616 CHAPTER 18 Macroeconomics in an Open Economy

foreign currency. So, the exchange rate between the U.S. dollar and the British pound
can be stated as either 0.635 British pounds per U.S. dollar or 1/0.635 = 1.574 U.S.
dollars per British pound.
Banks are the most active participants in the market for foreign exchange. Typi
cally, banks buy currency for slightly less than the amount for which they sell it. This
spread between the buying and selling prices allows banks to cover their expenses from
currency trading and to make a profit. Therefore, when most businesses and individu
als buy foreign currency from a bank, they receive fewer units of foreign currency per
dollar than would be indicated by the exchange rate shown on online business sites or
printed in the newspaper.
Based on Wall Street Journal, October 13, 2011.

MyEconLab Your Turn: Test your understanding by doing related problem 2.6 on page 633 at the end of this
chapter.

The market exchange rate is determined by the interaction of demand and supply,
just as other prices are. Lets consider the demand for U.S. dollars in exchange for
Japanese yen. There are three sources of foreign currency demand for the U.S. dollar:
1. Foreign firms and households that want to buy goods and services produced in the
United States.
2. Foreign firms and households that want to invest in the United States either through

foreign direct investment buying or building factories or other facilities in the

United States or through foreign portfolio investment buying stocks and bonds
issued in the United States.
3. Currency traders who believe that the value of the dollar in the future will be greater
than its value today.

Equilibrium in the Market for Foreign Exchange

Figure 18.2 shows the demand and supply of U.S. dollars for Japanese yen. Notice that as
we move up the vertical axis in Figure 18.2, the value of the dollar increases relative to
the value of the yen. When the exchange rate is 150 = $ 1, the dollar is worth 1.5 times
as much relative to the yen as when the exchange rate is 100 = $1. Consider, first,
the demand curve for dollars in exchange for yen. The demand curve has the normal
downward slope. When the value of the dollar is high, the quantity of dollars demanded
will be low. A Japanese investor will be more likely to buy a $1,000 bond issued by the
U.S. Treasury when the exchange rate is 100
$1 and the investor pays only 100,000
Figure 18.2 Exchange
rate (/$) Supply
Equilibrium in the Foreign Surplus of dollars
Exchange Market
150 Supply of dollars
When the exchange rate is 150 to the dol -| in exchange for
lar, it is above its equilibrium level, and yen
there will be a surplus of dollars. When the
exchange rate is 100 to the dollar, it is be
low its equilibrium level, and there will be 120
a shortage of dollars. At an exchange rate
of 120 to the dollar, the foreign exchange
market is in equilibrium. 100 Demand for dollars
in exchange for
Shortage of dollars yen

Demand

0 Quantity of dollars traded

 The Foreign Exchange Market and Exchange Rates 61 7

to buy $1,000 than when the exchange rate is 150 =

$1 and the investor must pay
150,000. Similarly, a Japanese firm is more likely to buy $150 million worth of micro
chips from Intel Corporation when the exchange rate is 100 = $1 and the microchips
can be purchased for 15 billion than when the exchange rate is 150 = $1 and the
microchips cost 22.5 billion.
Consider, now, the supply curve of dollars in exchange for yen. The supply curve
has the normal upward slope. When the value of the dollar is high, the quantity of dol
lars supplied in exchange for yen will be high. A U.S. investor will be more likely to
buy a 200,000 bond issued by the Japanese government when the exchange rate is
200 = $ 1 and he needs to pay only $1,000 to buy 200,000 than when the exchange
rate is 100 = $ 1 and he must pay $2,000. The owner of a U.S. electronics store is more
likely to buy 20 million worth of television sets from the Sony Corporation when the
exchange rate is 200 = $ 1 and she only needs to pay $100,000 to purchase the televi
sions than when the exchange rate is 100 = $ 1 and she must pay $200,000.
As in any other market, equilibrium occurs in the foreign exchange market where
the quantity supplied equals the quantity demanded. In Figure 18.2, 120 = $1 is the
equilibrium exchange rate. At exchange rates above 120 = $1, there will be a surplus
of dollars and downward pressure on the exchange rate. The surplus and the downward
pressure will not be eliminated until the exchange rate falls to 120 = $ 1. If the exchange
rate is below 120 = $ 1, there will be a shortage of dollars and upward pressure on the
exchange rate. The shortage and the upward pressure will not be eliminated until the ex
change rate rises to 120 = $ 1. Surpluses and shortages in the foreign exchange market
are eliminated very quickly because the volume of trading in major currencies such as the
dollar and the yen is very large, and currency traders are linked together by computer.
Currency appreciation occurs when the market value of a countrys currency in Currency appreciation An increase
creases relative to the value of another countrys currency. Currency depreciation oc in the market value of one currency
curs when the market value of a countrys currency decreases relative to the value of relative to another currency.
another countrys currency.
Currency depreciation A decrease
in the market value of one currency
relative to another currency.
How Do Shifts in Demand and Supply
Affect the Exchange Rate?
Shifts in the demand and supply curves cause the equilibrium exchange rate to change.
Three main factors cause the demand and supply curves in the foreign exchange market
to shift:
1. Changes in the demand for U.S.-produced goods and services and changes in the
demand for foreign-produced goods and services
2. Changes in the desire to invest in the United States and changes in the desire to in
vest in foreign countries
3. Changes in the expectations of currency traders about the likely future value of the
dollar and the likely future value of foreign currencies

