notes15–exchangeratesandinternationalmacro.docVIP

NOTES 15 – Exchange Rates and International Macro A. How Exchange Rates are Determined If I were going to purchase a car from Japan, I would have to pay for that car in Yen (the Japanese currency). That means I must be willing to trade dollars for Yen. Likewise, if someone in Japan wanted to buy a U.S. computer, they would have to pay in dollars. That means they must trade their Yen for dollars. If someone in the U.S. wants to buy a Japanese product, they are simultaneously willing to demand more Yen and willing to supply more dollars. (They must supply dollars to get Yen). If someone in Japan wants to by a U.S. product, they are simultaneously willing to demand more dollars and willing to supply more Yen. As a result, we can formulate a market for Yen. We will treat Yen like any other good. Supply and demand forces will determine the price of Yen (measured in dollars). We will define the price of Yen as how many dollars we give up for one Yen (this is the price of Yen - in terms of dollars, Dollars/Yen). In the U.S., however, we often report the price of the dollar. If the dollar appreciates, that means it costs more yen to buy one dollar. (That is, we are often interested in the amount of Yen for one dollar). If the price of yen goes up, the price of the dollar will fall. In other words, if the price of foreign currency falls, the dollar, by definition, appreciates. Below illustrates the market for Yen: We will now look at the three factors that cause movements in the exchange rate market. a) GDP Suppose the GDP in the US increases. As we know, as Y increases, there are more expenditures in the U.S. – U.S. consumers, businesses and governments are purchasing more goods. It is highly likely, that some of these goods are produced abroad. That means that imports will increase. As we get richer, we would want to buy more imports. We need foreign currency to buy imports. Our demand for foreign currency increases. As a re