#AP Macroeconomics: Exchange Rates - The Night Before 🌃

Hey! Let's nail this exam. We're going to break down exchange rates, how they work, and what makes them tick. Think of this as your last-minute cheat sheet, packed with everything you need to feel confident. Let's get started!

#What are Exchange Rates?

Exchange rates are simply the price of one currency in terms of another. It's how much of one currency you need to buy another. Think of it like a price tag for different countries' money. 💰

• Increase in Exchange Rate: Means it's more expensive to buy that currency, making goods from that country pricier.
• Decrease in Exchange Rate: Means it's cheaper to buy that currency, making goods from that country cheaper.

#The Gold Standard: A Blast from the Past 🕰️

Before the Great Depression, many countries used the gold standard. This meant exchange rates were fixed and tied to the value of gold.

• Fixed Exchange Rates: No daily fluctuations, unlike today.
• Arbitrage: People could exploit price differences by trading gold between currencies. (Buy gold with dollars, use gold to buy francs, use francs to buy more dollars).
• Problem: It didn't work well, often causing trade imbalances. Many economists believe it contributed to the Great Depression.

#Cost of a US Dollar: Appreciation vs. Depreciation

Let's look at some examples:

Cost of one U.S. Dollar

• British Pound: Exchange rate increased (.75 to .80). The pound appreciated (became more expensive).
• Euro: Exchange rate decreased (1.10 to 1.05). The euro depreciated (became less expensive).

Calculating Prices: To find the price of a U.S. good in another currency, multiply the U.S. price by the exchange rate. Example: $300 hotel room in the U.S. = 💷225 in Britain (if the exchange rate is .75).$

#Factors That Change Exchange Rates: Supply and Demand 📈

Exchange rates are determined by supply and demand, just like any other market. Think of it as the price of "buying a pound" with dollars.

#1. Consumer Tastes 😋

• Scenario 1: Americans love European goods:

  • Demand for euros increases (to buy those goods).
  • Demand curve for euros shifts right. ➡️
  • Price of euros increases (dollar depreciates).

  

  • X-axis: Quantity of euros, Y-axis: Dollar price of a euro.

• Scenario 2: Europeans love American goods:

  • Demand for dollars increases.
  • Demand curve for dollars shifts right. ➡️
  • Price of dollars increases (dollar appreciates).

  

  • X-axis: Quantity of dollars, Y-axis: Euro price of a dollar.

• Key Point: Changes in demand for one currency affect the other currency. If demand for euros goes down, the dollar appreciates.

#2. Relative Income 💰

• Higher Income = More Spending: If a country's GDP and incomes rise, people buy more of everything, including foreign goods.
• Example: If Europe is booming and the US is in recession, Europeans will buy more US goods, increasing the demand for dollars and appreciating its value.

#3. Relative Inflation 🎈

• High Inflation = More Imports: If one country has higher inflation than another, its consumers will buy cheaper goods from the other country.
• Example: If Europe has high inflation, US goods will seem cheaper. Demand for US goods increases, and the dollar appreciates.

#4. Speculation 🤔

• Currency as Assets: Investors buy and sell currencies to make a profit.
• Example: If investors expect US interest rates to fall relative to Europe, they'll buy more euros, increasing the euro's value and depreciating the dollar.

<memory_aid> Remember the factors using the acronym 'TIRS':

• Tastes (consumer preferences)
• Income (relative income levels)
• Relative Inflation
• Speculation </memory_aid>

<exam_tip>

• When analyzing exchange rate shifts, always consider which currency's demand is changing and how it affects the other currency.
• Use supply and demand graphs to visualize the shifts and their impact on exchange rates. </exam_tip>

#Final Exam Focus 🎯

• High-Value Topics: Understand the relationship between exchange rates, net exports, and aggregate demand. Focus on how changes in exchange rates affect trade balances.
• Common Question Types:
  • MCQs on currency appreciation/depreciation and their effects on trade.
  • FRQs requiring you to analyze how specific events impact exchange rates and trade.
• Time Management: Quickly identify the key concepts in each question. Use graphs to support your answers in FRQs.
• Common Pitfalls:
  • Confusing appreciation with depreciation.
  • Forgetting the reciprocal relationship between currencies.
  • Not considering the impact of exchange rates on aggregate demand.

<high_value_topic>

• Impact on Net Exports: A weaker currency (depreciation) makes exports cheaper and imports more expensive, potentially increasing net exports (X-M). A stronger currency (appreciation) does the opposite. </high_value_topic>

#Practice Questions

<practice_question>

#Multiple Choice Questions

1. If the exchange rate between the US dollar and the Japanese yen changes from1 = ¥100 to $1 = ¥110, then: (A) The dollar has depreciated, and US goods are now cheaper for the Japanese. (B) The dollar has appreciated, and US goods are now cheaper for the Japanese. (C) The dollar has depreciated, and US goods are now more expensive for the Japanese. (D) The dollar has appreciated, and US goods are now more expensive for the Japanese. (E) There is no change in the dollar's value.

2. Which of the following would cause the dollar to depreciate? (A) An increase in US interest rates relative to other countries. (B) An increase in demand for US exports. (C) An increase in the US inflation rate relative to other countries. (D) An increase in US productivity relative to other countries. (E) A decrease in speculation that the dollar will appreciate.

3. If a country's currency appreciates, what is the likely effect on its net exports? (A) Net exports will increase because imports become cheaper. (B) Net exports will decrease because exports become more expensive. (C) Net exports will remain unchanged because exchange rates do not affect trade. (D) Net exports will increase because exports become cheaper. (E) Net exports will decrease because imports become cheaper.

#Free Response Question

Assume the United States and Canada are trading partners. The current exchange rate is 1 US dollar = 1.3 Canadian dollars.

(a) Draw a correctly labeled graph of the foreign exchange market for the Canadian dollar, showing the supply and demand curves. Indicate the equilibrium exchange rate and quantity of Canadian dollars.

(b) Suppose that Canadian consumers develop a strong preference for US goods. On your graph in part (a), show the effect of this change on the demand for the Canadian dollar. Explain how this change will affect the exchange rate between the US dollar and the Canadian dollar.

(c) What will be the effect of the change you identified in part (b) on the US net exports? Explain.

(d) Suppose that the Canadian central bank wants to keep the exchange rate constant. What action can the Canadian central bank take in the foreign exchange market to achieve this goal? Explain.

#FRQ Scoring Guidelines

(a) Graph (3 points):

• One point for correctly labeled axes (Quantity of Canadian dollars on the x-axis, Price of Canadian dollar in US dollars on the y-axis).
• One point for correctly drawn supply and demand curves.
• One point for showing the equilibrium exchange rate and quantity.

(b) Demand Shift and Exchange Rate (3 points):

• One point for showing a leftward shift of the demand curve for the Canadian dollar.
• One point for correctly explaining that the demand for the Canadian dollar decreases because Canadians are buying more US goods.
• One point for explaining that the Canadian dollar depreciates (or the US dollar appreciates).

(c) Effect on US Net Exports (2 points):

• One point for stating that US net exports will increase.
• One point for explaining that the US dollar appreciation makes US goods cheaper for Canadians, increasing US exports and decreasing US imports.

(d) Central Bank Intervention (2 points):

• One point for stating that the Canadian central bank should buy Canadian dollars in the foreign exchange market.
• One point for explaining that this increases the demand for Canadian dollars, counteracting the initial leftward shift in demand.

Alright, you've got this! Review these concepts, take a deep breath, and go crush that exam. You're ready! 💪