2. Interest rates in the United States rise faster than interest rates in Canada.

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1 Exchange Rates Interaction Between Currencies When Americans buy more foreign goods, U.S. dollars are sold in the international currency market to purchase foreign currencies that are used to pay producers in their own domestic currencies. Supply and demand graphs are used to demonstrate such transactions. If the demand for one country s currency increases the currency appreciates (strengthens) in value. Currencies sold to purchase other monies depreciate (weaken) in value. Consider the following situations. In each case, an underlying event causes a change in the supply and demand for currencies. Indicate the impact of each scenario on each currency. The first example is done for you as a model. 1. The prices of U.S. goods rise relative to the prices of German goods. Rationale: Americans will demand less expensive German goods, thereby increasing the demand for euros and supplying more dollars to the foreign exchange market. The U.S. dollar depreciates. The euro appreciates. 2. Interest rates in the United States rise faster than interest rates in Canada. Rationale: Canadian investors will demand U.S. dollars to purchase U.S. investments, causing the U.S. dollar to appreciate. The supply of Canadian dollars will increase because Canadians are trading Canadian dollars for U.S. dollars. The Canadian dollar will depreciate. Adapted from: Morton, John C. Advanced Placement Economics: Microeconomics and Macroeconomics. New York, NY: National Council of Economic Education, 2001.

2 3. French tourists flock to Mexico s beaches. Rationale: The demand for pesos increases to pay for the beach vacations. The supply of euros increases because the French are exchanging euros for Mexican pesos. The Mexican peso is appreciating, and the euro is depreciating. 4. Japanese video games become popular with U.S. children. Rationale: Demand for Japanese yen increases as U.S. children buy more Japanese video games; the supply of dollars to the exchange market increases. The U.S. dollar depreciates. The Japanese yen appreciates.

3 Fiscal or Monetary Policy Expansionary monetary policy Interest Rates DECREASE RISE Domestic Investment AD Will Shift RIGHT Value of Domestic Currency DEPRECIATE Why? Foreign investors seek nations with higher interest rates on financial assets, thus decreasing the demand for the currency. Domestic investors seek nations with higher interest rates on financial assets, thus increasing the supply of the currency. Net Exports Real GDP RISE RISE RISE Price Level Contractionary monetary policy INCREASE FALL LEFT APPRECIATE FALL FALL FALL Expansionary fiscal policy RIGHT DEPRECIATE Domestic consumers will demand more goods, including foreign goods, thus increasing the supply of domestic currency and increasing the demand for foreign currency in the foreign exchange market. FALL RISE RISE Contractionary fiscal policy LEFT APPRECIATE RISE FALL FALL

4 How Monetary and Fiscal Policies Affect Exchange Rates Changes in a nation s monetary and fiscal policies affect its exchange rates and its balance of trade through the interest rate, income and the price level. Changes in the value of a country s currency may affect the balance of trade and aggregate demand. The value of real output and price levels may also be affected. Domestic policies influence currency values, and currency values influence domestic policies. The complexity of the connection leads to careful evaluation of any change in domestic policy goals. Policy makers cannot ignore the international effects of changes in monetary and fiscal policies. A series of situations is presented below. In each case: Evaluate the expected effects on exchange rates in the United States and the other country. Use the currency graphs provided to reflect changes in the currency values. Analyze the impact of the currency changes on the U.S. economy as it applies to net exports, balance of trade, aggregate demand and price levels. Work out the situations in the short run only. 1. The U.S. federal budget deficit increases, which causes the interest rate to rise. a. What will happen as a result to the loanable funds markets in the United States and Great Britain? British investors will want to buy U.S. bonds. c. In Graph B, the British pound (appreciates / d. As a result of the changing value of the U.S. dollar, i. U.S. exports (increase / decrease) because: It takes more pounds to buy each dollar; therefore U.S. goods cost more in pounds than previously, and exports to Great Britain decrease. ii. U.S. imports (increase/decrease) because: Each dollar buys more pounds; therefore British goods are cheaper in U.S. dollars, and imports from Great Britain increase. iii. U.S. aggregate demand shifts (left / right). iv. Price levels in the United States will (rise / fall).

5 2. The U.S. government initiates a personal income tax reduction plan, leaving every tax-paying American with more disposable income. a. What will happen as a result to trade between the United States and Taiwan? Americans will buy more Taiwanese and domestic goods. c. In Graph B, the Taiwanese dollar (appreciates / d. As a result of the fiscal policy, i. U.S. aggregate demand shifts (left / right). ii. Price levels in the United States (rise / fall). iii. U.S. imports (increase / decrease) because: The increase in disposable income increases the demand for all goods, including foreign goods. Furthermore, the increase in U.S. prices makes foreign goods relatively less expensive. iv. U.S. exports (increase / decrease) because: The relative price to foreigners of U.S. goods has increased, so foreigners buy less. 3. Japan s fiscal policies lead to an increase in Japan s real GDP. a. What will happen as a result to trade between the United States and Japan? Japan buys more U.S. goods because Japanese incomes rise. c. In Graph B, the Japanese yen (appreciates / d. As a result of the changing value of the U.S. dollar, i. U.S. exports will (increase / decrease) because: It takes more yen to buy each dollar; therefore U.S. goods cost more in yen than previously, and exports to Japan decrease. iii. U.S. aggregate demand shifts (left / right). ii. U.S. imports will (increase / decrease) because: Each dollar buys more yen; therefore Japanese goods are cheaper in U.S. dollars, and imports from Japan increase. iv. Price levels in the United States (rise / fall).

6 4. There is a rapid increase in the Canadian price level while the U.S. price level remains relatively constant. a. What will happen as a result to trade between the United States and Canada? Canadians will want to buy U.S. goods. c. In Graph B, the Canadian dollar (appreciates / d. As a result of the changing value of the U.S. dollar, i. U.S. exports (increase / decrease) because: It takes more Canadian dollars to buy each U.S. dollar; therefore U.S. goods cost more in Canadian dollars than previously. Therefore exports to Canada decrease. iii. U.S. aggregate demand shifts (left / right). ii. U.S. imports (increase / decrease) because: Each U.S. dollar buys more Canadian dollars; therefore Canadian goods are cheaper in U.S. dollars. Therefore imports from Canada increase. iv. Price levels in the United States (rise / fall).