[MUSIC] This section on exchange rates is going to center on how the value of a currency is determined. And, of course, we're all interested in this. You're interested in knowing what makes your currency go up or down. And maybe even more interesting, what could make it go up or down in the future so that you're ready for that change before it comes. And the good news is that, in some ways, this is a very simple market to analyze. What we'll use to describe and to predict the value of a currency is the simple supply and demand diagram that you would have used in microeconomics. And I'm going to be drawing it for you in just a moment, but I'd like you just now to maybe grab a piece of paper and sit down and draw it on the paper. What we'll do is we'll draw this normal supply and demand diagram. There's an axis, a vertical axis, which will be the price of the currency. It's the exchange rate, technically. It's how many units of a foreign currency you need to buy one unit at the domestic currency. So just call that the price of the currency, the vertical axis. And then horizontal axis, it goes this way, is the quantity of the currency that is traded at different prices, okay? Since this is a very, very competitive market, a very free market in most cases, we've got hundreds, thousands, millions of transactions happening in any given moment in time in a currency. And these different transactions will give rise to supply of the currency and a demand of the currency which we can show on this graph. So start with the supply, you're going to draw the supply curve upward. The idea is that when the price of the currency is low, not a lot of people want to supply it on the market. When the price of the currency is high, we do supply it because we get a lot of foreign currency for it, so we're happier to trade. Okay, so the supply curve will go this way. The demand curve, then, you can draw slopping downward from left to right as all demand curves do, okay? And the demand curve shows, at a high price for the currency we don't want to buy very much of it. At low price for the currency we want to buy a lot of it, okay? Now the question we want to answer is, where is the equilibrium value of the currency? And you can already see this on the graph that you've just drawn. You're going to see that where the two curves coincide, that's equilibrium, that will be the price for the currency at any given moment in time. In economics, equilibrium just means rest. That doesn't mean it's the perfect value, the ideal value, the stable value. It can keep moving all the time. And if you have ever observed currency markets, you can see that a currency that's widely traded like the dollar can be moving every second up and down. Okay, so equilibrium may move. But what we want to see here is what drives that equilibrium. Well, the first thing that would drive the equilibrium if we're thinking on the supply side, why would I supply, say, dollars to the international currency market? Well, I would supply dollars so that I can buy imports from other countries. If I want to buy a Japanese car, the importer will first have to provide the dollars by the yen, and then obtain the car. So imports lead to a supply of a currency. Another thing that leads to a supply of a currency is when money flows out of the country to be invested in foreign asset. So, say, an American investor wanted to buy Japanese government bonds, this would be outward foreign investment, we'll talk about this when we get to the payments. They first supply the dollars then they buy the yen and they obtain the bond, okay? Now, if you're thinking this through as we go, you're realizing as I supply dollars I'm demanding yen, okay? So we could draw two graphs and we could show both of these movements occurring. But right now, we'll just think of one, okay? Now another source of supply of a currency is that, thinking of the US and Japan, is that Americans go and visit Japan. Now they may be going for travel, for business, tourism, whatever, they go to Japan, they supply their dollars. They buy the yen and then they carry out their tourism or their business, whatever they're there for, okay? So these are the three big sources of supply of a currency. It would be imports from a foreign country. It would be purchase of foreign assets. And it would be travel to that country. Now additionally, there are some other sources of supply. And we'll be talking about these, maybe when we get to the demand side, it would be easier. Speculation and government intervention also will affect the supply of the currency. I'll leave that for just a few moments later. So, we've got our supply curve. Now, what will determine the demand curve? What will determine its shape, its position, and what might cause it to move. Well, it's just the mirror image of those same transactions. So with dollars and yen, say, I want to, that I'm going to sell my goods to Japan, okay? The Japanese that are going to buy my goods, will have to first buy the dollars, they will demand dollars as I export goods. So export leads to a demand of the currency. Then, if foreigners want to buy my assets, they want to buy a factory, they want to buy a government bond. First they come, they demand the dollars and then they buy the asset. So, any inward foreign investment leads to a demand of the currency. And then, of course, travel from abroad. So, they come to my country, as soon as they hit the border, they're going to buy dollars with their currency. Or maybe it's a big transaction, they use a debit card. But in any case, in this virtual foreign currency market, there's a demand for the currency occurring when foreigners come to our country. Now speculation and intervention are two other activities that we see these affecting currencies very much in the short run. I'll be talking about intervention in a moment, government intervention, just to think about speculation. Maybe, again, thinking of the dollar and the yen, maybe speculators think that something's going to happen to cause the dollar to rise. We'll be talking about specific determinants in just a moment. But imagine that speculators think the interest rate in the United States is going to rise, okay? It's going to go up, and this would attract money into US assets. So I think the dollar's going to rise, therefore, I buy the dollar now. Okay, and so, this would be speculation, something that may happen in the future, expectations, they could be wrong. But what will happen is that it will lead to demand for the dollar, supply of the yen in this particular case. All of these different sources of supply and demand will cause this very dynamic diagram to be moving, and the the equilibrium which is the price of the currency to be shifting all the time. [MUSIC]