MGEB06H3 Lecture Notes - Lecture 11: Foreign Exchange Market
Macroeconomics Notes: Lecture Eleven (Chapter Nineteen Part TWO):
The Role of Exchange Rate
ā¢ A countryās BOP accounts record the countryās international transactions with the rest of the
world; it also gives us the sources of demand for and supply of a countryās 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 ļ DC appreciates.
ā¢ When EFC/DC ļÆ, this means fewer FC are needed to exchange one unit of DC ļ DC
depreciates.
ā¢ Note: When one currency appreciates, the other currency depreciates because the exchange
rate is a relatively price of a countryās 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“ īÆī²¹
īÆī²·
ā¢ We believe that a countryās net exports and current account depend on the real change rate
because a countryās products become cheaper only when the countryās 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.
ļ 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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