate

$/€

Q€

S€

D€ 1

e1

q1

D€

e

qD€ .: e ↓ & Q€ ↓

.: € depreciates relative to the $

Decrease in the Demand for Euro relative to the dollar

€/$

Q$

S$

D$

e

q

S$ .: e ↑ & Q$ ↓

.: $ appreciates relative to €

S$1

e1

q1

Decrease in the Supply of the dollar relative to the Euro

Exchange Rate Determinants

Interest Rates– Ex. If U.S. investors expect that Swiss interest

rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. (or if interest rates ARE higher)

– This will cause the Swiss Franc to appreciate as demand for it will increase.

– Supply of the dollar will increase causing it to depreciate

Exchange Rate Determinants• Consumer Tastes

– Ex. a preference for Japanese goods creates an increase in the demand of yen and an increase in the supply of dollars in the currency exchange market.

– The increase in demand of the yen leads to the appreciation of the yen.

– The increase in the supply of dollars leads to the depreciation of the dollar.

Exchange Rate Determinants (cont.)

• Relative Income– Imports tend to be normal goods– Ex. If Mexico’s economy is becoming

stronger and the U.S. economy is in recession, then Mexicans will buy more of everything, including American goods.

– This increases the demand for the dollar, causing the dollar to appreciate and the peso to depreciate

Exchange Rate Determinants (cont)• Relative Price Level (or Rates of Inflation)

– Ex. If the price level is higher in Canada than in the United States, then American goods are relatively cheaper than Canadian goods.

– Thus Canadians will import more American goods causing the U.S. dollar to appreciate and the Canadian dollar to depreciate.

– Demand for the US dollar increased, supply of the Canadian dollar increased

Exchange Rate Determinants (cont)

• SpeculationCurrency speculators try to buy low and sell high.Speculators think the $ will depreciate in the future

They will sell their US $ now and buy a currency they think will appreciate in the future, say the Japanese yen (¥)When they sell the $ they supply it on the Forex MarketWhen they buy the ¥ they demand it on the Forex Market

Effects of ForEx on Xn• The exchange rate is a determinant of

both exports and imports• Xn is a component of GDP• GDP’s rate of change is the determinant

of economic status (recession or expansion)

• Depreciation of the dollar makes it to where “they” have to spend less of “their” currency for one US dollar.

• Therefore our products are cheaper over “there”

• Therefore “they” will buy more of our products

• Therefore our _______ will increase

• Appreciation of the dollar causes foreigners to spend more of their currency to buy one dollar.

• Therefore they have to spend more of their currency to buy our product.

• Therefore American goods are relatively more expensive and foreign goods are relatively cheaper.

• That reduces our exports and increases our imports

Depreciation• Depreciation causes Xn to go up

– Our money is cheaper therefore our products are cheaper

– Therefore “they” buy more of our products

– Because our money is cheaper it takes more $ to buy one yen

– Therefore their products are more expensive so imports go down

Appreciation• Appreciation causes Xn to go down

– Our money is more expensive therefore our products are more expensive

– This causes imports to go up– Our money is stronger and it buys more

foreign currency– Therefore it buys more foreign product– Therefore imports go up

Depreciation

• Demand to the left OR• Supply to the right

Appreciation

• Demand to the right OR• Supply to the left