Macro Economics Unit 6: Foreign Exchange Markets

Introduction

• Lecture by Jacob Reed from ReviewEcon.com
• Focus on Foreign Exchange Markets
• Accompanies the Total Review Booklet from ReviewEcon.com

Balance of Payments

• Definition: Accounting of transactions between countries.
• Components:
  • Current Account:
    • Purchases of goods
    • Purchases of services
    • Investment income
    • Net transfers
  • Capital and Financial Account:
    • Purchases of assets (physical and financial like stocks, currency, bonds)
• Accounting Terms:
  • Credits (Inflows): Positive numbers
  • Debits (Outflows): Negative numbers
  • Surplus: More credits than debits
  • Deficit: More debits than credits
  • Balance between both accounts always equals zero

Current Account Components

• Balance of Trade:
  • Exports vs. Imports
  • Trade Surplus: Exports > Imports
  • Trade Deficit: Imports > Exports (e.g., U.S. situation)
• Examples Influencing Current Account:
  • Increase in domestic price level → More imports, fewer exports → Decrease in current account
  • Increase in foreign national income → More exports → Increase in current account
  • Changes in interest rates affect capital inflow/outflow

Exchange Rates

• Definition: Price of one currency in terms of another
• Calculation Example:
  • 1 USD = 20 Mexican Pesos → Soda costs 40 pesos = $2
  • Appreciation: Currency value increases
  • Depreciation: Currency value decreases
• Example: 1 USD = 25 Pesos indicates appreciation of USD

Foreign Exchange Markets

• Determined by supply and demand
• Demand for U.S. Dollars:
  • Downward sloping curve
  • Determined by demand for exports, foreign tastes, foreign income, price levels, interest rates, future exchange rates
• Supply of U.S. Dollars:
  • Upward sloping curve
  • Determined by demand for imports, domestic tastes, domestic income, price levels, interest rates, future exchange rates
• Equilibrium exchange rate is where demand meets supply

Examples

• Decrease in U.S. National Income:
  • Fewer imports → Supply of USD decreases → USD appreciates
  • Decreases demand for trade partner currencies (e.g., Mexican Peso depreciates)
• Increase in U.S. Interest Rates:
  • Attracts foreign investors → Capital inflow to U.S.
  • Supply of pesos increases, demand decreases → Peso depreciates

Impact on Economy

• Currency Appreciation:
  • Imports cheaper, exports more expensive
  • Decrease in net exports → Leftward shift of aggregate demand
• Currency Depreciation:
  • Imports more expensive, exports cheaper
  • Increase in net exports → Rightward shift of aggregate demand

Conclusion

• Understanding these concepts is critical for acing economics exams
• Use ReviewEcon.com for additional resources and practice
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