[MUSIC] Let's turn now to the important topic of Exchange Rates. An exchange rate may be defined as the rate at which one nation's currency can be traded for another nation's currency. The first thing to understand about exchange rates is that they are quoted in pairs. With one country's currency exchanging for another country's at a particular rate. Here, we see that at this particular point and time, the U.S. dollar exchanges for 12.68 Mexican Pesos. While one Swiss Franc will trade for 0.70 British Pounds. This figure illustrates how exchange rates are determined by the forces of supply and demand in the global marketplace. We are looking at the market for Dollars versus Pounds. Note, that the equilibrium exchange rate will occur at the intersection of the demand for Pounds D1 and the supply of pounds S1. What do you think that equilibrium exchange rate is? That's right. If you want to buy 1 British pound, it will cost you a full $2. The second thing to understand about exchange rates, is that they can rise and fall over time. Note, that if a country's currency gains in value relative to another, it is said to appreciate. In contrast, if a country's currency loses value relative to another, it is said to depreciate. So, here's a question. Suppose the U.S. dollar exchanges today, for 1.2 Euros, but, by next year, exchanges for 1.5 euros. As it appreciated or depreciated. In this case, $1 can by more euros so it has risen in value and therefore appreciated. In contrast, if the exchange rate falls to one euro for $1, the dollar can buy fewer euros, and therefore has depreciated. So, what do you think are some of the reasons currencies appreciate or depreciate? Basically, there're five main reasons why exchange rates change over time, gaining or losing value. These include, differing rates of GDP growth between countries, differing rates of inflation, a change in real relative interest rates, a change in taste and simple speculation. The first reason why exchange rates may move is, a change in the relative GDP growth of two nations. In a nutshell, faster GDP growth in one country like Great Britain relative to another country like the United States, will typically lead to faster income growth in that nation. This faster income growth in turn means, British consumers will increase their purchases of U.S. imports. In this case, which currency do you think will appreciate relative to the other, the English pound or the US dollar? We can use this figure to answer this question under the assumption that a recession hits the United States. In a recession, US income will fall relative to British income. As a result the U.S. will buy fewer British imports and therefore need fewer British pounds to do so. This will decrease the demand for pounds and shift the demand curve inward. The result? The dollar appreciates relative to the British pound. Now, what about differing rates of inflation? Suppose, for example, that the rate of inflation in Canada is higher than in Europe. Will the Canadian dollar appreciate or depreciate relative to the euro? In this case, the Canadian dollar will depreciate relative to the euro. Why? Because exchange rates in the currency markets, must reflect real inflation adjusted price differences in the goods markets. Here's another way of looking at this important inflation factor driving exchange rates. Suppose inflation raises the actual or nominal price of, say, an auto made in Canada relative to the nominal price of an identical auto made in Europe. In this case, there must be a corresponding adjustment in the exchange rate so that the real, inflation adjusted prices of the two autos stays the same. Economists refer to this key concept as, The Law of One Price. Now here's an interesting historical note. As we will discuss later in the lecture, differing rates of inflation played a key role in the downfall of the so called gold standard, which was a key linchpin of the international monetary system. For over 60 years. A third reason why exchange rates move has to do with changes in relative interest rates across countries. Suppose, for example, the US Federal Reserve raises interest rates, while the Bank of England takes no such action. In this case, U.S. interest rates have risen relative to those in England. Which currency will appreciate relative to the other? The dollar or the pound? And why? In this case, British investors will respond to a rise in American interest rates by shifting more of their investment funds from Britain to America. For example, they may wish to buy US government bonds at the higher interest rates. But, in order to do this, they must first sell some of their domestic investments and then exchange pounds for dollars in global currency markets. This figure illustrates the adjustment process, as British investors trade their pounds for dollars in global currency markets. This increase in the supply of pounds leads to a rightward shift of the supply curve. This in turn causes the dollar to appreciate. In the example, it now takes only $1 to buy a British pound rather than $2. Still a fourth reason for exchange rate movements is a change in tastes. For example, suppose that Japanese autos decline in popularity in the United States, perhaps because of some increased concerns over safety. What do you think will happen to the value of the Japanese yen? Clearly, the Japanese yen will depreciate relative to the U.S. dollar, as U.S. consumers reduce their purchases of Japanese autos and therefore, their demand for yen. The fifth, and final, reason for exchange rate movements has to do with currency speculation. For example, suppose currency traders believe that the Brazilian Central Bank is going to raise interest rates to fight inflation. Will currency traders be more likely to buy or sell Brazil's currency, the rial, before the Central Bank makes it's forecast and move. As we've learned, should Brazil's central bank raise interest rates, this rise in relative interest rates will likely attract more foreign investment into Brazil. This, in turn, should boost the demand for the Brazilian real. Therefore, a currency speculator is likely to buy the Brazilian real before the move. In effect, betting the real will appreciate.
