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Chapter 19

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Slide 1Slide 2Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Slide 30Slide 31Slide 32Slide 33Slide 34Slide 35Slide 36Slide 37Slide 38Slide 39Slide 40Slide 41Slide 42Slide 43Exchange ratesCurrencies are bought and sold in the foreign exchange market. The price at which one currency exchanges for another in the foreign exchange market is called the exchange rate. For example, suppose one U.S. dollar buys 0.80 euros, i.e., 80 European cents. Therefore,$1 = €0.80 which means that €1 =1____0.80= $1.25.Thus the euro exchange rate in terms of dollars is just the reciprocal of the dollar exchange rate in terms of euros. Why? 0.80 is the number of euros per dollar, or €/$. If we want to obtain the number of dollars per euro, or $/€, then$/€ =1____€/$ =1____0.80= $1.25.The market for currencies is derived from the international market for goods and services and assets.For example, when Americans buy goods or assets from a foreign country, they must obtain some of the foreign country’s currency in order to make the transaction. This gives rise to a supply of dollars and a demand for the foreign currency in the foreign exchange market.Similarly, when foreigners buy American goods or assets, they must first acquire dollars, which gives rise to a supply of the foreign currency and a demand for dollars in the foreign exchange market.The demand for dollarsThe quantity of U.S. dollars demanded in the foreign exchange market is the amount of dollars that traders plan to buy during a given time period at a given exchange rate. Foreign residents demand dollars because of the U.S. goods and services (U.S. exports) and assets (bonds, stocks, bank deposits) the dollars can buy them.The lower the dollar exchange rate (euros per dollar) the greater is the quantity of dollars demanded; the higher the dollar exchange rate, the less is the quantity of dollars demanded:A currency depreciation is the fall in the value of one currency in terms of another currency.For example, if the dollar falls from €0.80 to €0.75, the dollar has depreciated against the euro by approximately 6%. Vice versa, a currency appreciation is the rise in the value of one currency in terms of another.For example, if the dollar falls from €0.80 to €0.75, this means the euro has appreciated from $1.25 to $1.33 (1/0.75 = 1.33), which is approximately a 6% appreciation.Why is there an inverse relationship between the quantity of dollars demanded and the price of the dollar in euros? The lower the dollar exchange rate, or in other words the weaker the dollar relative to the euro, the cheaper are American goods and services to Europeans: fewer euros are required to buy a dollar, or, in other words, a euro buys more dollars and therefore more American goods and services.Therefore Europeans demand more American goods and services, and consequently they must buy more dollars in order to buy these goods and services. Therefore the quantity of dollars demanded by Europeans increases.Factors that shift the demand curve for dollarsinterest rates in the U.S. and in other countries the expected future exchange rate. Interest rates:The higher the interest rate on U.S. financial assets (bonds, bank deposits) compared to foreign assets, the more U.S. assets will be purchased, both by Americans and by foreigners. What matters is not the level of U.S. interest rates by itself, but the U.S. interest rate minus the foreign interest rate. This gap is called the U.S. interest rate differential.If the U.S. interest rate differential increases, there will be an increase in the demand for dollars. Foreigners will be more interested in purchasing U.S. assets (and less interested in purchasing their own assets) and therefore, at any given exchange rate, they will be more interested in purchasing dollars. The demand curve for dollars will shift to the right.Expected future exchange rate:The higher the expected future exchange rate, the greater is the expected profit from holding dollars and the greater is the demand for dollars. If people expect the dollar to be stronger in the future, they will buy more dollars at any given current exchange rate and the demand curve for dollars will shift to the right.The supply of dollarsThe quantity of U.S. dollars supplied in the foreign exchange market is the amount of dollars that traders plan to sell during a given time period at a given exchange rate. U.S. residents supply dollars in exchange for foreign currency in order to buy foreign goods and services (U.S. imports) and assets (bonds, stocks, bank deposits).The higher the dollar exchange rate (euros per dollar) the greater is the quantity of dollars supplied; the lower the dollar exchange rate, the less is the quantity of dollars supplied:Why is there a positive relationship between the quantity of dollars supplied and the price of the dollar in euros? The higher the dollar exchange rate, or in other words the stronger the dollar relative to the euro, the cheaper are European goods and services to Americans: fewer dollars are required to buy a euro, or, in other words, a dollar buys more euros and therefore more European goods and services.Therefore Americans demand more European goods and services, and consequently they must sell more dollars, i.e., buy more euros, in order to buy these goods and services. Therefore the quantity of dollars supplied by Americans in exchange for euros increases.Factors that shift the supply curve of dollarsinterest rates in the U.S. and in other countries the expected future exchange rate. Interest rates:The higher the interest rate on U.S. financial assets (bonds, bank deposits) compared to foreign assets, the more U.S. assets will be purchased, both by Americans and by foreigners. Again, what matters is not the level of U.S. interest rates by itself, but the U.S. interest rate minus the foreign interest rate, i.e., the U.S. interest rate differential.If the U.S. interest rate differential increases, there will be a decrease in the supply of dollars. Americans will be more interested in purchasing their own domestic assets (and less interested in purchasing foreign assets) and therefore, at any given exchange rate, they will be less interested in selling dollars in exchange for euros. The supply curve of dollars will shift to the


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