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AP®︎/College Macroeconomics

Unit 6: Lesson 4

Effect of changes in policies and economic conditions on the foreign exchange market

Lesson summary: effect of changes in policies and economic conditions on the foreign exchange market

AP.MACRO:
MKT‑5 (EU)
,
MKT‑5.E (LO)
,
MKT‑5.E.1 (EK)
,
MKT‑5.E.2 (EK)
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MKT‑5.E.3 (EK)
In this lesson summary review and remind yourself of the key terms and graphs related to how changes in economic policies or conditions can affect the foreign exchange market.

Lesson summary

Changes in the supply of or demand for a currency will cause that currency to appreciate or depreciate. The demand for a currency changes based on other countries' wanting to buy goods, services, or assets using that currency. The supply of a currency changes based on how much people using that currency want the goods, services, or assets in other countries.
For example, the demand for the currency of Roasterland changes when other countries want more (or less) of Roasterland’s goods, services, and assets. The supply of the currency of Roasterland changes when Roasterland wants more (or less) of other countries goods, services or assets.

Key Terms

Key termDefinition
tariffa tax on imported goods; if Maxistan places a tariff on goods from other countries, it will supply less of its own currency because it will want to buy fewer foreign goods.
quotaa limit on the quantity of goods that can be imported; if Maxistan places a restrictive quota on goods from other countries, it will supply less of its own currency because it will buy fewer foreign goods.
real exchange ratethe nominal exchange rate of a currency adjusted for the relative price level in each country

Key graphs

Changes in the demand for a currency

Figure 1: An increase in the demand of the Roasterland bean (R, B), causing the R, B to appreciate
You can use the mnemonic TIPSY to remember the factors that shift the demand for a currency:
Factors that shift the demand for a currencyDescriptionExample
Tastes and preferences the goods bought with that currencyIf the demand for imports from a country changes because people’s tastes changeReading Hamsterville literary epics becomes fashionable in the United States. Demand for the Hamsterville snark (SN) increases, and the SN appreciates.
The interest rate in a country relative to other countriesHigher interest rate in one country relative to another country make assets in that country more attractive; conversely, lower relative interest rates make them less attractiveHigher real interest rates in Atlantis attract Mexican investors. Mexican investors need more Atlantian dollars (A, dollar sign) to buy Atlantian bonds. Demand for the A, dollar sign increases and the A, dollar sign appreciates.
The price level in that country, relative to other countriesWhen prices are lower in one country relative to another country, more of the cheaper goods will be wanted, so more of that currency is demandedInflation in Jacksonia is 3, percent, but inflation in Hamsterville is 10, percent. Hamstervillians want to buy more goods from Jacksonia that are relatively cheaper. Demand for the Jacksonian jay (J, J) increases, the J, J appreciates.
SpeculationWhen people believe a currency, or assets in a country, will appreciate, the demand for that currency increasesConcerns about a possible coup in Hamsterville lead Jacksonians to view those assets as riskier. The demand for the Hamsterville snark (S, N) decreases, and the SN depreciates.
National income (Y)More national income leads to higher demand for another countries goods, and therefore their currencyAn economic boom in Petmickistan increases their demand for Jacksonian cream cheese. The demand for the Jacksonian jay (J, J) increases and the J, J appreciates

Changes in the supply of a currency

Figure 2: Changes in the supply of a currency
How does a country like the United States get another country’s currency, such as the Roasterland bean? It has to buy it with its own currency. To demand a currency in another market, you must supply your currency in your own. That means that the supply of a currency is based on domestic buyers wanting to buy stuff from other countries, such as Americans wanting to buy coffee or government bonds from Roasterland.
We can modify the table above to reflect that:
Factors that shift the demand for a currencyExampleImpact on demand for one currencyImpact on the supply of the other currency
Tastes and preferences the goods bought with that currencyReading Hamsterville literary epics becomes fashionable in the United States.Demand for the Hamsterville snark (S, N) increases and the S, N appreciates.Supply of the U.S. Dollar (U, S, dollar sign) increases, and the dollar depreciates.
The interest rate in a country relative to other countriesHigher real interest rates in Atlantis attract Mexican investors.Demand for the A, dollar sign increases and the A, dollar sign appreciates.Supply of the Mexican peso increases and the peso depreciates.
The price level in that country, relative to other countriesInflation in Jacksonia is 3%, but inflation in Hamsterville is 10%.Hamstervillians want to buy more goods from Jacksonia that are relatively cheaper. Demand for the Jacksonian jay (JJ) increases, and the JJ appreciates.Supply of the Hamsterville snark increases and the SN depreciates.
SpeculationConcerns about a possible coup in Hamsterville lead Jacksonians to view those assets as riskier.The demand for the Hamsterville snark (SN) decreases, and the SN depreciates.The supply of the Jacksonian jay (JJ) decreases and the JJ appreciates.
National income (Y)An economic boom in Petmickistan increases their demand for Jacksonian cream cheese.The demand for the Jacksonian jay (JJ) increases, and the JJ appreciates.The supply of the Petmickian plunket (PP) increases, the PP depreciates.

