Sign In
Sign Up
flag-sg

Demystifying Exchange Rates in Global Economics
Dive into the world of exchange rates and their impact on international trade. Our comprehensive guide breaks down complex concepts, making it easy to understand and apply in real-world scenarios.

  1. Intros0/4 watched
  1. 0/4
Now Playing:Changes in the exchange rate – Example 0a
Intros
0/4 watched
  1. Shifts to Demand Curve for US Dollars
    • 3 Ways It can Shift
    • World Demand for US Exports
    • US Interest Rate Differential
    • Expected Future Exchange Rate
  2. Shifts to Supply Curve for US Dollars
    • 3 Ways it can Shift
    • World Demand for US Imports
    • US Interest Rate Differential
    • Expected Future Exchange Rate
Foreign exchange market
Jump to:NotesConceptFAQsPrerequisites
Notes

Shifts to Demand Curve for US Dollars

The Demand Curve can shift right or left in the graph.

Changes in the Exchange Rate


How does it shift? There are 3 ways:

  1. World Demand for US Exports: With the number of the exports, we see that
    1. If the demand for US exports increase, then the demand for US dollars increase. (right shift)
    2. If the demand for US exports decrease, then the demand for US dollars decrease. (left shift)

  2. US Interest Rate & Foreign Interest Rate: The gap between the US interest rate and the foreign interest rate is called the US interest rate differential.
    1. If the US interest rate differential increase, then the demand for US dollars increase. (right shift)
    2. If the US interest rate differential decrease, then the demand for US dollars decrease. (left shift)

  3. Expected Future Exchange Rate: Depending on the exchange rate in the future, people could either make profit holding US dollars or foreign currency, which determines the demand of US dollars.
    1. If expected future exchange rate increase, then the demand for US dollars increase. (right shift)
    2. If expected future exchange rate decrease, then the demand for US dollars decrease. (left shift)


Shifts to Supply Curve for US Dollars

The Supply Curve can shift right or left in the graph.

Changes in the Exchange Rate


How does it shift? There are 3 ways:

  1. World Demand for US Imports: With the number of the imports, we see that
    1. If the demand for US imports increase, then the demand for US dollars increase. (right shift)
    2. If the demand for US imports decrease, then the demand for US dollars decrease. (left shift)

  2. US Interest Rate & Foreign Interest Rate: The gap between the US interest rate and the foreign interest rate is called the US interest rate differential.
    1. If the US interest rate differential decrease, then the supply for US dollars increase. (right shift)
    2. If the US interest rate differential increase, then the supply for US dollars decrease. (left shift)

  3. Expected Future Exchange Rate: Depending on the exchange rate in the future, people could either make profit holding US dollars or foreign currency, which determines the demand of US dollars.
    1. If expected future exchange rate decrease, then the supply for US dollars increase. (right shift)
    2. If expected future exchange rate increase, then the supply for US dollars decrease. (left shift)


Appreciation & Depreciation of US dollars

With shifts in demand and supply, we can also see the appreciation and depreciation of US dollars.

Case 1: Suppose the Federal reserve in the US decides to raise the interest rate.

If a foreign country’s interest rate does not change, then there is an increase in the US interest rate differential. In this case, the demand for US dollars increases and the supply for US dollars decrease.

So, we get the following graph,

Changes in the Exchange Rate


The result in the graph shows that the quantity of US dollars stays the same, but the exchange rate rises, causing an appreciation for US dollars.

Case 2: Suppose the Federal reserve in the US decides to decrease the interest rate.

If a foreign country’s interest rate does not change, then there is a decrease in the US interest rate differential. In this case, the demand for US dollars decreases and the supply for US dollars increase.

So, we get the following graph,

Changes in the Exchange Rate


The result in the graph shows that the quantity of US dollars stay the same, but the exchange rate falls, causing a depreciation for US dollars.


Real Exchange Rate

Real Exchange Rate: measures the price of domestic goods relative to the price of foreign goods. It is calculated by using the formula

RER = E  ×  PP∗\large \frac{E \; \times \; P} {P^{*}}

Where:
EE = exchange rate
PP = price level of domestic goods
P∗P^{*} = price level of foreign goods.

Short Run: Changes in the nominal exchange rate also changes the real exchange rate. This is due to price levels of domestic and foreign goods not changing every time the nominal exchange rate changes.

Short-run changes to the real exchange rate changes the quantity of imports demanded and exports supplied.

