ModuleThe ForeignExchangeMarket

KRUGMAN'SMACROECONOMICS for AP*

42

Margaret Ray and David Anderson

HousekeepingHousekeeping

•Read modules 43-44

•Test - Friday 5/2 – AP 5

•Test – Monday 5/5 – AP 3

Do NowDo Now

How do foreign currency exchange rates impact you?

What you will learnWhat you will learn

in thisin this ModuleModule::

• The role of the foreign exchange market and the exchange rate

• Determinants of FX rate changes

• The importance of real exchange rates and their role in the current account

What is an exchange rate?What is an exchange rate?

Price of one currency in terms of units of another currency.

Example: Activity 53

USD 1.4 = ₤ 1.00 or….

₤ 0.71 = USD 1.00

Activity # 53 – Part AActivity # 53 – Part A

Convert foreign prices to USD.

Which currencies appreciated vs. the USD?

Which depreciated?

Also do 7 & 8.

The Equilibrium Exchange RateThe Equilibrium Exchange Rate

• FOREX follows laws of supply & demand

•Equilibrium Exchange Rate

Figure 42.2 An Increase in the Demand for U.S. DollarsRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Determinants of FX ratesDeterminants of FX rates

Current account flows (X-M)

Capital flows (real interest rates, business opportunities, political)

Two Ways to Look at FX MarketsTwo Ways to Look at FX Markets

Activity 53 - # 9 – page 307

Germany & US Trade

Activity 53.3 – 53.5Activity 53.3 – 53.5

Graph changes in FX markets using both approaches.

Inflation and Real ExchangeInflation and Real Exchange Rates Rates

Real exchange rate = current rate * change in relative price indexes

( FX rate currency A / 1.00 currency B) * (price index B/ price index A)

Example 1 – US vs. Mexico. Assume no inflation, so price level index equals 100 in both countries:

The real exchange rate = 12.5*(100/100) = 12.5 pesos per dollar

Inflation and Real ExchangeInflation and Real Exchange Rates Rates

Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and price index Mex=110. Real exchange rate = 12.5*(100/110) = 11.4 pesos per dollar.

So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods. 

Why are real exchange rates Why are real exchange rates important?important?

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Exercise: Exchange rates and Exercise: Exchange rates and inflationinflation

Do # 10 a, b, c and d

HousekeepingHousekeeping

•Read modules 43-46. Focus on 43 and 44.

•Test – Postponed until after AP exam.

• Monday - brief review of Economic Growth concepts (Section 7).

• Practice tests and reviews thru 5/14.

Purchasing Power ParityPurchasing Power Parity

Purchasing Power Parity (PPP): nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.

 

• Big Mac Index

•Nominal Exchange Rates and PPP

SummarySummary

FX rates are the price of foreign currency

Currencies appreciate or depreciate.

Shifts in FX supply and demand result from current account or capital account flows.

Current account = trade

Capital account = interest rates, animal spirits.

Summary 2Summary 2

Real exchange rates reflect changes in nominal FX rates adjusted by relative changes in the price level.

Real exchange rates drive the current account.

Purchasing power parity is an exchange rate that equalizes the cost of the same basket of goods across all countries.

Helps compare economies.

Identifies under or overvalued currencies.

Exit ticket / HomeworkExit ticket / Homework

FRQs 2009 and 2010