International businessLesson 2 of 4 in the course Exchange Rates and International Capital Flows

Foreign-Exchange Shifts, Currency Expectations, and Purchasing Power Parity

5 flashcards · 5 quiz questions · 5 match pairs · 5 fill-in sentences · English

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Summary

This lesson introduces how demand and supply determine exchange rates and explains how expectations about future currency values can shift both curves.

Firms, households, and investors demand and supply currencies through banks and foreign exchange dealers. In a market diagram, the vertical axis records the exchange rate and the horizontal axis records the quantity of currency traded.

All flashcards

Foreign-exchange market equilibrium
The exchange rate and traded quantity at which currency demand equals currency supply.
Reciprocal exchange-rate quotes
Quotes that express the same currency relationship from opposite currency perspectives.
Relative rates of return
Higher expected returns in a country tend to attract investment and demand for its currency.
Relative inflation
Higher inflation tends to reduce demand for a currency and increase its supply.
Purchasing power parity (PPP) exchange rate
The rate that equalizes prices of internationally traded goods across countries after currency conversion.

Quiz questions

  1. If expected returns on U.S. financial assets rise relative to Mexican assets, what is a likely effect in the foreign-exchange market?Answer: Demand for U.S. dollars shifts right as investors seek dollars to buy those assets.
  2. What tends to happen to a currency when its country has higher inflation than other countries?Answer: Demand tends to fall, while supply tends to rise.
  3. What does the purchasing power parity exchange rate represent?Answer: A rate that equalizes prices of internationally traded goods after currency conversion.
  4. What is arbitrage in international goods markets?Answer: Buying and selling across borders to profit from price differences.
  5. Why can PPP exchange rates help economists compare countries' GDP?Answer: They can make comparisons less sensitive to short-term market exchange-rate fluctuations.

Based on Principles of Economics 3e by Steven A. Greenlaw, David Shapiro, Daniel MacDonald (OpenStax), licensed CC BY 4.0. Adapted into a summary, flashcards and quizzes.

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