1. A currency appreciates when its value rises relative to other currencies, meaning it can buy more of other currencies. It depreciates when its value falls. Appreciation improves a country's balance of payments while depreciation worsens it. 2. Exchange rates can change due to shifts in demand and supply in the foreign exchange market. Reasons for shifts include changes in consumer tastes, relative incomes, relative prices, interest rates, speculation, government debt levels, and foreign direct/portfolio investment flows. 3. Exchange rate changes that improve a trade deficit or worsen a trade surplus set in motion a self-correcting process, as the now cheaper/more expensive currency boosts/reduces

1. Introduction to Exchange Rates
(part 2)

2. Introduction to Exchange Rates:
3.) Change in Equilibrium – Appreciate vs Depreciate
1.) Classical Dichotomy - Nominal vs. Real
2.) Equilibrium - LoOP vs. PPP
4.) Change in Equilibrium – Reasons
5) Foreign Exchange regimes 制度

3. A fall in the value of a currency
compared to other currencies.
It now buys less then before.
ex. - £1 = € 1.50 £1 = € 1.45
the balance of payments should ‘improve’
Depreciation Appreciation
A rise in the value of a currency
compared to other currencies.
It now buys more then before.
ex. - £1 = $1.85 £1 = $1.91
the balance of payments should get
‘worse’
This will depend on elasticity
of imports and exports
(Weak) (Strong)
3.) Change in Equilibrium – Appreciate vs Depreciate

4. All the people in this
land only use this
money
All the people in this
land only use this
money
Marvel
Land
DC
Land
FOREX graph example
(Country B)(Country A)

5. Tony Stark has a
motorcycle for sale in
his country
Batman wants to buy it
But first he has to
exchange his money
So he is going to go
to the FOREX market
to exchange the
money
Marvel
Land
DC
Land
FOREX graph example
(Country B)(Country A)

6. Marvel
Land
DC
LandThe FOREX market is an
imaginary market that
shows the supply and
demand for both
currencies
Amount
of B to
get an
A
Marvel Land
Money
DC land
Money
Amount
of A to
get an
B
(Country B)(Country A)
FOREX graph example

7. Marvel
Land
DC
Land
Amount
of B to
get an
A
Marvel Land
Money
DC land
Money
Amount
of A to
get an
B
(Country B)(Country A)
FOREX graph example
For B to get A stuff
B has to get A money
D from B D from A
For A to get B stuff
A has to get B money

8. Marvel
Land
DC
Land
Amount
of B to
get an
A
Marvel Land
Money
DC land
Money
Amount
of A to
get an
B
(Country B)(Country A)
FOREX graph example
D from B D from A
For B to get A money
B has to supply B money
S from BS from A
For A to get B money
A has to supply A money

9. Marvel
Land
DC
Land
Amount
of B to
get an
A
Marvel Land
Money
DC land
Money
Amount
of A to
get an
B
(Country B)(Country A)
FOREX graph example
D from B D from A
S from BS from A
If B wants to buy the motorcycle,
will demand more A money

10. Marvel
Land
DC
Land
Amount
of B to
get an
A
Marvel Land
Money
DC land
Money
Amount
of A to
get an
B
(Country B)(Country A)
FOREX graph example
D from B D from A
S from BS from A
This also means that he will supply
more money in the open FOREX market

11. Marvel
Land
DC
Land
Marvel Land
Money
DC land
Money
(Country B)(Country A)
FOREX graph example
D from B D from A
S from BS from A
So A money =
more valuable
B/A A/B
And B money =
less valuable

12. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
So …..
Country B buys a
motorcycle from
country A means…
Exchange rate valueExchange rate value
Trade surplus Trade deficit
Appreciation Depreciation
Current Account Current Account

13. This is true from the point I started at
However
This process is like a circle so if I started at a
different point then the opposite would
happen
FOREX graph example

14. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
so …..
This is step one in a
circular process
This exchange rate system
will “automatically” fix
itself and his depreciated
currency will then fix the
trade deficit
They have a trade
deficit
They also have a
depreciated currency

15. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
Since B’s currency is depreciated
It is now possible for A’s money to
buy more of B’s money
They have a trade
deficit
They also have
a depreciated
currency
So for example…

16. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
B/A
Country A Money
A/B
Country B Money
D from A
D from B
S from BS from A
Start here now…

17. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
B/A
Country A Money
A/B
Country B Money
D from A
D from B
S from BS from A
Things in country B now look much
cheaper for the people in country A

18. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
B/A
Country A Money
A/B
Country B Money
D from A
D from B
S from BS from A
So A will buy more things from B which means
he will first demand more of B’s money

19. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
B/A
Country A Money
A/B
Country B Money
D from A
D from B
S from BS from A
But to do that, country A will supply
more of it’s own money in the FOREX
so we should go
back to the same
(PPP) because of
LoOP

20. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
So …..
Current account
If you have a trade deficit…
Exchange rate value
Trade deficit
Depreciation
A depreciation currency will
make you stuff look cheap for
others…
So it should
“automatically” fix
the deficit
Trade deficit gets smaller

21. Marvel
Land
DC
Land
(Country B)(Country A)
FOREX graph example
Current account
The same thing will be true
on the other side too just the
opposite…
Exchange rate value
Trade surplus
Appreciation
An appreciated currency
tends to reduce a trade
surplus.
Trade surplus gets smaller

22. But with “floating” exchange rates everything
should “smooth” out in the long run
Surplus
Time
Deficit
Long Run
Short Run
So in the short run things go up and down and
can be quite volatile
Of course we always live in the short run causing things to be volatile but we
usually drift back and move towards the long run because of (LoOP)
FOREX graph example

23. Introduction to Exchange Rates:
3.) Change in Equilibrium – Appreciate vs Depreciate
1.) Classical Dichotomy - Nominal vs. Real
2.) Equilibrium - LoOP vs. PPP
4.) Change in Equilibrium – Reasons
5) Foreign Exchange regimes 制度

24. Mostly things that change in demand for imports and exports
Mostly things that change the demand for investments
1.) Consumer Tastes
2.) Relative incomes (booms and recessions)
3.) Relative prices (PPP) (Inflation)
5.) Speculation
4.) Interest rates
4.) Change in Equilibrium – Reasons
Reasons that change on the Current Account side
Reasons that change on the Financial Account side
6.) Government debt
7.) FDI or Portfolio investment

25. - Increased preferences for imports
increases demand and visa versa.
Country B’s Demand
for Country A’s goods
Appreciation in Country A
Example:
1.) Consumer Tastes
B/A
Country A
D from B
S from A
D from B1
Country B
A/B
S from B
S from B1
4.) Change in Equilibrium – Reasons

26. - Recessions lowers demand for imports,
booming economies raise demand for imports.
Example:
2.) Relative Incomes
Country A
Econ good times
Appreciation in
Country BCountry B
Econ bad times
A Demands more
B money
B Supplies less
B money
4.) Change in Equilibrium – Reasons

27. - Recessions lowers demand for imports,
booming economies raise demand for imports.
Example:
2.) Relative Incomes
Country A
Econ good times
Appreciation in
Country BCountry B
Econ bad times
A Demands more
B money
B Supplies less
B money
A/B
Country B Money Country B Money
A/B
*** for country A
everything would be the
exact opposite
** notice both these graphs
are really the same graph
for the same country
4.) Change in Equilibrium – Reasons

28. Example:
3.) Relative Prices
(PPP) (Inflation)
- If a nation’s price level is rising faster then
another nations, consumers seek cheaper goods.
( Real vs. Nominal changes important to note)
Country
A’s prices
in their
economy
Appreciation
in country B
Country B’s
stay the same
A demands more B money
B demands less A money
B supplies less B money
A supplies more A money
Deprecation
in country A
4.) Change in Equilibrium – Reasons

29. Example:
4.) Interest Rates - Increased interest rates means larger
investment income by investors.
Country A’s
interest rates
Appreciation
in country A
Country B’s
stay the same
A demands less B money
B demands more A money
B supplies more B money
A supplies less A money
Deprecation
in country B
4.) Change in Equilibrium – Reasons

30. Country A’s
interest rates
B Demands less A money
A supplies more A money
Deprecation
in country A
Since currencies can be traded as assets, investors
seek profit buying low and selling high.
Country B’s
stay the same
4.) Speculation
Example:
Less desire to
have A money
since the
possible income
from having it
falls.
*3.) interest rates
4.) Change in Equilibrium – Reasons

31. Country A’s
interest rates
B Demands less A money
A supplies more A money
Deprecation
in country A
Since currencies can be traded as assets, investors
seek profit buying low and selling high.
Country B’s
stay the same
4.) Speculation
Example:
Less desire to
have A money
since the
possible income
from having it
falls.
B/A
Country A Money Country A Money
B/A
** notice both these graphs
are really the same graph
for the same country
*3.) interest rates
4.) Change in Equilibrium – Reasons

32. Country A’s
national debt
is a problem
B Demands less A money
A supplies more A money
Deprecation
in country A
Since currencies can be traded as assets, investors
seek profit buying low and selling high.
Country B’s
stay the same
4.) Speculation
Example:
Less desire to
have A money
since investors
worry that the
debt can be
causing a
problem for
growth in the
country.
*5.) government debt
4.) Change in Equilibrium – Reasons

