Relative Price Levels NEXT SLIDE When prices of domestic goods rise relative to foreign goods this will cause the domestic currency to depreciate relative to foreign goods. Let’s do an example. Let’s say a basket of good costs $1000 in the United States and costs 650 pounds in the UK. What is the exchange rate? If there is inflation and the cost of good rises 10% in the United States then what does this do to the exchange rate? Trade Barriers Barriers to free trade such as tariffs and quotas will create more demand for domestic goods relative to foreign goods – this will tend to cause the domestic currency to appreciate relative to the foreign currency. Preferences for Domestic versus Foreign Goods Increased demand for a country’s exports will cause its currency to appreciate. Increased demand for foreign imports will cause a country’s currency to depreciate. Productivity When productivity rises it tends to rise in domestic sectors that produce traded goods. Higher productivity is thus associated with a decline in the price of domestically produced traded goods relative to foreign traded goods. As a result the demand for domestically traded goods increases relatively to foreign goods and thus the domestic currency tends to appreciate. Exchange Rates in the Short Run In the short term one can consider the exchange rate as the price of domestic assets in a foreign currency. We can start with a supply and demand analysis of foreign exchange rates. NEXT SLIDE Let’s start by looking at a particular exchange rate USD and EUR. The exchange rate in EUR per USD is along the vertical axis. The horizontal axis is the quantity of dollar assets. It is assumed that the supply of dollar assets does not change with the exchange rate and thus it is vertical. The demand curve takes a bit of thought. In what follows we assume that the expected forward FX rate does not change. Thus a lower exchange
Relative Price Levels NEXT SLIDE When prices of domestic goods rise relative to foreign goods this will cause the domestic currency to depreciate relative to foreign goods. Let’s do an example. Let’s say a basket of good costs $1000 in the United States and costs 650 pounds in the UK. What is the exchange rate? If there is inflation and the cost of good rises 10% in the United States then what does this do to the exchange rate? Trade Barriers Barriers to free trade such as tariffs and quotas will create more demand for domestic goods relative to foreign goods – this will tend to cause the domestic currency to appreciate relative to the foreign currency. Preferences for Domestic versus Foreign Goods Increased demand for a country’s exports will cause its currency to appreciate. Increased demand for foreign imports will cause a country’s currency to depreciate. Productivity When productivity rises it tends to rise in domestic sectors that produce traded goods. Higher productivity is thus associated with a decline in the price of domestically produced traded goods relative to foreign traded goods. As a result the demand for domestically traded goods increases relatively to foreign goods and thus the domestic currency tends to appreciate. Exchange Rates in the Short Run In the short term one can consider the exchange rate as the price of domestic assets in a foreign currency. We can start with a supply and demand analysis of foreign exchange rates. NEXT SLIDE Let’s start by looking at a particular exchange rate USD and EUR. The exchange rate in EUR per USD is along the vertical axis. The horizontal axis is the quantity of dollar assets. It is assumed that the supply of dollar assets does not change with the exchange rate and thus it is vertical. The demand curve takes a bit of thought. In what follows we assume that the expected forward FX rate does not change. Thus a lower exchange