MGEB06H3 Lecture Notes - Lecture 11: Foreign Exchange Market

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Macroeconomics Notes: Lecture Eleven (Chapter Nineteen Part TWO):
The Role of Exchange Rate
ā€¢ A countryā€™s BOP accounts record the countryā€™s international transactions with the rest of the
world; it also gives us the sources of demand for and supply of a countryā€™s currency in the
foreign exchange market.
ā€¢ A simple demand-supply model can be used to discuss the determination of exchange rate in
the foreign exchange market.
Understanding Exchange Rate
ā€¢ Exchange rate (E) is the price of one currency in terms of another currency.
ā€¢ In our class, exchange rate is quoted as the number of foreign currency (FC) needed to
exchange a unit of domestic currency (DC); i.e., EFC/DC.
ā€¢ Exchange rate is determined in the foreign exchange market, which is mainly an over-the-
counter market.
ā€¢ When EFC/DC ļ‚­, this means more FC are needed to exchange one unit of DC ļƒž DC appreciates.
ā€¢ When EFC/DC ļ‚Æ, this means fewer FC are needed to exchange one unit of DC ļƒž DC
depreciates.
ā€¢ Note: When one currency appreciates, the other currency depreciates because the exchange
rate is a relatively price of a countryā€™s currency.
The Equilibrium Exchange Rate
ā€¢ We will develop a simple model for the foreign exchange market.
ā€¢ Demand for domestic currency, DDC, comes from exports of goods, services, and assets.
ā€¢ Supply of domestic currency, SDC, comes from imports of goods, services, and assets.
Inflation and Real Exchange Rates
ā€¢ The exchange rate, EFC/DC, we have been talking about is the nominal exchange rate, which
is unadjusted for the international difference in aggregate price levels.
ā€¢ Real exchange rate, REFC/DC, is exchange rate adjusted for international differences in
aggregate price levels, i.e.,
REFC/DC = EFC/DC ļ‚“ īƉī²¹
īƉī²·
ā€¢ We believe that a countryā€™s net exports and current account depend on the real change rate
because a countryā€™s products become cheaper only when the countryā€™s currency depreciates in
real terms (i.e., it take fewer units of foreign goods to exchange a unit of domestic goods).
ā€¢ In the short run, prices are sticky; changes in real exchange will be caused by changes in
nominal exchange rate.
ļƒž Thus, we can argue that in the income-expenditure model (where prices are held fixed),
exports and imports depend on nominal exchange rate.
Exports function: X = X0 ā€“ X1 ļ‚“ EFC/DC
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