# Ch 10 - Chapter 10:The Exchange Rateand the Balance of...

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C h a p t e r   1 0 : T h e   E x c h a n g e   R a t e a n d   t h e   B a l a n c e  o f   P a y m e n t s I. Currencies and Exchange Rates A. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. Foreign currency is necessary to buy goods and services produced in other countries. B. We get foreign currency and foreigners get U.S. dollars in the foreign exchange market —the market in which the currency of one country is exchanged for the currency of another. C. Exchange Rates 1. The price at which one currency exchanges for another is called a foreign exchange rate . a) A rise in the U.S. exchange rate is called an appreciation of the dollar. b) A fall in the U.S. exchange rate is called a depreciation of the dollar. 2. Figure 10.1 shows the exchange rate of the U.S. dollar in terms of five currencies from 1995 to 2005. The figure shows that the U.S. exchange rate has appreciated and depreciated at different times and against different countries. D. Nominal and Real Exchange Rates 1. The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how much of one money exchanges for a unit of another currency. 2. The real exchange rate is the relative price of foreign-produced goods and services to U.S.- produced goods and services. It tells how much of the quantity of the real GDP of other countries we get in exchange for a unit of U.S. real GDP. a) The real exchange rate equals the nominal exchange rate multiplied by the ratio of the U.S. price level to the foreign price level. b) In terms of a formula, RER = E p ( P/P *) where RER is the real exchange rate, E is the nominal exchange rate, P is the U.S. price level, and P * is the foreign price level. E. Trade-Weighted Index 1. The average exchange rate of the U.S. dollar against other currencies, with the individual currencies weighted by their importance in U.S. international trade, is the trade-weighted index. a) Figure 10.2 shows the nominal and real trade-weighted exchange rates from 1995 to 2005. b) Both the nominal and real U.S. exchange rate generally appreciated until 2001, after which they generally depreciated. F. Questions About the Exchange Rate 1. How are the nominal and real exchange rates determined? 2. How do exchange rate fluctuations influence U.S. international trade and international payments? 3. How do the Fed and other central banks operate in the foreign exchange market? II. The Foreign Exchange Market The exchange rate is a price that is determined by demand and supply in the foreign exchange market.

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2 1 8 A. The Demand for One Money Is the Supply of Another Money When U.S. residents demand, say, Euros, they supply U.S. dollars. B.
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## This note was uploaded on 04/03/2009 for the course ECON 2101 taught by Professor Bill during the Spring '09 term at Temple.

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Ch 10 - Chapter 10:The Exchange Rateand the Balance of...

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