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Department
Economics
Course
EC140
Professor
Justin Smith
Semester
Winter

Description
EC140 March 26 and 28 2013h Week 11: The Exchange Rate and the Balance of Payments - Many countries maintain their own currency - The 3 big ones: the U.S. dollar, yen, and euro. - On a day to day basis, the exchange rate between currencies changes - Why do currency exchange rates fluctuate? - There are many reasons, and we will explore them here - This will help you understand how nations interact with each other - In particular, much trade occurs between Canada and the United States, and we will see how the exchange rate enters the picture Currencies and Exchange Rates - There’s a market for buying and selling currencies (it’s just like buying or selling goods and services) - Exchange rate is the price you pay for a currency - To buy goods and services produced in another country we need money of that country. - Foreign bank notes, coins, and bank deposits are called foreign currency. - We get foreign currency and foreigners get Canadian dollars in the foreign exchange market. - Foreign exchange market: the market in which the currency of one country is exchanged for the currency of another. - Exchange rate: the price at which one currency exchanges for another. - Ex: On Mar 18, the Canada-U.S. exchange rate is 0.978 o This is the price of 1 Canadian dollar in U.S. dollars o If an American had 97.8 cents, they could buy one Canadian dollar - Ex2: On Mar 18, the Canada-Euro exchange rate is 0.76 o This is the price of 1 Canadian dollar in Euros - A fall in the value of one currency vs. another is currency depreciation. o If CA-US exchange rate goes to 0.965, the CA$ depreciates o But, the U.S. dollar appreciates - A rise in value of one currency vs. another currency is currency appreciation. - 0.965 is the number of US dollars to get a Canadian dollar - To get the number of Canadian dollars to get one US dollar you get the inverse = 1/0.965 The Demand for One Money Is the Supply of Another Money - When people who are holding $US want to exchange it for $CA, they: o Demand $CA o Supply $US - So, factors that influence the demand for $CA also influence the supply of $US (or any other currency used to buy $CA) - Also, factors that influence the demand for $US (or any other currency) also influence the supply of $CA. 1 EC140 March 26 and 28 2013 - Anything that affects the demand for Canadian dollars also affects the supply of US dollars Demand in the Foreign Exchange Market - The quantity of $CA that traders plan to buy in the foreign exchange market depends on: o The exchange rate o World demand for Canadian exports o Interest rates in Canada and other countries o The expected future exchange rate - The demand curve for $CA is the relationship between the exchange rate and quantity of $CA demanded - Holding the other factors constant - If the price of Canadian dollar is expected to rise in the future, you’d buy lots now and then sell them for the higher price (buy low, sell high) Law of Demand for Foreign Exchange - Other things equal, the higher the exchange rate (the price of a $CA), the smaller is the quantity of $CA demanded in the foreign exchange market. - Higher exchange rate increases the price of a Canadian dollar from the foreign perspective - If the CA-US exchange rate increases from 0.9877 to 1.0877, quantity of $CA demanded falls - Why is the demand curve for Canadian Dollars downward sloping? o Exports effect o Expected profit effect Exports Effect - From a foreigner’s perspective, the exchange rate determines the price of Canadian goods in foreign currency - A lower exchange rate (depreciation of $CA) lowers the price of our goods for foreigners, so they buy more. - They need more $CA to buy our goods, so they demand more - Works in reverse for an increase in the exchange rate Expected Profit Effect - The larger the expected profit from holding Canadian dollars, the greater is the quantity of Canadian dollars demanded today. o Depends on expectations about future rates - Say we expect the CA-US exchange rate to be 1 tomorrow o Since it is 0.9877 today, Americans will demand more $CA today  Because they can sell them for US$ 1 tomorrow o The lower the exchange rate today, the more $CA they demand o The higher the exchange rate today, the less $CA they demand 2 EC140 March 26 and 28 2013 The Demand Curve for Canadian Dollars - Figure illustrates the demand