Session 8Exchange 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

(3) 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.(4) 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

Num

ber o

f Eur

os p

er D

olla

r

Quantity of Dollars Traded

S1

D1

1

S2

2

Increasing supply of dollars

Leads to a falling price (value)

1 2

Num

ber o

f Eur

os p

er D

olla

r

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 priceIdentical 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 rateRate 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?