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# Economics Essay

782 words - 4 pages

Macroeconomics BE-202

Exchange Rate Determination and Open Economy Macroeconomics

Recall fiscal policy mainly works through consumption spending (C) and government spending (G). Monetary policy has a major impact on investment spending (I).

Question: What is the major factor influencing net export?

1. Exchange Rates
An exchange rate is the # of units of one currency trading for one unit of another currency.

Example: Assume that 4 Euros (€) trade for 1 U.S. Dollar (USD). The exchange rate would be 4€/1USD = 4.

Today: €4 = 1USD or €1 = 0.25USD
Tomorrow: €2 = 1USD or €1 = 0.50USD

When we can obtain more € per USD, the USD is said to appreciate against the €, or ...view middle of the document...

€/USD

S\$

4

D\$

USD/day

Determinants of exchange rates

Any factor that changes the demand or supply for a currency will cause a change in the exchange rate.

Question: What factors cause changes in exchange rates?

There are long-run factors, medium-run factors, short-run factors, and very short-run factors that can cause changes in exchange rates.

a) Long-run factors:
Relative price levels between countries (Purchasing Power Parity (PPP)).

Assume that a Big Mac costs \$2.00 in the U.S. and costs €8 in France.  €8 = \$2 or €4 = \$1

Exchange rate = Price level in France / Price level in U.S.
As PU.S.  relative to PFrance  demand for U.S. goods falls  demand for \$   \$ depreciates

Point: If our economy experiences an inflation rate which is higher than our trading partners, our currency will depreciate.

b) Medium-run factors:
Level of economic activity as measured by real GDP (Y)

Assume that YU.S.   Disposable income in the U.S.   Consumption in the U.S.   U.S. imports   U.S. residents demand more French francs and hence supply more dollars  \$ depreciates
Point: If our economy grows faster than our trading partners, our currency will depreciate.

c) Short-run factors:
Relative interest rates (i)

Assume that iU.S.   international investors will find investing in the U.S. more attractive  Demand for \$   \$ appreciates

This also results in a capital inflow.

...

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