Class Notes (839,394)
Canada (511,324)
Economics (953)
Lecture

Chapter 25 Notes.docx

12 Pages
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Department
Economics
Course Code
Economics 1022A/B
Professor
Jeannie Gillmore

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Chapter 25 Notes Foreign Exchange Market  when we talk about foreign money, we refer to it as foreign currency o foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits o we buy foreign currencies and foreigners buy Canadian dollars in the foreign exchange market Trading Currencies  the currency of one country is exchanged for the currency of another in the foreign exchange market o is made up of importers and exporters, banks, international investors and speculators, international travellers, and specialist traders called foreign exchange brokers o opens on Monday morning in Australia and Hong Kong  around $3 trillion is traded a day ($600 trillion in a year) Exchange Rate  an exchange rate is the price at which one currency exchanges for another in the foreign exchange market o e/x on 1 September 2011, 1 Canadian dollar bought 79 Yen, so the exchange rate was 79 yen per Canadian dollar  a rise in the exchange rate is called an appreciation of the dollar, and a fall in the exchange rate is called depreciation of the dollar o e/x when the exchange rate rises form 79 yen to 100 yen per dollar, the dollar appreciates Exchange Rate is a Price  an exchange rate is a price (the price of one currency in terms of another), determined in the foreign exchange market  the Canadian dollar trades in foreign exchange market and is supplied and demanded by traders o because it has many traders and no restrictions on who may trade, the foreign exchange market is a competitive market o since it is a competitive market, the supply and demand determine the price Demand for One Money is the Supply of Another Money  when people who are holding the money of some other country want to exchange it for Canadian dollars, they demand Canadian dollars and supply that other country’s money (and vice-versa) o the factors that influence the demand for Canadian dollars also influence the supply of US dollars, euros, yen, etc. o the factors that influence the demand for that other country’s money also influence the supply of Canadian dollars Demand in the Foreign Exchange Market  people buy Canadian dollars in the foreign exchange market so that they can buy Canadian produced goods and services (Canadian exports) as well as other Canadian financial assets (e/x stocks, bonds, etc.)  the quantity demanded depends mainly on the following factors: o exchange rate o world demand for Canadian exports o interest rates in Canada and other countries o expected future exchange rate The Law of Demand for Foreign Exchange  ceteris parabas, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign exchange market o e/x if the price of Canadian dollar rises from 80 to 90 cents US, the quantity that people plan to buy in the foreign exchange market decreases  the exchange rate influences the quantity of Canadian dollars demanded for two reasons: o exports effect  the larger the value of Canadian exports, the larger is the quantity of Canadian dollars demanded in the foreign exchange market  however, the value of Canadian exports depends on the prices of Canadian-produced goods and services expressed in the currency of the foreign buyer, which depend on the exchange rate  the lower the exchange rate, the lower the prices of Canadian- produced goods to foreigners, and the greater volume of exports  if exchange rate falls, the quantity of Canadian dollars demanded in the foreign exchange market increases o expected profit effect  the larger the expected profit from holding Canadian dollars, the greater is the quantity of Canadian dollars demanded in the foreign exchange market  however, expected profit depends on exchange rate  for a given expected future exchange rate, the lower the exchange rate today, the larger is the expected profit from buying Canadian dollars today and holding them, the greater is the quantity of Canadian dollars demanded in the foreign exchange market today Demand Curve for Canadian Dollars  an increase in the exchange rate decreases the quantity of dollars demanded  a decrease in the exchange rate increases the quantity of dollars demanded Supply in the Foreign Exchange Market  people sell Canadian dollars and buy other currencies so that they can buy foreign-produced goods and services (Canadian imports) as well as other foreign assets (e/x stocks, bonds)  the quantity of Canadian dollars supplied depends on four main factors: o exchange rate o Canadian demand for imports o interest rate in Canada and other countries o expected future exchange rate The Law of Supply of Foreign Exchange  ceteris parabas, the higher the exchange rate, the greater is the quantity of Canadian dollars supplied in the foreign exchange market o e/x if the exchange rate rises from 100 yen to 120 yen per Canadian dollar, the quantity of Canadian dollars that people plan to sell in the foreign market increases  exchange rate influences the quantity of dollars supplied in two ways: o imports effect  the larger the value of Canadian imports, the larger is the quantity of Canadian dollars supplied in the foreign exchange market  however, the value of Canadian imports depends on the prices of foreign-produced goods and services expressed in Canadian dollars, which depend on the exchange rate  the higher the exchange rate, the lower the prices of foreign produced goods and services to Canadian and the greater is the import volume  if the exchange rate rises, the quantity of Canadian dollars supplied in the foreign exchange market increases o expected profits effect  the higher the exchange rate today, the larger is the expected profit from selling Canadian dollars today and holding foreign currencies, so the