Foreign Exchange Rates Review for AP Economics (page 2)
Review questions for this study guide can be found at:
Main Topics: The Currency Market, Depreciation and Appreciation, Changes in Exchange Rates, Connection to Monetary Policy
The previous section of the chapter discussed accounting for the flow of goods and services and currency between trading partners. The foreign exchange market, the topic of the following section, facilitates the importing and exporting of goods around the world.
When nations trade goods and services, they are implicitly trading currency. The rate of exchange between two currencies is determined in the foreign currency market. Some nations fix their exchange rates while others are allowed to "float" with the forces of demand and supply. For example, in the flexible exchange market for euros pictured in Figure 17.5, the equilibrium $2 dollar price of a euro is at the intersection of the supply of euros and the demand. Likewise, in the market for dollars seen in Figure 17.6 the equilibrium euro price of one dollar is .50 euros. This floating exchange rate has an impact on the balance of payments of both the United States and the European Union.
- The exchange rate between two currencies tells you how much of one currency you must give up to get one unit of the second currency.
- For example, if $2 = 1 euro, $1 = .5 euro.
- For example, if $1 = 10 pesos, $.10 = 1 peso.
"Don't forget to label your axes"
—Timot, AP Student
Appreciating and Depreciating Currency
If the U.S. economy is strong, Americans increase their demand for European goods and services. As American consumers increase their demand for the euro, they increase the supply of dollars in the foreign exchange market; the dollar price of a euro rises, and the euro price of a dollar falls. The euro as an asset is appreciating in value and the dollar as an asset is depreciating in value. The changing value of euros and dollars is seen in Figures 17.7 and 17.8.
- When the price of a currency is rising, it is said to be appreciating or "stronger". More dollars are needed to buy a euro.
- When the price of a currency is falling, it is said to be depreciating or "weaker". Fewer euros are needed to buy a dollar.
Changes in Exchange Rates
The above example illustrates that market forces and changing macroeconomic variables have an impact in the rate of exchange between the dollar and the euro. There are several determinants that affect currency appreciation and depreciation.
Consumer Tastes. When domestic consumers build a stronger preference for foreignproduced goods and services, the demand for those currencies increases and the dollar depreciates. On the other hand, if foreign consumers increase their demand for U.S.-made goods, the dollar appreciates.
Relative Incomes. When one nation's macroeconomy is strong and incomes are rising, all else equal, they increase their demand for all goods, including those produced abroad. So if Europeans are enjoying economic growth and the United States is in a recession, the relative buying power of European citizens is growing. They increase their consumption of both domestic and U.S.-made goods, increasing demand for the dollar and appreciating its value.
Relative Inflation. If one nation's price level is rising faster than another nation, consumers seek the goods that are relatively less expensive. If European inflation is higher than inflation in the United States, American-made goods are a relative bargain to German consumers and the dollar appreciates. This is another good reason for the Fed to keep inflationary pressure low.
Speculation. Because foreign currencies can be traded as assets, there are investors who seek to profit from buying currency at a low rate and selling it at a higher rate. For example, if it appears that future interest rates will fall in the United States relative to interest rates in Japan, the yen is looking like a good investment. Speculators would then increase their demand for Japanese assets, thus appreciating the yen and depreciating the dollar.
Connection to Monetary Policy
A final variable that affects the price of one currency relative to another is a difference in relative interest rates between nations. When the Fed increases the money supply, the interest rates on American financial assets begin to fall. If the interest rate is relatively lower in the United States, people around the world see U.S. financial assets as less attractive places to put their money. Demand for the dollar falls, and the dollar depreciates relative to other foreign currencies. A depreciating dollar makes goods in the United States less expensive to foreign consumers, so American net exports increase, which shifts the AD to the right. Likewise, if the Fed decreases the money supply, American interest rates begin to rise and the dollar appreciates relative to foreign currencies. An appreciating dollar makes American goods more expensive to foreign consumers, decreasing American net exports, shifting AD to the left.
Be careful! When interest rates rise, we see a decrease in capital investments (machinery and other equipment) because it becomes more costly to borrow for those projects. But, when interest rates rise, we see an increase in financial investments (bonds) because income earned on those bonds is rising.
- Pay attention to the relationship between relative interest rates and exchange rates because it has made an appearance on several recent AP Macroeconomics exams.
- All else equal, demand for the U.S. dollar increases and the dollar appreciates relative to the euro if:
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