Foreign Exchange Market

1. Foreign Exchange Market
(FOREX)
Most countries have their own currency that is used by
people to buy and sell goods/services
Differing currencies do not stop people from buying and
selling each other goods and services
As with any other good/service, currencies are subjected to
supply and demand
The Foreign Exchange Market is not a “real” place
(physically)
It is a composite representation of the world-wide trade of
currencies between people, businesses, international
financial institutions and the central banks of most
countries

2. Foreign Exchange Market
(FOREX)
Reasons for exchanging one currency for
another
1. Change in preferences for a
good/service
2. Change in the quality of a good/service
3. Change in relative price levels
4. Change in relative incomes (GDP)
5. Changes in relative interest rates

3. Foreign Exchange Market
(FOREX)
When you think of currencies:
THINK DERSIRABILITY

4. Foreign Exchange Market
(FOREX)
• Example: Assume Europeans are impressed by the latest
computers made by Dell Computers. The quality is excellent and
they like the variety of colors that they come in. Also assume the
Euro-area countries are in the midst of an economic recovery AND
the U.S. economy is in a recession which has depressed the
average price level.
– This example hits four of the factors that affect the exchange
rates between two currencies
• Change in preferences (color of computers)
• Change in quality (improved computers)
• Change in relative Price Level (prices lower In U.S.)
• Change in relative incomes (GDP)
– The average European has more income and will tend to
purchase not only more European goods/services, but imports
as well. In our case from the U.S.

5. Foreign Exchange Market
(FOREX)
• Dell Computers have become more
desirable for a variety of reasons,
therefore the U.S Dollar has become more
desirable as well.
• REMEMBER: DESIRABILITY!!!

6. Foreign Exchange Market
The Market for EUROS
Supply of Euros
“Take my
Euros!
“Now we
Have more
Euros!
Demand for Euros
“A”
Qeuro*
Quantity of Euros
Dollar
Price
Per
Euro
$/Euro*
($1.00)
(“How
many
Dollars
does it
Take to
buy a
Euro”)
FOREX
If Europeans want to buy U.S. Goods/Services they must give up their Euros
in order to obtain Dollars. Initially the SUPPLY of Euros is going to INCREASE
in the Market for Euros.

7. Foreign Exchange Market
The Market for EUROS
Supply of Euros
“Take my
Euros!
“Now we
Have more
Euros!
Supply of Euros1
Demand for Euros
Qeuro*
Quantity of Euros
Dollar
Price
Per
Euro
(“How
many
Dollars
does it
Take to
buy a
Euro”)
Qeuro1
Notice that the Dollar Price Per Euro is now lower than it was at the
previous equilibrium point. It NOW takes FEWER dollars to buy a Euro
than it did before. The Dollar has APPRECIATED in value relative to the Euro
FOREX
$/Euro*
($1.00)
$/Euro1
($.50)
“A”
“B”

8. Foreign Exchange Market
The Market for Dollars
Supply of $
“Give me $$$”
Demand for $
Q$*
Quantity of Dollars
Euro
Price
Per
Dollar
Euro/$*
(€.1.00)
(“How
many
Euros
does it
Take to
buy a
Dollar”)
“Europeans are
DEMANDING
Dollars from us!”
After the Europeans have given up their Euros, they are going to want
(DEMAND) Dollars for those Euros.
The DEMAND for the Dollar will INCREASE
FOREX
“A”

9. Foreign Exchange Market
The Market for Dollars
Supply of $
D$1
Demand for $
“A”
Q$*
“B”
Q$1
Quantity of Dollars
Euro
Price
Per
Dollar
Euro/$1
(€2.00)
Euro/$*
(€.1.00)
(“How
many
Euros
does it
Take to
buy a
Dollar”)
“Europeans are
DEMANDING
Dollars from us!”
“Give me $$$”
Notice that the Euro Price Per Dollar is now higher than it was at the
previous equilibrium point. It NOW takes more Euros to buy a dollar
than it did before. The Euro has DEPRECIATED in value relative to the Dollar.

10. Foreign Exchange Market
Effect NOW on Exports and
Imports
The Dollar has APPRECIATED in value
relative to the Euro. This means now it
takes FEWER Dollars to buy a Euro
than it did before (Americans have to
give up fewer Dollars to buy the same
amount of Euros than before). This
means Europeans goods/service will
be relatively LESS expensive for
Americans to buy (like a sale) and
IMPORTS from Europe will tend to
INCREASE.

11. Foreign Exchange Market
Effect NOW on Exports and
Imports
The Euro has DEPRECIATED in value
relative to the Dollar. This means now
it takes MORE Euros to by a Dollar
than it did before (Europeans have to
give up more Euros to buy the same
amount of Dollars than before). This
means American goods and services
will be relatively MORE expensive for
Europeans to buy and EXPORTS to
Europe will tend to DECREASE.

