International Macro Part 3 Definition and Market for Foreign Exchange
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International Macro Part 3 Definition and Market for Foreign Exchange


– Okay, now let’s go ahead
and talk about exchange rates. And for right now,
let’s go ahead and talk about what we call
the nominal exchange rate. So the Nominal
exchange rate is the one you’re going to hear
reported in the newspaper and it can be reported
either in foreign currency units per dollar or dollars
per foreign currency unit, both are equally fine. We’re going to go ahead
and discuss it in terms of foreign currency units
per dollar. And I’m going to go ahead
and parallel the main — textbook here and go ahead
and think about yen. So we might have the exchange
rate be 100 yen per dollar or we might have it
be 120 yen per dollar, and we could go ahead and
have it be 80 yen per dollar. And let’s think about some item
that costs $10, so if it costs $10 in the US if
the exchange rate is 80 yen per dollar than for Japanese
consumers it costs 8,000 yen, and if it’s 100 yen per dollar than for Japanese consumers
it costs 10,000 yen, and up here we’re up
at 12,000 yen. So two things to notice here, when this exchange rate rises
the higher or stronger
dollar we’ve talked about, or when the dollar appreciates, than US goods become
more expensive. And if we did an example where we were looking
at Japanese goods and translating them
into dollars, we would also see that foreign
goods become cheaper. So that’s going to impact
the relative demand for US goods
versus foreign goods. So we’re going to go ahead
and see that, at least in the short run, this is going to impact
of the medium run maybe, this is going
to impact net exports. And I’m going to now
ignore that, sort of, thing that I alluded
to with the J shaped curve and we’re just going
to think about the fact that US goods become
more expensive, foreign goods become cheaper and that’s going to mean
that US net exports, which are exports minus imports, US net exports are going
to go ahead and do what? Well, if US goods become
more expensive than US Exports are going
to fall because foreign buyers don’t want as much of them and
if foreign goods become cheaper than imports are going to rise, so overall net exports are
going to go down, so they’re going to become, in the case of the US, more negative because we’re
already running a trade deficit. So this idea of is a stronger
or weaker currency a good thing or a bad thing,
a little bit depends. If you’re really worried
about the trade deficit, a stronger dollar is actually
a bad thing. So that’s one thing
to keep with that here. So one way of looking at exchange rates is
to look at our market for exchange rates and we can
have a supply and demand curve, and we have the price
of a dollar so this is the market four
dollars. And we could equivalently
talk about the market for yen and that would be just fine too. It would be basically
the inverse of that and this would be
the quantity of dollars. And again, the price of a dollar we measure in terms
of yen per dollar. Well, where does the demand
for dollars come from? Well, the demand for dollars in the foreign exchange
market comes from Japanese or other foreign people
who want to buy things that are sold in dollars. So most obviously that’s
US produced goods and services because US producers pay their
workers and suppliers in dollars and so they want
to be paid in dollars. So if more people want to go
to Disneyland that increases the demand for dollars. Or if more people want,
you know, Harley Davidsons
or something like that, that increases the demand
for dollars. Less obviously,
if you want to buy stocks on the US Stock Market or
if you want to buy real estate in the US you need dollars
to do that. So US assets also
generate demand for dollars because basically when you
think about it there’s only two things you can do
with a countries currency. You can buy their assets
or you can buy their goods. And when you’re buying
their assets actually, what you’re doing is you’re
preserving your stock pile of dollars and hopefully
making some income, but of course that income is also going to be
paid in dollars. So essentially
there’s really only one thing you can do
with a countries currency, buy their goods. It could be their goods now or
it could be their goods later, but eventually that’s
all US dollars are useful for. So where does the supply
of dollars come from? Well, supply
of dollars comes from US firms and households who want
to buy foreign goods. Yeah, foreign is Japanese
in this case, but we’re using the yen, of course, as a stand
in for all countries. So who want to buy foreign goods
or foreign assets because, again, you know, if you want
to buy foreign goods those foreign suppliers want
to be paid in dollars. Or if you want to buy stock
on the Tokyo Stock Market, well those things are
priced in dollars. So let’s go ahead
and think about a, sort of, supply and demand problem here. So let’s suppose that now
we’re thinking about the price of a dollar and now we’re going
to think about euros– let’s see, let me get
the euro symbol right here, I think that’s roughly it– euros per dollar and what’s going to happen here
if people become more optimistic that the euro is going
to stay together and be stable. Well, presumably, US Investors
will want to buy more euros and euro denominated assets. So US investors are going
to supply more of their dollars because they need
to sell dollars to get them exchanged for euros
so they can get US assets. So we would predict that if
this happens and if people think that the euro is likely
to be more stable, that is going to push down the value of the dollar relative
to the euro. We could describe
that as the dollar weakening or we could describe
that as the euro strengthening. So higher demand for euro assets means
higher supply of dollars in exchange markets, which means weaker dollar. And then that would correspondingly
affect net exports. In particular, this weaker
dollar would eventually, we think, lead
to higher net exports. So there’s one example
of that kind of method going on.

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