Shifts in the Demand for Foreign Exchange Consider how the three factors
listed above will affect the demand for U.S. dollars in exchange for Japanese yen. Dur
ing an economic expansion in Japan, the incomes of Japanese households will rise, and
the demand by Japanese consumers and firms for U.S. goods will increase. At any given
exchange rate, the demand for U.S. dollars will increase, and the demand curve will shift
to the right. Similarly, if interest rates in the United States rise, the desirability of invest
ing in U.S. financial assets will increase, and the demand curve for dollars will also shift
to the right. Speculators are currency traders who buy and sell foreign exchange in an Speculators Currency traders who
attempt to profit from changes in exchange rates. If a speculator becomes convinced that buy and sell foreign exchange in an
the value of the dollar is going to rise relative to the value of the yen, the speculator will attempt to profit from changes in
sell yen and buy dollars. If the current exchange rate is 120 = $1, and the speculator exchange rates.
is convinced that it will soon rise to 140 = $ 1, the speculator could sell 600,000,000
and receive $5,000,000 (= 600,000,000/120) in return. If the speculator is correct
618 CHAPTER 18 Macroeconomics in an Open Economy

and the value of the dollar rises against the yen to 140 = $1, the speculator will be
able to exchange $5,000,000 for 700,000,000 ( = $5,000,000 X 140), for a profit of
100,000,000.
To summarize, the demand curve for dollars shifts to the right when incomes in
Japan rise, when interest rates in the United States rise, or when speculators decide that
the value of the dollar will rise relative to the value of the yen.
During a recession in Japan, Japanese incomes will fall, reducing the demand for
U.S.-produced goods and services and shifting the demand curve for dollars to the left.
Similarly, if interest rates in the United States fall, the desirability of investing in U.S.
financial assets will decrease, and the demand curve for dollars will shift to the left.
Finally, if speculators become convinced that the future value of the dollar will be lower
than its current value, the demand for dollars will fall, and the demand curve will shift
to the left.

Shifts in the Supply of Foreign Exchange The factors that affect the sup
ply curve for dollars are similar to those that affect the demand curve for dollars. An
economic expansion in the United States increases the incomes of Americans and
increases their demand for goods and services, including goods and services made in
Japan. As U.S. consumers and firms increase their spending on Japanese products, they
must supply dollars in exchange for yen, which causes the supply curve for dollars to
shift to the right. Similarly, an increase in interest rates in Japan will make financial
investments in Japan more attractive to U.S. investors. These higher Japanese interest
rates will cause the supply of dollars to shift to the right, as U.S. investors exchange dol
lars for yen. Finally, if speculators become convinced that the future value of the yen will
be higher relative to the dollar than it is today, the supply curve of dollars will shift to
the right as traders attempt to exchange dollars for yen.
A recession in the United States will decrease the demand for Japanese products and
cause the supply curve for dollars to shift to the left. Similarly, a decrease in interest rates
in Japan will make financial investments in Japan less attractive and cause the supply
curve of dollars to shift to the left. If traders become convinced that the future value of
the yen will be lower relative to the dollar, the supply curve will also shift to the left.