Key takeaways:

Demand for a currency derives from foreign buyers of goods, services, and assets

If people from anywhere else want to buy goods, services, and assets inside a country, they need that country’s currency. If you want to buy coffee from Guatemala, and you live in the United States, you are going to need some of Guatemala's currency—the Guatemalan Quetzl (G, T, Q)—to do your buying.

Supply of a currency derives from domestic buyers of foreign goods, services, and assets

If people inside one country want to get another currency to buy foreign goods, they are going to need to supply their own currency to get the other one. If you want to buy coffee from Guatemala, and you live in the United States, you are going to have to supply dollars.

Monetary and fiscal policy can impact exchange rates

Previously we learned that monetary and fiscal policy impact output, inflation, unemployment, and interest rates. If monetary policy or fiscal policy impacts the price level, that country’s relative price level is higher relative to other countries, making its goods more expensive. This leads to a decrease in the demand for that currency, and therefore a depreciation of that currency.

Key Equation

The real exchange rate

The real exchange rate (R.E.R.) of a currency depends on the nominal exchange rate and the relative price levels in two countries:
R, point, E, point, R, point, start subscript, dollar sign, end subscript, equals, start text, o, t, h, e, r, space, c, u, r, r, e, n, c, y, space, p, e, r, space, d, o, l, l, a, r, end text, times, start fraction, P, L, start subscript, U, point, S, point, end subscript, divided by, P, L, start subscript, start text, o, t, h, e, r, space, c, o, u, n, t, r, y, end text, end subscript, end fraction
For example, suppose the consumer price index (CPI) in the United States is 110 and the CPI in Ghana is 100. The nominal exchange rate of the dollar is currently 5 cedi per dollar. The real exchange rate of the dollar is:
\begin{aligned} R.E.R_\&=5\text{ cedi per }\ \times \dfrac{110}{100} \\\\ &=5 \text{ cedi per }\\times 1.1\\\\ & = 5.5 \text{ cedi per }\ \end{aligned}
If the price level in the United States increases, the real exchange rate of the dollar increases and the dollar appreciates. For example, if the CPI in the United States increases to 120:
\begin{aligned} R.E.R_\&=5\text{ cedi per }\ \times \dfrac{120}{100} \\\\ &=5 \text{ cedi per }\\times 1.2\\\\ & = 6 \text{ cedi per }\ \end{aligned}

Questions for review:

• Fio is a trading partner of Elizaland. Elizaland has recently engaged in expansionary fiscal policy that has resulted in an increase in the price level. What happens to the nominal value of Elizaland’s currency and the nominal value of Fio’s currency? Explain.
• What will happen to the value of the U.S. dollar if it places a restrictive quota on the importation of poetry by Snorri Sturluson from Iceland?
• The currency of Fio is the franc and the currency of Lincolnland is the lira. If residents of Fio think that financial assets in Lincolnland are riskier than they used to be, show the effect of this on:
(a) The foreign exchange market for the Lincolnland lira.
(b)The foreign exchange market for the Fio franc.

Want to join the conversation?

• The example in the key equation question and the example in Questions for review contradict each other. One says a price level increase leads to appreciation and the other says it leads to depreciation. Which one is it? Common sense would suggest inflation is bad for an economy so it will devalue the currency
• You might be confusing the nominal value and the real value in this situation. If you sketch the market for this currency, the nominal value decreases.

Also, inflation is not necessarily "bad". Inflation can occur along with economic growth.
• Maybe someone will find the following remark on R.E.R. helpful.

If I understand correctly, the real exchange rate is actually unitless: R.E.R. equal to 6, for example, means that you will be able to buy 6 times more goods by exchanging dollars into cedi. The article implies, however, that the unit of R.E.R. can be "cedi per $", which was rather confusing to me and seems not to be entirely valid. (2 votes) • I think that there might be two definitions of RER. Definition 1: RER1 = exchange rate * (P-$ / P-cedi),
where P-$and P-cedi are the prices of some basket of goods (in units of$ and cedi).

This is the RER you described. It is unitless.

Definition 2: RER2 = exchange rate * (CPI-$/ CPI-cedi), where CPI-$ = P-$/ P0-$ * 100,
where P0-$is the price of the basket of goods in some base year. After some manipulation, RER2 = RER1 / (P0-$ / P0-cedi).

So the two definitions are the same, up to a constant term relating to base year prices. Because of this term, RER2 has units of "cedi/\$". It measures the exchange rate relative to base year prices (similar to how real GDP measures the GDP relative to base year prices).