Long Run: Changes in the nominal exchange rate does not change the real exchange rate. This is due to price levels of domestic and foreign goods changing every time the nominal exchange rate changes.
Concept

Introduction to Exchange Rates

Welcome to our exploration of exchange rates, a crucial concept in international economics! Exchange rates represent the value of one currency in terms of another, playing a vital role in global trade and finance. They affect everything from the price of imported goods to the competitiveness of a country's exports. Our introduction video provides an excellent starting point for understanding this complex topic. It breaks down the basics of exchange rates, explaining how they're determined and why they fluctuate. As your math tutor, I'm excited to guide you through this fundamental aspect of global economics. The video will help you visualize the concept, making it easier to grasp the mathematical relationships involved. By the end of this section, you'll have a solid foundation in exchange rates, setting you up for success in more advanced economic calculations. Let's dive in and unravel the fascinating world of international currency exchange!

FAQs

  1. What is an exchange rate?

    An exchange rate is the value of one currency in terms of another currency. It represents the amount of one currency that can be exchanged for a unit of another currency. For example, if the exchange rate between the US dollar and the euro is 1 USD = 0.85 EUR, it means you can exchange 1 US dollar for 0.85 euros.

  2. How do interest rates affect exchange rates?

    Interest rates have a significant impact on exchange rates. When a country's central bank raises interest rates, it typically leads to an appreciation of that country's currency. This is because higher interest rates attract foreign investment, increasing demand for the currency. Conversely, lower interest rates can lead to currency depreciation as investors seek higher returns elsewhere.

  3. What's the difference between nominal and real exchange rates?

    Nominal exchange rates are the actual rates at which currencies are exchanged in the foreign exchange market. Real exchange rates, on the other hand, take into account the purchasing power of currencies by considering price levels in different countries. Real exchange rates provide a more accurate picture of the relative value of currencies in terms of goods and services they can buy.

  4. How do exchange rates affect international trade?

    Exchange rates significantly impact international trade. When a country's currency appreciates, its exports become more expensive for foreign buyers, potentially reducing demand. Simultaneously, imports become cheaper for domestic consumers. Conversely, when a currency depreciates, exports become more competitive in international markets, while imports become more expensive. These changes can affect a country's trade balance and overall economic performance.

  5. What factors influence exchange rate fluctuations?

    Several factors can cause exchange rates to fluctuate, including:

    • Interest rates and monetary policy
    • Inflation rates
    • Political and economic stability
    • Government debt
    • Terms of trade
    • Speculation and market sentiment
    • Economic performance and growth prospects
    Understanding these factors can help predict potential currency movements and make informed decisions in international finance and trade.

Prerequisites

Understanding the foundations of economics is crucial when delving into complex topics like changes in exchange rates. One key prerequisite topic that plays a significant role in this area is influencing factors in data collection. This concept is particularly relevant to exchange rates because it helps us comprehend how various factors can impact currency supply and demand, ultimately affecting exchange rates.

When studying changes in exchange rates, it's essential to recognize that the foreign exchange market is influenced by numerous factors, many of which are related to data collection and analysis. Understanding how to identify and interpret these factors influencing currency supply is crucial for anyone looking to grasp the complexities of exchange rate fluctuations.

For instance, economic indicators such as inflation rates, interest rates, and GDP growth are all examples of data that can significantly impact exchange rates. The methods used to collect and analyze this data can have a profound effect on how markets interpret and react to this information. By studying the influencing factors in data collection, students can develop a more nuanced understanding of how these economic indicators are gathered and how they might affect currency values.

Moreover, political events, trade balances, and market sentiment are additional factors that can influence exchange rates. The way this information is collected, reported, and disseminated can create ripples in the forex market. A solid grasp of data collection principles helps in critically evaluating the reliability and impact of such information on exchange rates.

Another aspect where influencing factors in data collection becomes relevant is in understanding market speculation and forecasting. Traders and analysts often rely on various data points to predict future exchange rate movements. The quality and interpretation of this data, influenced by collection methods, can significantly affect market expectations and, consequently, exchange rates.

Furthermore, in today's globalized economy, the interconnectedness of financial markets means that data from one country can impact exchange rates worldwide. Understanding how different countries collect and report economic data, and the potential biases or limitations in these processes, is crucial for a comprehensive analysis of exchange rate dynamics.

In conclusion, the study of influencing factors in data collection serves as a fundamental building block for understanding changes in exchange rates. It equips students with the critical thinking skills necessary to evaluate the quality and relevance of economic data, interpret market reactions, and analyze the complex web of factors that drive currency valuations. By mastering this prerequisite topic, students will be better prepared to navigate the intricate world of foreign exchange and develop a more sophisticated understanding of global economic dynamics.