Adjustment to a New Equilibrium The factors that affect the demand and
supply for currencies are constantly changing. Whether the exchange rate increases or
decreases depends on the direction and size of the shifts in the demand curve and supply
curve. For example, as Figure 18.3 shows, if the demand curve for dollars in exchange
for Japanese yen shifts to the right by more than the supply curve shifts, the equilibrium
exchange rate will increase.

Figure 18.3 Exchange

2. ... while the demand
curve for dollars shifts
Shifts in the Demand and rate (/$) further to the right . . .
Supply Curve Resulting in
a Higher Exchange Rate Si
Holding other factors constant, an increase s2
in the supply of dollars will decrease the
equilibrium exchange rate. An increase
1. The supply curve
in the demand for dollars will increase 130 e
3. . . . causing the of dollars shifts to
the equilibrium exchange rate. In the case equilibrium exchange the right . . .
shown in this figure, the demand curve and rate to rise. A
120
the supply curve have both shifted to the
right. Because the demand curve has shifted
to the right by more than the supply curve, D2
the equilibrium exchange rate has increased
from 120 to $1 at point A to 130 to $1 at Di
point B.
0 Quantity of dollars traded
 The Foreign Exchange Market and Exchange Rates 619

Making What Explains the Fall and Rise

the and Fall of the Dollar?
Connection An American vacationing in Paris during the spring of 2002
could have bought a meal for 50 and paid the equivalent of
$44 for it. In the summer of 2008, that same 50 meal would have cost the equivalent of
$79. A few months later, in early 2009, it would have cost only $64. In the fall of 2011, it
would have cost $69. Clearly, during these years, the value of the dollar in exchange for the
euro was going through substantial fluctuations. And it wasnt just against the euro that
the dollar was losing value, then regaining some of it, and then losing it again. The graph
below shows fluctuations for the period from 1990 to late 2011 in an index of the value
of the dollar against an average of other major currencies, such as the euro, the British
pound, the Canadian dollar, and the Japanese yen. The shaded areas indicate recessions.
The graph indicates that although the dollar gained value against other currencies
for a brief period during late 2008 and early 2009, and again during mid-2010, overall it
has lost value since 2002. What explains the decline in the value of the dollar? We have
just seen that an increase in the demand by foreign investors for U.S. financial assets can
increase the value of the dollar, and a decrease in the demand for U.S. financial assets
can decrease the value of the dollar. The increase in the value of the dollar in the late
1990s, as shown in the graph, was driven by strong demand from foreign investors for
U.S. stocks and bonds, particularly U.S. Treasury securities. This increase in demand
was not primarily due to higher U.S. interest rates but to problems in the international
financial system that we will discuss in Chapter 19. Many investors saw U.S. financial
assets as a safe haven in times of financial problems because the investors believed the
U.S. Treasury was unlikely to default on its bonds.

Trade-weighted
exchange index
=
(1973 100)
120

100

80

60

40

20

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Data from Federal Reserve Bank of St. Louis.

Conditions began to change in 2002, however, for a couple of reasons. First, as we

saw in Chapter 15, the Fed began aggressively cutting the target for the federal funds
rate to deal with the recession of 2001 and the initially slow recovery that followed. By
May 2003, the target for the federal funds rate was at a historically low level of 1 per
cent. Low U.S. interest rates mean that investors are likely to buy foreign assets rather
than U.S. assets, which depresses the demand for dollars and lowers the exchange value
of the dollar. Although the Fed did begin raising the target for the federal funds rate
in 2004, it resumed cutting the target in the fall of 2007. Low U.S. interest rates have
played a role in the declining value of the dollar. Second, many investors and some cen
tral banks became convinced that the value of the dollar was too high in 2002 and that
it was likely to decline in the future. As we will see later in this chapter, the United States
has run large current account deficits since the early 2000s. Many investors believed
that the substantial increase in the supply of dollars in exchange for foreign currencies
that resulted from these current account deficits would ultimately result in a significant
620 CHAPTER 18 Macroeconomics in an Open Economy