33. Country A’s
national debt
is a problem
B Demands less A money
A supplies more A money
Deprecation
in country A
Since currencies can be traded as assets, investors
seek profit buying low and selling high.
Country B’s
stay the same
4.) Speculation
Example:
Less desire to
have A money
since investors
worry that the
debt can be
causing a
problem for
growth in the
country.
B/A
Country A Money Country A Money
B/A
*5.) government debt
** notice both these graphs
are really the same graph
for the same country
4.) Change in Equilibrium – Reasons

34. Direct
Investment:
Portfolio
Investment:
- Investors putting their funds into stocks and
shares, government bonds and property.
Strong inflows from overseas cause increased
demand in the country’s cuurency/
- An economy that attracts high net inflows
of capital investment from overseas will
have increased demand for the country’s
currency.
7.) FDI or Portfolio investment
Appreciation
in the country
Appreciation
in the country
4.) Change in Equilibrium – Reasons

35. Mostly things that change in demand for imports and exports
Mostly things that change the demand for investments
1.) Consumer Tastes
2.) Relative incomes (booms and recessions)
3.) Relative prices (PPP) (Inflation)
5.) Speculation
4.) Interest rates
Reasons that change on the Current Account side
Reasons that change on the Financial Account side
6.) Government debt
7.) FDI or Portfolio investment
4.) Change in Equilibrium – Reasons

36. A few examples…

37. Demand for country
A’s goods
How would a change in consumer tastes cause
Appreciation in country A ?
Appreciation in country A
Supply of A’s
currency How would Appreciation in country A cause a
change in consumer spending?
Appreciation in country A
Demand for country
A’s goods
Supply of A’s
currency
4.) Change in Equilibrium – Reasons

38. How would an increase in relative prices
(inflation) cause Deprecation in country A ?
Country A’s
prices
Demand for
A’s goods
Supply of A’s
currency
Deprecation
in country A
How would Deprecation in country A effect the
foreign exchange market?
Deprecation
in country A
Demand for
A’s goods
Supply of A’s
currency
*** But only if the
deprecation is
larger than the
price increase
4.) Change in Equilibrium – Reasons

39. If country A is experiencing bad economic times (recession) how
could that lead to appreciation of it’s currency?
Appreciation in
country's
FOREX
Country has
Econ bad times
Country’s
supply of
currency
How could appreciation effect an economy?
Appreciation in
country's'
FOREX
Demand exports
Demand imports
*** It depends on
which effect is
higher and what
caused the bad
times
4.) Change in Equilibrium – Reasons

40. If country A is experiencing bad economic times (loss of comparative advantage)
how could that lead to deprecation of it’s currency?
Deprecation in
country's'
FOREX
Country has
Econ bad times
Demand of
country’s
goods
How could Deprecation effect an economy?
Deprecation in
country's'
FOREX
Demand exports
Demand imports
*** It depends on
which effect is
higher and what
caused the bad
times
4.) Change in Equilibrium – Reasons

41. If a country’s government decides to increase the interest rate
it pays on bonds what will happen to the exchange rate?
Country’s
interest rates
Demand for
country’s
currency
Supply of
country’s
currency
Appreciation
in country’s
currency
4.) Change in Equilibrium – Reasons

42. So to summarize…

43. Law of One Price
- A unit of any currency should be
able to buy the same quantity of
goods in all countries.
(should end up with same.
nominal values everywhere )
- based on the law of one price.
Purchasing Power Parity
( PPP)
(Nominal = Real)
2.) Equilibrium - LoOP & PPP
Long run – Everything should balance be worth the same

44. A fall in the value of a currency
compared to other currencies.
It now buys less then before.
ex. - £1 = € 1.50 £1 = € 1.45
the balance of payments should ‘improve’
Depreciation Appreciation
A rise in the value of a currency
compared to other currencies.
It now buys more then before.
ex. - £1 = $1.85 £1 = $1.91
the balance of payments should get
‘worse’
This will depend on elasticity
of imports and exports
(Weak) (Strong)
3.) Change in Equilibrium – Appreciate vs Depreciate

45. Marvel
Land
DC
Land
Marvel Land
Money
DC land
Money
(Country B)(Country A)
FOREX graph example
D from B D from A
S from BS from A
So A money =
more valuable
B/A A/B
And B money =
less valuable

46. Mostly things that change in demand for imports and exports
Mostly things that change the demand for investments
1.) Consumer Tastes
2.) Relative incomes (booms and recessions)
3.) Relative prices (PPP) (Inflation)
5.) Speculation
4.) Interest rates
Reasons that change on the Current Account side
Reasons that change on the Financial Account side
6.) Government debt
7.) FDI or Portfolio investment
4.) Change in Equilibrium – Reasons

47. End of part 2
Thanks! 