copyright © 2004 south-western mods 42-44 the open economy: forex models, graphs, and practice

Copyright © 2004 South-Western

Mods Mods 42-4442-44The Open Economy:

FOREX Models, Graphs, and Practice


Understanding Exchange Rates

Foreign Exchange Market

•Exchange Rates

•Appreciate

•Depreciate

US $ JP ¥ €

$1.00 1 98.3 0.77

¥1 0.0101 1 .0078

€1.00 1.3 127.9 1


Quick Review Guide of Exchange Rate Features

Appreciation:• When a currency appreciates, it gains in value in

relation to another currency. It would take less of that currency to “buy” the other currency.

• We say that the appreciated currency has strengthened.

• Because of that appreciation, the goods of that country would cost more for other countries to buy, so exports of the appreciated currency’s country would decline.

• Appreciation of your currency is good if you are traveling, but bad if you are an exporter of goods.


Quick Review Guide of Exchange Rate Features

Depreciation:• When a currency depreciates, it loses in value in

relation to another currency. It would take more of that currency to “buy” the other currency.

• We say that the depreciated currency has weakened.

• Because of that depreciation, the goods of that country would cost less for other countries to buy, so exports of the depreciated currency’s country would increase.

• Depreciation of your currency is bad if you are traveling, but good if you are an exporter of goods.


•FOREX follows laws of supply & demand

•Equilibrium Exchange Rate

The Equilibrium Exchange Rate Graph


The steps for FOREX analysis

1. Draw 2 FOREX graphs (S & D graphs)

2. For X axes:• One for Q of 1 country’s currency—QD

• One for Q of other country’s currency--Q€

3. For Y axes, always put the country’s currency that you’ve drawn the graph for as the denominator. In other words, “what goes below (in the X axis), goes below” (in the Y axis denominator).


The steps for FOREX analysis

3. Draw in S & D curves on each FOREX graph

4. Look at the problem or scenario• Think: “Who is wanting to buy what?”• On the graph for the country that will be doing the

buying, shift supply to show increase in supply of their currency.

• On the graph for the country where things will be bought, shift demand to show increase in demand for their currency

5. Read the new Ep for appreciation or depreciation


Wksht Practice

• FOREX Wksht

• Capital Flows Wksht

• Monetary and Fiscal Policy and Exchange Rates Wksht


Inflation and Real Exchange Rates

•Nominal Exchange Rates

•Real Exchange Rates


Exchange Rate PolicyExchange Rate Policy• Governments have more

power to influence nominal exchange rates than other prices

• Exchange rates are important to countries where exports and imports are a large fraction of GDP


Exchange Rate RegimesExchange Rate Regimes

•Exchange Rate Regime

•Fixed Exchange Rate

•Floating Exchange Rate

•"Managed" & "Target Zone"


How Can an Exchange Rate BeHow Can an Exchange Rate Be Held Fixed? Held Fixed?

•Exchange Market Intervention

•Foreign Exchange Reserves

•Foreign Exchange Controls


The Exchange Rate RegimeThe Exchange Rate Regime Dilemma Dilemma

•The Case for Fixed Exchange Rates

• Facilitates trade by creating certainty about the exchange rate

• Acts as a check on inflationary policies


The Exchange Rate RegimeThe Exchange Rate Regime Dilemma Dilemma

•The Case against Fixed Exchange Rates

• Requires large foreign currency reserves

• May divert monetary policy

• Distorts incentives

• Opportunity for corruption


Purchasing Power Parity

•The notion that a dollar should buy the same amount in all countries. •In the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country. •The Economist mag’s Big Mac Index:

•Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries.


Big Mac Index—January 2014

copyright © 2004 south-western mods 42-44 the open economy: forex models, graphs, and practice

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