International Trade
FOREIGN CURRENCY AND FOREIGN
EXCHANGE SIMULATION & OVERVIEW
Foreign Exchange Rates
(AKA FX or forex)
 What are exchange rates?

The price of a currency in terms of another - the rate at which one
currency can be exchanged for another (multiply foreign price by
exchange rate to calculate)

Ex. If $2= 1euro, $1 = .5 euro or if $1 = 10 pesos, $10 = 1 peso
 Why do exchange rates exist?

Because people have a demand for other currencies.
 What is the demand?

People have a demand for other currencies because they have a
demand for goods & services that can be purchased with that
currency.

For example, in our simulation, you demanded candy and therefore
you demanded ‘bucks’ with which to purchase the candy
Foreign Exchange Rates
 Some nations fix their rates and others are allowed to
“float” with the forces of supply and demand
 Fixed Rate of exchange stays the same; in past basis
was gold (set by central bank - rarely works)
 Gold
WWI

Standard was used as global exchange rate prior to
Floating Rate: based on supply and demand for each
currency (Currently using “managed float” in US)
 Rates
determined in foreign currency market through
Supply and Demand
 IMF (International Monetary Fund) helps regulate
monetary stability and promote foreign trade
Factors that change Supply & Demand and thus alter the
exchange rate
Assumptions related to
Exchange Rates
Determinants of Exchange
Rates
 If the demand for a nation’s
 Tastes
currency increases (all else
equal), that currency will
appreciate. If Demand declines,
it will depreciate.
 If the supply of a nation’s
currency increases, that currency
will depreciate. If supply
decreases, that currency will
appreciate
 If a nation’s currency
appreciates, some foreign
currency depreciates relative to
it.
 Income
 Price Level
 Interest
Rates/Speculation
Appreciation and Depreciation
 Appreciation (strong dollar)
 dollar
buys more of another currency,
resulting in less expensive imports and more
expensive exports
 Depreciation (weak dollar)
 dollar
buys less of another currency, resulting
in more expensive imports and less expensive
exports
Tastes
Factors that change Supply & Demand and thus alter the exchange rate
 When domestic consumers build a strong preference
for foreign produced goods and services, the demand
for those currencies increases and the dollar
depreciates

Ex: Japanese autos gain popularity in US (Yen appreciates,
USD depreciates)
 If foreign consumers increase their demand for U.S.-
made goods, the dollar appreciates.

Ex: European tourists flock to the US (USD appreciates; Euro
depreciates)
Income
Factors that change Supply & Demand and thus alter the exchange rate
 When one nation’s macroeconomy is strong and
incomes are rising, ceteris paribus, demand for all
goods increases, domestically and abroad
 Ex: if Europeans are enjoying economic growth and
the US is in recession, the relative buying power of
European Citizens is growing. They will increase
their consumption of domestic and US made goods.
(demand for USD increases, USD appreciates)
 Ex: England encounters a recession, reducing its
imports, while US real output and real income surge,
increasing US imports (British pound appreciates,
USD depreciates.
Prices (Inflation)
Factors that change Supply & Demand and thus alter the exchange rate
 If one nations’ price level is rising faster than that of
another nation, consumers seek the goods that are
relatively less expensive.


Switzerland experiences a 3% inflation rate compared to
Canada’s 10% rate (Swiss franc appreciates; Canadian dollar
depreciates).
If European inflation is higher than inflation in the US,
American-made goods are a relative bargain to German
consumers and the dollar appreciates. (Another reason for the
Fed to keep inflationary pressure low!)
Interest Rates/Speculation
Factors that change Supply & Demand and thus alter the exchange rate
 Foreign currency is traded as an asset and investors
seek to profit from buying currency at a low rate and
selling it at a high rate



Ex: If it appears that future US interest rates will fall relative to
the rates in Japan, the Yen begins to look like a great
investment (speculators increase demand for Japanese assets,
thus appreciating the Yen and depreciating USDs)
Ex: Currency traders believe South Korea will have much
greater inflation than Taiwan (South Korea won depreciates;
Taiwan dollar appreciates)
Ex: Currency traders think Finland’s interest rates will
plummet relative to Denmark’s rates (Finland’s markka
depreciates; Denmark’s Krone appreciates)