greater is the quantity of Canadian dollars supplied Supply Curve for Canadian Dollars  a rise in the exchange rate increases the quantity of dollars supplied  a fall in the exchange rate decreases the quantity of dollars supplied Market Equilibrium  equilibrium depends on how the Bank of Canada and other central banks operate  the exchange rate acts as a regulator of the quantities demanded and supplied o if the exchange rate is too high, there is a surplus o if the exchange rate is too low there is a shortage  e/x if the exchange rate is 80¢ US per Canadian dollar, there is a shortage of Canadian dollars o all exchange rates among currencies are tied together so that no profit can be made by buying once currency, selling it for a second one, and then buying back the first Changes in Demand for Canadian Dollars  world demand for Canadian exports o an increase in the world demand for Canadian exports increases the demand for Canadian dollars o a decrease in the world demand for Canadian exports decreases the demand for Canadian dollars  Canadian interest rate relative to the foreign interest rate o the higher the interest rate the people can make on Canadian assets compared with foreign assets, the more Canadian assets they buy o the gap between the Canadian interest rate and the foreign interest rate is called the Canadian interest rate differential  the larger the CIRD, the greater is the demand for Canadian assets and the greater is the demand for Canadian dollars in the foreign exchange market  expected future exchange rate o a rise in the expected future exchange rate increases the profit that people expect to make by holding Canadian dollars and the demand for Canadian dollars increases today Change in Supply of Canadian Dollars  Canadian demand for imports o an increase in the Canadian demand for imports increases the supply of Canadian dollars in the foreign exchange market o a decrease in the Canadian demand for imports decreases the supply for Canadian dollars  Canadian interest rate relative to foreign interest rate o the larger the CIRD, the smaller the supply of Canadian dollars in the foreign exchange market  people want to keep more money in Canada as they can get a higher return o a rise in the Canadian interest rate, ceteris parabas, decreases the supply of Canadian dollars in the foreign exchange market  expected future exchange rate o a fall in the expected future exchange rate decreases the profit that can be made by holding Canadian dollars and decreases the quantity of Canadian dollars that people want to hold  to reduce holdings, people sell today  a fall in the expected future exchange rate increases the supply of Canadian dollars Changes in the Exchange Rate  if demand increases and supply is constant, exchange rate rises  if demand decreases and supply is constant, exchange rate falls  if supply decreases and demand is constant, exchange rate rises  if supply increases and demand is constant, exchange rate falls Fundamentals, Expectations, and Arbitrage  changes in the expected exchange rate change the actual exchange rate o the expected exchange rate changes because of fundamental influences on the exchange rate  the world demand for Canadian exports, Canadian demand for imports, and the Canadian interest rate relative to the foreign interest rate  expectations about these variables change the exchange rate through their influence on the expected exchange rate, and the effect is instant  e/x suppose news breaks that the Bank of Canada will raise the interest rate next week o traders now expect the demand for dollars to increase and the dollar to appreciate  they expect to profit by buying dollars today and selling them next week for a higher price than they paid  the rise in expected future value of the dollar increases the demand for dollar today, decreases the supply of dollars today, and raises the exchange rate  profiting by trading in the foreign exchange market often involves arbitrage, the practice of buying in one market and selling for a higher price in another related market o ensures that exchange rate is the same in Toronto, New York, and all other trading centres  ie. it isn’t possible to buy at a low price in London and sell for a higher price in Toronto  arbitrage also removes profit from borrowing in one currency and lending in another and buying goods in one currency and selling them in another  arbitrage brings about: o interest rate parity  suppose a bank deposit earns 1% a year in Tokyo and 3% in Toronto  people would move their funds to Toronto and even borrow in Japan in an activity called the carry trade  the Toronto deposit is in dollars and the Tokyo deposit is in yen, so a change in exchange rate brings risk to borrowing in one currency and lending in another  if investors expect the yen to appreciate by 2% a year and they buy and hold yen for a year they will earn 1% interest and expect a 2% return from the higher yen o the total expected return is 3%, the same as on Canadian dollars in Toronto  this situation is called interest rate parity, which means equal rates of return  adjusted for risk, interest rate parity always prevails  funds move to get the highest expected return available o if for a few seconds a higher return is available in Toronto than in Tokyo, the demand for Canadian dollars increases and the exchange rate rises until the expected rates of return are equal o purchasing power parity  suppose a memory stick costs 5000 yen in Tokyo and $50 in Toronto  if the exchange rate is 100 yen per dollar, the two monies have the same value, and you can buy a memory stick in either Tokyo or Toronto for the same price  this situation is called purchasing power parity, which means equal value of money  if it fails, powerful arbitrage forces go to work  suppose the Toronto price rises to $60, but Tokyo price remains 5000 y
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