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Module The Foreign Exchange Market

Explore how exchange rates are determined, why they matter, and the equilibrium exchange rate in the foreign exchange market. Learn about real exchange rates and Purchasing Power Parity. Practice with examples and be prepared for financial analysis scenarios.

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Module The Foreign Exchange Market

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  1. ModuleThe ForeignExchangeMarket 42 KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

  2. What you will learnin thisModule: • How are exchange rates determined? • Why do they matter?

  3. Understanding Exchange Rates • Foreign Exchange Market • Exchange Rates • Appreciate • Depreciate

  4. The Equilibrium Exchange Rate • FOREX follows laws of supply & demand • Equilibrium Exchange Rate

  5. The Equilibrium Exchange Rate 1) The Euro floats against the dollar. Assume the US starts exporting corn to Germany. 2) The Singapore dollar floats against the US dollar. Silk from Singapore becomes popular among Hollywood stars. 3) The RMB floats against the US dollar. Show the effect of the Chinese sending their children for education in the US. 4) The Congolese Franc floats against the RMB. Show the effect of Chinese imports of rare earth minerals from the Congo.

  6. The Equilibrium Exchange Rate Assume Germany, via the EU, sent aid to China to help recover from an earthquake in Sichuan. Show the effect on the... 1) Balance of Payments 2) FOREX market Be careful! 3) Loanable Funds Market 4) AD-AS 5) Phillips Curve – Long and Short Run

  7. Inflation and Real Exchange Rates • Nominal Exchange Rates • Real Exchange Rates • Real exchange rate = nominal rate * (domestic price level/international price level) • KEY POINT! - increase in inflation means that currency is getting weaker. It means it take MORE of that currency to buy something. Use this to check your work!

  8. Inflation and Real Exchange Rates • 1) 1 euro = 1.5$, US inflation grew by 10% relatively. How many dollars should 1 euro buy? • 2) 1,000 Korean won = 7 RMB, Korean inflation grew by 5% relatively. What is the real value of 1,000 won if we spend 7 RMB? • 3) 31 New Taiwan dollars = 7 RMB, Taiwanese inflation grew by 15% relatively. How many RMB should 31 NT$ buy? • 4) 7 RMB = 22,000 Vietnamese Dong, Vietnamese inflation changed by -10% relatively. How many Dong should we use to buy 7 RMB?

  9. Extra Practice • 1) 7 RMB = 10 Rupees, Chinese inflation grew by 5% relatively. How many RMB should 10 Rupees buy? • 2) 1 USD = 7 RMB, US inflation grew by 5% relatively. What is the real value of 1$ if we spend 7 RMB to buy it? • 3) 33,000 Dinar = 100 Yen, Japanese inflation grew by 15% relatively. How many Yen should 33,000 Dinar buy? • 4) 7 RMB = 1.25 Canadian $, Chinese inflation changed by -10% relatively. How many RMB should we use to buy 1.25 Canadian $?

  10. Inflation and Real Exchange Rates - Practice • For the following, assume 7 RMB buys 1$, and that we are in the US. 1) US treasury bonds are paying 2%, but the Bank of China just released bonds of 3%. Graph this effect. Remember, start in equilibrium, then show the effect. 2) Because of situation 1 above, the Chinese government now has funding to start large infrastructure projects. What will be the effect on the economy? 3) Assume the inflation from 2 above has increased by 5%, how would this change the real exchange rate? Do it from both country's perspectives.

  11. Purchasing Power Parity • Purchasing Power Parity (PPP) • Market Basket and FOREX • Big Mac Index • Nominal Exchange Rates and PPP

  12. Practice Time https://www.mruniversity.com/node/140924

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