12. The Foreign Exchange Market
Effect NOW on Exports and Imports
The NET EXPORT N(x) Effect:
Exports Decreasing and Imports Increasing
Net Exports are DECREASING
Therefore GDP is Decreasing
AD Shifts to the Left
AD DECREASES!!!!
SAY WHAT?????

13. The Foreign Exchange Market
Effect NOW on Exports and Imports
• IT SEEMS SELF-DEFEATING!!!
• Well…It is!
• Foreigners BUY more U.S. made
Computers (which is an export) but in the
process they APPRECIATE the currency
which makes the everything else
(including Dell computers) eventually more
expensive….Welcome to the world of the
FOREX!!

14. Foreign Exchange Market
The Interest Rate Effect
• Interest rates affect the value of a currency in
the Foreign Exchange Market.
• In the FOREX, we think of interest rates in terms
of SAVING and/or INVESTING.
• Money (financial capital) does not care about
national boundaries.
• It wants to go where it can grow the biggest (in
terms of Rate of Return)
• It will seek the place with the highest interest
rate, regardless of the currency that the interest
rate is available.

15. Foreign Exchange Market
The Interest Rate Effect
• Example: Assume the Interest Rates on
savings/investing in the U.S. is higher than
the Interest Rates in Europe.
• Europeans want to put their money where it
can grow the biggest.
• But they have Euros?? What to do??
• They exchange their Euros for Dollars in the
FOREX

16. Foreign Exchange Market
The Market for EUROS
Supply of Euros
“Now we
Have more
Euros!
Demand for Euros
“A”
Qeuro*
Quantity of Euros
Dollar
Price
Per
Euro
$/Euro*
($1.00)
(“How
many
Dollars
does it
Take to
buy a
Euro”)
“Take my
Euros!
FOREX
If Europeans want to invest in U.S. FINANCIAL ASSETS which are now more
DESIRABLE! They must give up their Euros in order to obtain Dollars. Initially the
SUPPLY of Euros is going to INCREASE in the Market for Euros.

17. Foreign Exchange Market
The Market for EUROS
Supply of Euros
“Take my
Euros!
“Now we
Have more
Euros!
Supply of Euros1
Demand for Euros
Qeuro*
Quantity of Euros
Euros
Dollar
Price
Per
Euro
(“How
many
Dollars
does it
Take to
buy a
Euro”)
Qeuro1
Notice that the Dollar Price Per Euro is now lower than it was at the
previous equilibrium point. It NOW takes FEWER dollars to buy a Euro
than it did before. The Dollar has APPRECIATED in value relative to the Euro
FOREX
“A”
“B”
$/Euro*
($$/1E.u00r)o1
( $.50)

18. Foreign Exchange Market
The Market for Dollars
Supply of $
“Give me $$$”
Demand for $
Q$*
Quantity of Dollars
Euro
Price
Per
Dollar
Euro/$*
(“How
many
Euros
does it
Take to
buy a
Dollar”)
(€1.00)
“Europeans are
DEMANDING
Dollars from us!”
After the Europeans have given up their Euros, they are going to want
(DEMAND) Dollars for those Euros.
The DEMAND for the Dollar will INCREASE
FOREX
“A”

19. Foreign Exchange Market
The Market for Dollars
Supply of $
D$1
Demand for $
Euro/$1
(€2.00) “A”
Q$*
“B”
Q$1
Quantity of Dollars
Euro
Price
Per
Dollar
Euro/$*
(€1.00)
(“How
many
Euros
does it
Take to
buy a
Dollar”)
“Europeans are
DEMANDING
Dollars from us!”
“Give me $$$”
Notice that the Euro Price Per Dollar is now higher than it was at the
previous equilibrium point. It NOW takes more Euros to buy a dollar
than it did before. The Euro has DEPRECIATED in value relative to the Dollar.

20. Foreign Exchange Market
Effect NOW on Exports and
Imports
The Dollar has APPRECIATED in value
relative to the Euro. This means now it
takes FEWER Dollars to buy a Euro
than it did before (Americans have to
give up fewer Dollars to buy the same
amount of Euros than before). This
means Europeans goods/service will
be relatively LESS expensive for
Americans to buy (like a sale) and
IMPORTS from Europe will tend to
INCREASE.

21. Foreign Exchange Market
Effect NOW on Exports and
Imports
The Euro has DEPRECIATED in value
relative to the Dollar. This means now
it takes MORE Euros to by a Dollar
than it did before (Europeans have to
give up more Euros to buy the same
amount of Dollars than before). This
means American goods and services
will be relatively MORE expensive for
Europeans to buy and EXPORTS to
Europe will tend to DECREASE.

22. Foreign Exchange Market
Effect NOW on Exports and Imports
The NET EXPORT N(x) Effect:
Exports Decreasing and Imports Increasing
Net Exports are DECREASING
Therefore GDP is Decreasing
AD Shifts to the Left
AD DECREASES
Say What….Again!!

