Econ 98-Chiu Clarifying Exchange Rates Spring 2005Page 1 of 7Exchange rates are a confusing concept despite the fact that we have to deal withexchange rates whenever we travel abroad. The handout will tackle the commonmisconceptions with exchange rates and simplify it to the lowest common denominator.More importantly, the handout will pull together previous macroeconomic concepts (i.e.monetary policy, fiscal policy, interest rates, and GDP) with exchange rates to give youa taste of international monetary economics! If you are interested in learning more, thenyou should take Econ 100B (Intermediate Macroeconomics), Econ 182 (InternationalMonetary Economics) and Econ 115 (World Economic History). By the way, WilliamLOVES international monetary economics.Definitions and terminologyWhat is an exchange rate (Pfx)?The exchange rate is the dollar price of foreign exchange. Lets look at a specific exchange rate:The exchange rate for yen is the dollar price of yen (Pyen). The exchange rate tells me how manydollars I need to buy one yen. It also tells me how many dollars a Japanese person gets when shesells one yen.More generally, the exchange rate is the number of dollars per unit of foreign currency.What does it mean the dollar appreciates or gets “stronger”?If the dollar appreciates, then that means $1 can buy more yen than before the appreciation. Astrong dollar is a dollar that can buy a lot of yen.What does it mean that the dollar depreciates or gets “weaker”?If the dollar depreciates, then that means $1 can buy less yen than before the depreciation. Aweak dollar is a dollar that can buy very few yen.What happens to the dollar when Pfx goes up?The dollar depreciates. I know this sounds confusing because the exchange rate is increasing.But remember the exchange rate (in this class) is the dollar price of yen. Hence when Pyen goesup, then the price of yen goes up, which means yen is relatively MORE expensive than the dollarthat implies that the dollar is relatively cheaper.What happens to the dollar when Pfx goes down?The dollar appreciates. I know this sounds confusing, but just remember that Pyen is the dollarprice of yen. If the yen is relatively cheaper than the dollar, then the dollar MUST BE relativelymore expensive than the yen.Econ 98-Chiu Clarifying Exchange Rates Spring 2005Page 2 of 7Demand & Supply (revisited)What is the demand for yen?Hopefully by now you realize that our simple demand and supply models explain a lot of theworld’s activities in many pertinent markets that affect our lives and economy.The buyers are always the people who control the DEMAND curve. The people who buy yen areAmericans! Remember that Japanese people who live in Japan DO NOT buy yen. That’s as sillyas saying that Americans who live in the USA buy dollars. That makes no sense!Hence, when you think about the demand for yen, think about Americans who want to buy yen!Why do Americans want to buy yen?There are two reasons why Americans want to buy yen.First reason is to buy Japanese goods and services. You realize that when you fly to Japan, thatyou cannot technically buy any goods and services with your US dollars because the medium ofexchange in Japan is yen! Hence, Americans buy yen to buy Japanese stuff (i.e. computers,clothes, magazines, DVDs, and shoes).Second reason is to buy yen-denominated financial assets. When you graduate from Cal, you aregoing to start making income. You will seek to maximize the return on your income by“investing” in American stocks, bonds, AS WELL as foreign stocks and bonds. Hence,Americans buy yen to buy Japanese stocks and bonds.What is the supply for yen?The sellers are always the people who control the SUPPLY curve. The people who sell yen arethe Japanese. Hence, when you think about the supply for yen, think about Japanese people whowant to sell yen!Why do Japanese people want to sell yen?First reason is to buy American goods andservices.Second reason is to buy American financialassets.Where is the graph, William?Finally, you realize the importance of graphs!Look to the right.QyenPyenDSP*yenEcon 98-Chiu Clarifying Exchange Rates Spring 2005Page 3 of 7Exchange Rates and GDPWhy should someone who never travels even care about exchange rates?Exchange rates affect net exports that affect PAE which affect GDP! And we all care about GDPbecause it measures our national income! And GDP measures our economy’s well being.How does the appreciation of the dollar affect GDP?If the dollar appreciates (Pfx goes down), then the dollar is stronger which means that $1 can buymore yen than before the appreciation. Imagine that you are an American with dollars that canbuy a lot more yens than before. What are you going to do? If prices remain constant,then Japanese goods and services are relatively cheaper than American goods and services.Americans will buy more Japanese goods and services, which raises US imports from Japan.At the same time, American goods and services are relatively more expensive than Japanesegoods and services. Japanese people will buy less American goods and services, which reducesUS exports to Japan.The effect is a decline in net exports (NX). Remember that Y = C+I+G+NX. If Pfx goes down,NX falls, PAE falls, and Y falls via the multiplier effect. Hence the appreciation of the dollardecreases Y!So the next time someone tells you that a strong dollar is good for America, then you should say,“Well, GDP (our income) declines if the dollar becomes stronger.” DO NOT FALL FOR THETRAP THAT A “STRONG” DOLLAR REPRESENTS A “STRONG” AMERICA.THAT’S NOT NECESSARILY TRUE!How does the depreciation of the dollar affect GDP?If the dollar depreciates (Pfx goes up), then the dollar is weaker which means that $1 can buy lessyen than before the depreciation. If prices remain constant, then Japanese goods andservices are relatively more expensive than American goods and services. Americans will buyless Japanese goods and services, which lowers US imports from Japan.At the same time, American goods and services are relatively cheaper than Japanese goods andservices. Japanese people will buy more American goods and services, which increases USexports to Japan.The effect is an increase in net exports (NX). If Pfx goes up, NX goes up, PAE goes up, and Ygoes up via the multiplier effect. Hence the depreciation of the dollar increases Y!So the next time someone tells you that a weak dollar is bad for America, then you should say,“Well, GDP increases if
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