decline in the value of the dollar. Once investors become convinced that the value of a
countrys currency will decline, they become reluctant to hold that countrys financial
assets. A decreased willingness by foreign investors to buy U.S. financial assets decreases
the demand for dollars and lowers the exchange value of the dollar.
What explains the increase in the value of the dollar in late 2008 and early 2009 and
again in mid-2010? The increase was largely the result of the deepening of the financial
crisis in the fall of 2008. Just as during the financial crisis of the late 1990s, many inves
tors saw U.S. Treasury securities as a safe haven and demanded dollars in order to invest
in them. By the summer of 2009, the easing in the financial crisis resulted in the dollar

resuming its decline. Worries that some European governments particularly Greece
might default on their government bonds caused a temporary increase in the value of
the dollar during mid-2010. A smaller increase in the value of the dollar during 2011
caused the problems for McDonalds mentioned in the chapter opener.
The fall in the value of the dollar over the long run has been bad news for U.S.
tourists traveling abroad and for anyone in the United States buying foreign goods and
services. It has been good news, however, for U.S. firms exporting goods and services to
other countries.

MyEconLab Your Turn: Test your understanding by doing related problems 2.14 and 2.15 on page 634 at the
end of this chapter.

Some Exchange Rates Are Not Determined

by the Market
To this point, we have assumed that exchange rates are determined in the market. This
assumption is a good one for many currencies, including the U.S. dollar, the euro, the
Japanese yen, and the British pound. Some currencies, however, have fixed exchange rates
that do not change over long periods. For example, for more than 10 years, the value of
the Chinese yuan was fixed against the U.S. dollar at a rate of 8.28 yuan to the dollar. As
we will discuss in more detail in Chapter 19, a countrys central bank has to intervene in
the foreign exchange market to buy and sell its currency to keep the exchange rate fixed.

How Movements in the Exchange Rate

Affect Exports and Imports
When the market value of the dollar increases, the foreign currency price of U.S. exports
rises, and the dollar price of foreign imports falls. For example, suppose that initially the
market exchange rate between the U.S. dollar and the euro is $1 = 1. In that case, an
Apple iPhone that has a price of $200 in the United States will have a price of 200 in
France. A bottle of French wine that has a price of 50 in France will have a price of $50
in the United States. Now suppose the market exchange rate between the U.S. dollar and
the euro changes to $1.20 = 1. Because it now takes more dollars to buy a euro, the
dollar has depreciated against the euro, and the euro has appreciated against the dollar.
The depreciation of the dollar has decreased the euro price of the iPhone from 200 to
$200/(1.20 dollars/euro) = 167. The dollar price of the French wine has risen from
$50 to 50 X 1.20 dollars/euro == $60. As a result, we would expect more iPhones to
be sold in France and less French wine to be sold in the United States.
To generalize, we can conclude that a depreciation in the domestic currency will
increase exports and decrease imports, thereby increasing net exports. As we saw in
previous chapters, net exports is a component of aggregate demand. If real GDP is
currently below potential GDP, then, holding all other factors constant, a deprecia
tion in the domestic currency should increase net exports, aggregate demand, and real
GDP. An appreciation in the domestic currency should have the opposite effect: Exports
should fall, and imports should rise, which will reduce net exports, aggregate demand,
and real GDP.
 The Foreign Exchange Market and Exchange Rates 621

Don't Let This Happen to You

Don't Confuse What Happens When a
Currency Appreciates with What Happens
When It Depreciates
One of the most confusing aspects of exchange rates is that
they can be expressed in two ways. We can express the ex
change rate between the dollar and the yen either as how
many yen can be purchased with $1 or as how many dol
lars can be purchased with 1. That is, we can express the
exchange rate as 100 = $1 or as $0.01 = 1. When a
currency appreciates, it increases in value relative to an
other currency. When it depreciates, it decreases in value
relative to another currency.
If the exchange rate changes from 100 = $1 to
120 = $1, the dollar has appreciated and the yen has de
preciated because it now takes more yen to buy $1. If the
exchange rate changes from $0.01 = 1 to $0,015 = 1,
however, the dollar has depreciated and the yen has appre
ciated because it now takes more dollars to buy 1. This
situation can appear somewhat confusing because the ex
change rate seems to have increased in both cases. To
determine which currency has appreciated and which has
depreciated, it is important to remember that an appre
ciation of the domestic currency means that it now takes
more units of the foreign currency to buy one unit of the
domestic currency. A depreciation of the domestic cur
rency means it takes fewer units of the foreign currency to
buy one unit of the domestic currency. This observation
holds no matter which way we express the exchange rate.
MyEconLab
Your Turn: Test your understanding by doing related
problem 2.5 on page 633 at the end of the chapter.