23. Foreign Exchange Market
Bottom Line
• What causes the Dollar to Appreciate
(INCREASE the DEMAND for $’s)
– Preferences for U.S. made Goods/Services
– Improved Quality of Goods/Services
– Lower Price Level in U.S relative to other
countries
– Foreign Incomes increase (GDP increases)
– Higher Interest Rates in U.S. relative to other
countries (U.S. Financial Assets more desirable)

24. Foreign Exchange Market
Bottom Line
• What causes the Dollar to Depreciate
(INCREASE the SUPPLY of $’s)
– Preferences for Foreign Made Goods/Services
– Improved Quality of Foreign Made Goods/Services
– Lower Price Level in Foreign Countries relative to
U.S.
– U.S. incomes increase (U.S. GDP Increases)
– Higher Interest Rates in Foreign Countries relative to
the U.S. (Foreign Financial Assets more desirable)

25. FOREX – Example
Assumption – Mercedes Benz makes cars in both the U.S. and Germany.
Lets say that yesterday the exchange rate between the $ and the € is $1.00
equals € 1.00. To buy a Mercedes costs $50,000 or € 50,000. You are
indifferent to who sells you the car. In the paper today you find out the U.S.
interest rate relative to the interest rate in Europe is LOWER. You check the
FOREX and you find out that the exchange rate is now USD/EURO is $1.35
(dollar price (cost) per euro is $1.35). Use the following worksheet to graph
what happened in the FOREX market and answer the questions that follow.

26. USD $50,000 = EURO €50,000
Exchange Rate was $1.00 = €1.00
Exchange Rate is now
or
How much does that Mercedes cost now in each currency for an American to buy and a German to buy?
If you are a German and you convert your Euros to Dollars that Mercedes will cost you:
If you are an American and you convert your Dollars to Euros that Mercedes will cost you:
Where do Americans want to buy their Mercedes?
Where do Germans want to buy their Mercedes?
What happens to Exports from U.S
What happens to Imports to U.S.

27. USD $50,000 = EURO €50,000
Exchange Rate was $1.00 = €1.00
Exchange Rate is now
$1.35 = € 1.00 (dollar price (cost) per euro is $1.35)
or
€.74 = $1.00 (euro price (cost) per dollar is €.74)
How much does that Mercedes cost now in each currency for an American to buy and a German to buy?
If you are a German and you convert your Euros to Dollars that Mercedes will cost you:
$50,000 = No. of Euros needed x $1.35 (for each Euro exchanged he can get $1.35)
$50,000 / $1.35 = No. of Euros needed
€ 37,037
If you are an American and you convert your Dollars to Euros that Mercedes will cost you:
€ 50,000 = No. of Dollars needed x €.74 (for each Dollar exchanged he can get €.74)
€ 50,000 / €.74= No. of Dollars needed
$67,567
Where do Americans want to buy their Mercedes?
In U.S.
Where do Germans want to buy their Mercedes?
In U.S
What happens to Exports from U.S
What happens to Imports to U.S.

28. FOREX – Example
Assumption – Mercedes Benz makes cars in both the U.S. and Germany.
Lets say that yesterday the exchange rate between the $ and the € is $1.00
equals € 1.00. To buy a Mercedes costs $50,000 or € 50,000. You are
indifferent to who sells you the car. In the paper today you find out the U.S.
interest rate relative to the interest rate in Europe is HIGHER. You check the
FOREX and you find out that the exchange rate is now USD/EURO is $.75
(dollar price (cost) per euro is $.75). Use the following worksheet to graph
what happened in the FOREX market and answer the questions that follow.

29. USD $50,000 = EURO €50,000
Exchange Rate was $1.00 = €1.00
Exchange Rate is now
or
How much does that Mercedes cost now in each currency for an American to buy and a German to buy?
If you are a German and you convert your Euros to Dollars that Mercedes will cost you:
If you are an American and you convert your Dollars to Euros that Mercedes will cost you:
Where do Americans want to buy their Mercedes?
Where do Germans want to buy their Mercedes?
What happens to Exports from U.S
What happens to Imports to U.S.

30. USD $50,000 = EURO €50,000
Exchange Rate was $1.00 = €1.00
Exchange Rate is now
$.75 = € 1.00 (dollar price (cost) per euro is $.75)
or
€.1.33 = $1.00 (euro price (cost) per dollar is €.1.33)
How much does that Mercedes cost now in each currency for an American to buy and a German to buy?
If you are a German and you convert your Euros to Dollars that Mercedes will cost you:
$50,000 = No. of Euros needed x $.75 (for each Euro exchanged he can get $.75
$50,000 / $.75 = No. of Euros needed
€ 66,667
If you are an American and you convert your Dollars to Euros that Mercedes will cost you:
€ 50,000 = No. of Dollars needed x €1.33 (for each Dollar exchanged he can get €1.33)
€ 50,000 / €1.33= No. of Dollars needed
$37,594
Where do Americans want to buy their Mercedes?
In Germany.
Where do Germans want to buy their Mercedes?
In Germany
What happens to Exports from U.S?
What happens to Imports to U.S?