Slide 1Slide 2The World of International FinanceSlide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.1 of 28Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.2 of 28Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.3 of 28The World ofInternational FinanceMacroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XUP R E P A R E D B YToday, the world currency markets are always open. When foreign exchange traders in New York City are sound asleep at 3:00 A.M., their counterparts in London are already on their phones and computers at 8:00 A.M.Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.4 of 28C H A P T E R 19The World ofInternational FinanceWhat Are Exchange Rates?• exchange rateThe price at which currencies trade for one another in the market.• euroThe common currency in Europe.An increase in the value of a currency relative to the currency of another nation is called an appreciation of a currency.A decrease in the value of a currency relative to the currency of another nation is called a depreciation of a currency.HOW EXCHANGE RATES ARE DETERMINED19.1Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.5 of 28C H A P T E R 19The World ofInternational FinanceHow Demand and Supply Determine Exchange Rates FIGURE 19.1The Demand for and Supply of U.S. DollarsHOW EXCHANGE RATES ARE DETERMINED19.1Market equilibrium occurs where the demand for U.S. dollars equals the supply.Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.6 of 28C H A P T E R 19The World ofInternational FinanceChanges in Demand or Supply FIGURE 19.2Shifts in the Demand for U.S. DollarsHOW EXCHANGE RATES ARE DETERMINED19.1An increase in the demand for dollars will increase (appreciate) the dollar’s exchange rate. Higher U.S. interest rates or lower U.S. prices will increase the demand for dollars.Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.7 of 28C H A P T E R 19The World ofInternational FinanceChanges in Demand or Supply FIGURE 19.3Shifts in the Supply of U.S. DollarsHOW EXCHANGE RATES ARE DETERMINED19.1An increase in the supply of dollars will decrease (depreciate) the dollar exchange rate. Higher European interest rates or lower European prices will increase the supply of dollars.Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.8 of 28C H A P T E R 19The World ofInternational FinanceChanges in Demand or SupplyLet’s summarize the key facts about the foreign exchange market, using euros as our example: 1 The demand curve for dollars represents the demand for dollars in exchange for euros. The curve slopes downward. As the dollar depreciates, there will be an increase in the quantity of dollars demanded in exchange for euros.2 The supply curve for dollars is the supply of dollars in exchange for euros. The curve slopes upward. As the dollar appreciates, there will be an increase in the quantity of dollars supplied in exchange for euros.3 Increases in U.S. interest rates and decreases in U.S. prices will increase the demand for dollars, leading to an appreciation of the dollar.4 Increases in European interest rates and decreases in European prices will increase the supply of dollars in exchange for euros, leading to a depreciation of the dollar.HOW EXCHANGE RATES ARE DETERMINED19.1Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.9 of 28C H A P T E R 19The World ofInternational Finance• real exchange rateThe price of U.S. goods and services relative to foreign goods and services, expressed in a common currency.REAL EXCHANGE RATES AND PURCHASING POWER PARITY19.2R E A L - N O M I N A L P R I N C I P L EWhat matters to people is the real value of money or income—its purchasing power—not the face value of money or income..Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.10 of 28C H A P T E R 19The World ofInternational Finance FIGURE 19.4Real Exchange Rate and Net Exports as Percent of GDP, 1980–2007REAL EXCHANGE RATES AND PURCHASING POWER PARITY19.2The figure shows the real exchange rate for the United States compared to its net exports as a share of GDP. Notice that, in general, when the real (multilateral) exchange rate increased, U.S. net exports fell.Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.11 of 28C H A P T E R 19The World ofInternational Finance• law of one priceThe theory that goods easily tradable across countries should sell at the same price expressed in a common currency.• purchasing power parityA theory of exchange rates whereby aunit of any given currency should beable to buy the same quantity ofgoods in all countries.REAL EXCHANGE RATES AND PURCHASING POWER PARITY19.2Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall. Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e.12 of 28C H A P T E R 19The World ofInternational FinanceBIG MACS AND PURCHASING POWER PARITYAPPLYING THE CONCEPTS #1: Can the price of hamburgers around the world give us a clue to the proper value for exchange