Chapter 9
How Exchange Rates
are Determined
©2000 South-Western College Publishing
1
Exchange Rate
The number of units of
foreign currency that can
be acquired with one unit
of domestic money
2
Foreign Currency
(Money)
Supplies of foreign
exchange
3
Appreciated means...
When a currency has
increased in value relative
to another currency
4
Depreciated means...
When a currency has
decreased in value relative
to another currency
5
(9.1)
Exchange rate
6
Foreign Exchange Market
The market for buying and
selling the different
currencies of the world
7
How Movements in the Exchange Rate
Affect the Dollar Price of Foreign Goods
Yen Price of Exchange Rate Dollar Price of
Japanese Auto
Japanese Auto
(1)
(2)
(1)/(2)
2,000,000 Yen
2,000,000 Yen
2,000,000 Yen
$1 = 150 Yen
$1 = 100 Yen
$1 = 50 Yen
$13,333
$20,000
$40,000
8
(9.2)
9
(9.3)
=
–
10
U.S. Purchases (Demand) Foreign Goods, Services, and Securities
United
States
U.S. Supplies
Dollars as
U.S. Demands
Yen to Pay
Foreigners
Foreign
Exchange
Market
Foreigners Supply
Yen
as Foreigners
Demand Dollars to
Pay U.S.
Rest
of the
World
Foreign Purchases (Demand)U.S. Goods, Services, and Securities
Exhibit 9-1
11
(9.4)
Yen (foreign)
price of U.S. goods
=
Dollar price
of U.S. goods
× Exchange rate
12
Since $1 = 100 yen and $1 = 1.5 marks,
then 100 yen = 1.5 marks. If 100 yen = 1.5
marks, we can find how much 1 yen is
worth by dividing both sides of the equation
by 100 to arrive at 1 yen = .015 marks.
100/100 yen = 1.5/100 marks
This is the marks/yen exchange rate.
We can find out how much 1 mark is worth
by dividing both sides of the equation by 1.5
to arrive at 1 mark = 67 yen.
1.5/1.5 marks = 100/1.5 yen
13
If an IBM Computer costs $1,500 and the
yen /dollar exchange rate is 100, then in
Japan, assuming transportation costs are
zero, the computer will cost
1,500
 100 yen
150,000 yen
If the exchange rate appreciates to 150, then
the computer will cost
1,500
 150 yen
225,000 yen
14
(9.5)
+
Supply of dollars = F(U.S. demand for
foreign goods, services,
and securities)
15
(9.6)
Quantity supplied
+
of dollars/month = F (exchange rate)
16
The Market for Dollars
Yen/
Dollar
100
Supply of
Dollars
A
Demand for
Dollars
Quantity of Dollars / Month
Exhibit 9-2
17
Changes in the Exchange Rate
Supply of
Dollars
Yen/Dollar
Exchange
Rate
100
50
A
B
Supply of
Dollars after
Rise in U.S.
Income
Demand for
Dollars
Quantity of Dollars / Month
Exhibit 9-3
18
Changes in the Exchange Rate
Yen/Dollar
Exchange
Rate
100
50
Supply of
Dollars
A
B
Demand for
Dollars After Rise
in U.S. Prices
Demand for
Dollars
Quantity of Dollars / Month
Exhibit 9-4
19
Balance of Payments
The record of transactions
between the United States
and its trading partners in
the rest of the world over a
particular period of time
20
Credit
In the balance of
payments, any item that
results in a payment by
foreigners to Americans
21
Merchandise Exports
Foreign purchases
of U.S. exports
22
Debit
In the balance of payments,
any transaction that results
in a payment to foreigners
by Americans
23
Merchandise Imports
U.S. purchases of
foreign goods
24
Current Account
Transactions that involve
currently produced goods
and services, including the
balance of goods and services
and net unilateral transfers
25
Account
Component
Receipts
Payments
Balance
Use of $
Sources of $
by Foreigners by foreigners
Current (2) Merchandise Exports
+400
(4) Balance of Trade
(3) Merchandise Imports
-$600
(2) + (3) = -$200
(5) Net Exports of Services +500
(6) Balance on
Goods and Services:
(4) + (5) = -$150
Net Exports
(7) Net Unilateral Transfers
-$30
(1) Balance on
Current Account
(6) + (7) = $180
Capital (9) Capital Inflows
+$280
(8) Balance on
(10) Capital Outflows
-$100
Capital Account:
(9) + (10) = $180
Total Uses Total Sources
Balance of Payments
+$730
-$730
(1) + (8) = 0
Exhibit 9-5
26
Net Transfer Payments
In the current account, the
net amount of government
aid to foreigners plus
private charitable relief
27
Trade Balance
The difference between
merchandise exports
and imports
28
Trade Deficit
When merchandise imports
are greater than exports
29
Trade Surplus
When merchandise exports are
greater than imports
30
Balance of Goods and
Services
Net exports of services plus
the trade balance
31
European Currency Unit
(ECU)
A unit of account made up
of a weighted basket of
currencies of the countries
in the European Monetary
System
32
Balance on Current
Account
The balance of goods
and services plus net
unilateral transfers
33
Capital Account
The financial flow of funds
and securities between the
United States and the rest
of the world
34
Capital Inflows
Purchases of U.S.
financial securities by
foreigners and borrowing
from foreign sources by
U.S. firms and residents
35
Net Capital Inflow
Capital inflows
minus capital
outflows
36
Devaluation
Devaluation occurs when a
country increases the units
of currency that equal one
ounce of gold under a fixed
exchange rate system
37
Weighted Average Exchange Value of the U.S. Dollar:
March, 1973 = 100
200%
Recessions
150%
100%
50%
0%
1970 1975 1980 1985 1990 1995 1998
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