Class Notes (1,100,000)
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Lecture 35

ECO100Y5 Lecture Notes - Lecture 35: Tim Hortons, Big Mac Index, Shortage


Department
Economics
Course Code
ECO100Y5
Professor
Kalina Staub
Lecture
35

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ECO100: Chapter 35 - EXCHANGE RATES!
March 24th, 2014 !
!
Businesses in every country sell their product and pay their workers in __LOCAL__ currency.
Therefore, __FOREIGN EXCHANGE MARKETS __ are needed if people in one country want to
purchase goods from another.!
!
The exchange rate is __PRICE OF 1 UNIT OF FOREIGN CURRENCY IN TERMS OF LOCAL
CURRENCY_. For example the Canada-US exchange rate is the number of _CANADIAN_
dollars it takes to purchase one _US_ dollar. As of yesterday, this was _1.12___ CAD/USD.!
> 1/1.12 USD/CAD = 0.89 USD/CAD (we’ll be talking about how much it costs in Canadian
dollars to buy a unit of another currency) !
!
!
If this exchange rate increases, then the CAD is _DEPRECIATING__ or it costs more CAD to
purchase one USD.!
!
If this exchange rate decreases, then the CAD is __APPRECIATING___ or it costs fewer CAD
to buy one USD.!
!
If we want to think about the market for foreign exchange, we need to consider both the
___SUPPLY FOR FOREIGN EXCHANGE _ and the _DEMAND FOR FOREIGN EXCHANGE_.!
!
!
The _DEMANDERS_ of foreign currency are also the __SUPPLIERS__ of local currency.!
!
So let’s think about the supply and demand of USD:!
!
The supply of foreign exchange comes from Americans wanting to _BUY CANADIAN
EXPORTS_ (therefore they want to sell their USD for CAD), __PURCHASE CANADIAN
ASSETS_, and __DEMAND FOR CANADIAN DOLLAR RESERVES AT U.S INSTITUTION__. !
!
The quantity of USD supplied will increase as the CAD _DEPRECIATES_ (or the exchange rate
_INCREASES_) therefore, the supply curve will be __UPWARD_ sloping.!
!
The demand for foreign exchange comes from Canadians wanting to __US IMPORTS__,
__BUY U.S ASSETS___, or _CANADIAN INSTITUTIONS WANT TO INCREASE THEIR
RESERVE OF US DOLLARS_. The quantity of USD demanded will increase as the CAD
__APPRECIATES__, therefore the demand curve for USD will be __DOWNWARDS__ sloping.!
!
!
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Putting this together:!
!
!
e(cad/USD)!
!!!!! Q*!
!!!!! Q of USD !
!
Flexible Exchange rates!
If exchange rates are flexible, the exchange rate is then determined __BY THE INTERSECTION
OF S AND D IN FOREIGN EXCHANGE MARKET _.!
!
If e>e*, there will be __EXCESS SUPPLY__ of foreign exchange (or _EXCESS DEMAND__ for
CAD). This excess supply will force the exchange rate _DOWNWARDS_, or _APPRECIATE
the CAD.!
!
If e<e*, there will be _EXCESS DEMAND_ for foreign exchange (or _EXCESS SUPPLY E2_ of
CAD). This excess demand will force the exchange rate _UPWARDS__, or
___DEPRECIATE___ the CAD until __QD=QS__.!
!
What changes flexible exchange rates?!
1. Changes in the supply of foreign exchange!
-A change in the world price of exports !
!- world price of lumber increases, and Canada is an exporter of lumber, then people are !
!going to need more Canadian dollars to buy lumber. Supply more foreign exchange to !
!market !
-Inflation: if there is higher inflation in Canada compared to the US, then Americans want to
buy fewer Canadian exports since price increased. Supply of USD decreases !
-Interest rates: if Canada interest rate rises in the Canada rises compared to interest rate in
the US, then Americans are going to more Canadian Assets and will supply more USD to
market. !
-Changes in foreign preferences for Canadian exports. !
S of USD
D of USD
e*
e1
e2
CAD appreciates !
!
!
CAD depreciates
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