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notes15_2009_exchange_rates - NOTES 15 Exchange Rates and...

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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: Demand for Yen Supply of Yen Dollars/Yen 1
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We will now look at the three factors that causes 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 result, the demand for Yen would shift to the right. This is illustrated below. Dy1 Dy2 Sy Dollars/Yen An increase in the GDP of the US, increases the demand for Yen, causes the exchange rate to rise and the dollar to depreciate. (The exact opposite happens if US GDP falls). An increase in the GDP of Japan, increases the supply of Yen. If the Japanese have a greater income, they would want to buy more U.S. goods. In order to buy more U.S. stuff, they need dollars. Their demand for dollars would increase. If they want more dollars, they must supply more yen. Because their demand for dollars increases, the supply of Yen increases. The increase in Japan’s GDP would increase the supply of Yen, cause value of the Yen to fall and the dollar to appreciate. (The exact opposite happens if Japan’s GDP falls) Notice, with a GDP change in one country, only one of the curves shift!
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