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The Role of the Exchange Rate

How do we know if FA and CA offset each other?

(1) Understanding Exchange Rates

In general, goods, services, assets produced in a country must be paid in that countrys
Foreign exchange market: market in which currencies can be exchanged for each
other; international transactions
Exchange rates: the prices at which currencies trade
When a currency becomes more valuable in terms of other currencies, it appreciates
When a currency becomes less valuable in terms of other currencies, it depreciates

(2) The Equilibrium Exchange Rate

The level of exchange rates affects exports and imports
Appreciate exports fall, imports rise
Depreciate exports rise, imports fall
Equilibrium exchange rate: the exchange rate at which the quantity of a currency
demanded in the foreign exchange markets is equal to the quantity supplied
Ex) E0.95 per $1
Hypothetical example table
At equilibrium exchange rate, total quantity of USD Europeans want to buy = total
quantity of USD US want to sell
At equilibrium rate, CA = -FA

Capital flows from Europe to US increase demand for USD increase b/c
investors change Euro into USD shift of demand curve USD appreciates
When this happens, the effects on balance of payments
FA increases, CA decreases
Seung Rim Yoo 3/8/17 1:23 AM
B/c USD appreciation US to buy more from Europe, Europe to buy less
Comment [1]: Any change in the US
from US balance of payments on FA generates an
equal but opposite reaction in the balance
Reduction in capital flow from Europe to US demand for US falls dollar depreciates of payments CA
Americans buy less European goods, Europe buys more US goods Increase in CA

(3) Inflation and Real Exchange Rates

Real exchange rates: exchange rates adjusted for international differences in
aggregate price levels

Nominal exchange rates - exchanges rates not adjusted for inflation
Ex) Peso 10 15 per USD, price index 100 150
10 x (100/100) = 10
15 x (100/150) = 10
Peso has depreciated but real hasnt changed, so nominal depreciation of peso
will have no effect on the quantity of goods exported or imported by Mexico
The CA responds only to changes in real exchange rates, not nominal
(4) Purchasing Power Parity
Purchasing power parity: the nominal exchange rate at which a given basket of goods
and services would cost the same amount in each country
Calculations are made by estimating cost of buying broad market baskets containing
many G&S
Nominal exchange rates almost always differ from purchasing power parities
Agg price level are lower in poorer countries
Even in developed countries
If two countries have similar inflation, purchasing power parity doesnt change much
Nominal exchange rate < purchasing power parity market basket is more expensive in
Canada (in Canada dollars per USD)