Foreign Exchange aka FOREX Exchange Rate Relative

Foreign Exchange (aka. FOREX) Exchange Rate = Relative Price of Currencies Copyright ACDC Leadership 2015

I want a pallet of Mexican Avocados. Why? . . . Don’t ask questions. . . What do I have to do to get one?

FOREX Supply and Demand Simplified Imagine a huge bucket with all the different currencies from every country This is the Foreign Exchange Market! Just like at a product market, you can’t take things without paying. If you demand one currency, you must supply your currency. Ex: Canadians want Russian Rubles to buy fancy Soviet era vodka. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.

Exchange Rates In the FOREX market we only look at two countries/currencies at a time Ex: US Dollars and Euros We examine the price of one currency in terms of the other currency. Ex: $3 = € 2 The Exchange Rate depends on which currency you are converting. Here, the price of one US Dollar in terms of Euros is 1 Dollar = € 2/$3 = €. 66 The price of one Euro in terms of Dollars is 1 Euro = $3/€ 2= $1. 5 Copyright ACDC Leadership 2015

What happens if you need more dollars to buy one euro (the price for a euro increases)? Ex: From $3=€ 2 to $6=€ 2 • The U. S. Dollar DEPRECIATES relative to the Euro. Depreciation- The loss of value of a country's currency with respect to a foreign currency • More units of dollars are needed to buy a single unit of the other currency. • The dollar is said to be “Weaker” Copyright ACDC Leadership 2015

What happens if you need less dollar to buy one euro (the price for a euro decreases)? Ex: From $3= € 2 to $1= € 2 • The U. S. Dollar APPRECIATES relative to the euro. Appreciation- The increase of value of a country's currency with respect to a foreign currency • Less units of dollars are needed to buy a single unit of the other currency. • The dollar is said to be “Stronger” Copyright ACDC Leadership 2015

What happens if Europeans prefer vacationing in the United States? € $ Dollars $ € S er 1 S ere D 1 S 1 ere er 1 D Quantity of Dollars The Dollar APPRECIATES Copyright ACDC Leadership 2015 Euros D Quantity of Euros The Euro DEPRECIATES

Flexible Exchange Rates • Determinants of exchange rates • Factors that shift demand/supply – Changes in tastes – Relative income changes – Relative price-level changes • Purchasing-power-parity theory – Relative interest rates – Relative expected returns on assets – Speculation 38 -8

For the following examples… • DRAW A SIDE BY SIDE GRAPH OF THE MARKET FOR DOLLARS AND THE MARKET FOR BRITISH POUNDS

Change in Tastes Vs.

Change in Relative Income

Change in Relative Price Level

Change in Relative Interest Rates Change in Relative Expected Returns on Investment

Currency Speculation Selffulfilling prophecy

What will happen to the international value of the Mexican peso if there is high inflation in Mexico? The demand for pesos will decrease since Pesos Mexico's trading partners will not want to purchase higher priced Mexican products. The supply will increase as Mexicans look to buy lower priced imports. The peso DEPRECIATES relative to other currencies

Practice For each of the following examples, identify what will happen to the value of US Dollars and Japanese Yen. 1. American tourists increase visits to Japan. 2. The US government significantly decreases personal income tax. 3. Inflation in the Japan rises significantly faster than in the US. 4. Japan has a large budget deficit that increases Japanese interest rates. 5. Japan places high tariffs on all US imports. 6. The US suffers a larger recession. 7. The US Federal Reserve sells bonds at high interest rates. How do these scenarios affect exports and imports?

Practice Shifter Value of Dollar ($) Value of Yen (¥ ) 1 2 3 4 5 6 7 17 Copyright ACDC Leadership 2015

Practice Shifter Value of Dollar ($) Value of Yen (¥ ) 1 Tastes (S↑) Depreciates (D↑) Appreciates 2 Income (S↑) Depreciates (D↑) Appreciates 3 Price Level (D↑) Appreciates (S↑) Depreciates 4 Interest Rate (S↑) Depreciates (D↑) Appreciates 5 Regulation (D↓) Depreciates (S↓) Appreciates 6 Income (S↓)Appreciates (D↓) Depreciates 7 Interest Rate (D↑) Appreciates (S↑) Depreciates Scenarios 1, 2, and 4 will increase US exports because US products are now relatively “cheaper” 18 Copyright ACDC Leadership 2015

2008 Audit Exam

2008 Audit Exam High interest rates attract foreign currency

2010 FRQ #3 Copyright ACDC Leadership 2015

2010 FRQ #3 Copyright ACDC Leadership 2015

Exchange Rate Regimes Flexible Exchange Rate- The market determines the value of the country’s currency Fixed Exchange Rate- The government actively manages the country’s currency Some governments attempt to depreciate their country’s currency in order to promote exports Copyright ACDC Leadership 2015

Flexible Exchange Rates • Pro - Eliminates balance of payments deficit or surplus – Large imports from Britain increase demand for the pound, causing it to appreciate, making British goods more expensive and less likely to be imported moving forward. 38 -24

Flexible Exchange Rates • Disadvantages of flexible exchange rates? – Volatility – Uncertainty and diminished trade – Terms-of-trade changes – Macroeconomic instability • Depreciation of dollar = more exports = higher prices (inflation) • Appreciation of dollar = more imports/less exports = more unemployment

Fixed Exchange Rates – How to do it: • Government intervention – Alter Supply/Demand • Use of reserves (show on graph) – Selling pounds = transfer of assets • Trade policies – tariffs, subsidies • Exchange controls and rationing – Distorted trade lessens advantages – Favoritism to certain importers – Restricted choice for consumers – Black markets – LEVIS! 38 -26

Macroeconomic Adjustments to maintain fixed exchange rates • Use Monetary/Fiscal Policy – Trade deficit with Britain – Reduce demand for British Pounds by undertaking contractionary policy, reducing American incomes and thus imports of British goods – The cost? –Recession.

Exchange Rate Systems • Gold standard 1879 -1934 – Fixed exchange rate system • Bretton Woods 1944 -1971 – Fixed exchange rate system indirectly tied to gold – International Monetary Fund • Managed float 1971 -present 38 -29

Managed Float • Dependence on foreign exchange markets • Occasional intervention (IMF) – Tsunami • In support of managed float – Track Record • Concerns with managed float – Volatility – Manipulation 38 -30

5 Key Graphs Copyright ACDC Leadership 2015

Macro Review Copyright ACDC Leadership 2015