Solved Problem 18.2

The Effect of Changing Exchange Rates
on the Prices of Imports and Exports
In June 2011, the average price of goods imported into the
United States from Canada fell 2.1 percent. Is it likely that
the value of the U.S. dollar appreciated or depreciated versus
the Canadian dollar during this period? Is it likely that the
average price in Canadian dollars of goods exported from
the United States to Canada during June 2011 rose or fell?

Solving the Problem

Step 1 : Review the chapter material. This problem is about changes in the value of
a currency, so you may want to review the section How Movements in the
Exchange Rate Affect Exports and Imports on page 620.
Step 2: Explain whether the value of the U.S. dollar appreciated or depreciated
against the Canadian dollar. We know that if the U.S. dollar appreciates against
the Canadian dollar, it will take more Canadian dollars to purchase 1 U.S. dol
lar, and, equivalently, fewer U.S. dollars will be required to purchase 1 Canadian
dollar. A Canadian consumer or business will need to pay more Canadian dol
lars to buy products imported from the United States: A good or service that had
been selling for 100 Canadian dollars will now sell for more than 100 Canadian
dollars. A U.S. consumer or business will have to pay fewer U.S. dollars to buy
products imported from Canada: A good or service that had been selling for
100 U.S. dollars will now sell for fewer than 100 U.S. dollars. We can conclude
that if the price of goods imported into the United States from Canada fell, the
value of the U.S. dollar must have appreciated versus the Canadian dollar.
Step 3: Explain what happened to the average price in Canadian dollars of goods
exported from the United States to Canada. If the U.S. dollar appreciated
relative to the Canadian dollar, the average price in Canadian dollars of goods
exported from the United States to Canada will have risen.

Your Turn: For more practice, do related problem 2.10 on page 634 at the end of this chapter. MyEconLab
622 CHAPTER 18 Macroeconomics in an Open Economy
Real exchange rate The price of
domestic goods in terms of foreign
goods.
18.3 LEARNING OBJECTIVE
The Real Exchange Rate
We have seen that an important factor in determining the level of a countrys exports
to and imports from another country is the relative prices of each countrys goods. The
relative prices of two countries goods are determined by two factors: the relative price
levels in the two countries and the nominal exchange rate between the two countries
currencies. Economists combine these two factors in the real exchange rate, which is
the price of domestic goods in terms of foreign goods. Recall that the price level is a
measure of the average prices of goods and services in an economy. We can calculate the
real exchange rate between two currencies as
Domestic price level \
Real exchange rate = Nominal exchange rate X
Foreign price level /
Notice that changes in the real exchange rate reflect both changes in the nominal
exchange rate and changes in the relative price levels. For example, suppose that the ex
change rate between the U.S. dollar and the British pound is $1 = 1, the price level in
the United States is 100, and the price level in the United Kingdom is also 100. Then the
real exchange rate between the dollar and the pound is
100
Real exchange rate = 1 pound/dollar X = 1.00.
100
Now suppose that the nominal exchange rate increases to 1.1 pounds per dollar,
while the price level in the United States rises to 105 and the price level in the United
Kingdom remains 100. In this case, the real exchange rate will be
105
Real exchange rate = 1.1 pound/dollar X
100
= 1.15.
The increase in the real exchange rate from 1.00 to 1.15 tells us that the prices of U.S.
goods and services are now 15 percent higher than they were relative to British goods
and services.
Real exchange rates are reported as index numbers, with one year chosen as the
base year. As with the consumer price index, the main value of the real exchange rate is
in tracking changes over time in this case, changes in the relative prices of domestic
goods in terms of foreign goods.