curve for Canadian dollars on the foreign exchange market. - Just like any other demand curve o As price goes up, quantity demanded goes down Supply in the Foreign Exchange Market - The quantity of $CA supplied in the foreign exchange market is the amount that traders plan to sell a given exchange rate. - This depends on o The exchange rate o Canadian demand for imports o Interest rates in Canada and other countries o The expected future exchange rate - The supply curve for $CA is the relationship between the exchange rate and quantity of $CA supplied The Law of Supply of Foreign Exchange - Other things equal, the higher the exchange rate, the greater is the quantity of $CA supplied - Why is the supply curve for Canadian Dollars upward sloping? o Imports effect o Expected profit effect Imports Effect - From our perspective, the exchange rate determines the price of foreign goods in Canadian currency o A higher exchange rate (appreciation of $CA) lowers the price of foreign goods from our perspective. o With a lower price, we want more foreign goods o To get those goods, we need to supply more $CA to buy the foreign currency Expected Profit Effect - For a given expected future Canadian dollar exchange rate, the lower the current exchange rate, o The greater is the expected profit from holding Canadian dollars, 3 EC140 March 26 and 28 2013h o The smaller is the quantity of $CA supplied on the foreign exchange market. - If tomorrow’s exchange rate is expected to be 1 o Given today’s is $0.9801, you want to hold on to them (supply less) o The value tomorrow is higher than the value today - But, as today’s rate rises relative to future expectations, you are more willing to supply today Supply Curve for Canadian Dollars - Figure illustrates the supply curve of Canadian dollars in the foreign exchange market. - The higher the price, the higher the quantity supplied Market Equilibrium - Figure shows how demand and supply in the foreign exchange market determine the exchange rate. - If the exchange rate is too high, a surplus of Canadian dollars drives it down. - If the exchange rate is too low, a shortage of Canadian dollars drives it up. Changes in the Demand for Canadian Dollars - Changes in things other than the exchange rate will shift the demand curve for $CA - World demand for Canadian exports - Canadian interest rate vs. foreign interest rates - The expected future exchange rate 4 EC140 March 26 and 28 2013 World Demand for Canadian Exports - At a given exchange rate, if world demand for Canadian exports increases o The demand for dollars increases o The demand curve for $CA shifts rightward Canadian Interest Rate vs. Foreign Interest Rates - Canadian interest rate differential: The Canadian interest rate minus the foreign interest rate - If the Canadian interest differential rises, o The demand for dollars increases o The demand curve for Canadian dollars shifts rightward. The Expected Future Exchange Rate - At a given current exchange rate, if the expected future exchange rate for $CA rises, o The demand for $CA increases and the demand curve for dollars shifts rightward. o Why?  People buy now in anticipation of future gains  Today’s rate is 0.9801  If tomorrow’s rate is 1, one can make a profit by buying $CA today and selling $CA tomorrow  That profit is larger if tomorrow’s rate is 1.1 - Figure shows how the demand curve for $CA shifts in response to o Changes in Canadian exports o The Canadian interest rate differential o Expectations of future exchange rates. Changes in the Supply of Dollars - Changes in anything other than the exchange rate will shift the supply curve o Canadian demand for imports o Canadian interest rate differential o The expected future exchange rate - Notice how the last two are the same factors that affect demand. o Thus we will frequently observe both curves shifting at the same time 5 EC140 March 26 and 28 2013 Canadian Demand for Imports - At a given exchange rate, if the Canadian demand for imports increases o The supply of $CA on the foreign exchange market increases o The supply curve of $CA shifts rightward. Canadian Interest Rate Differential - If the Canadian interest differential rises o The supply for $CA decreases o The supply curve of Canadian dollars shifts leftward. The Expected Future Exchange Rate - At a given current exchange rate, if the expected future exchange rate for $CA rises, o The supply of $CA decreases and the supply curve for $CA shifts leftward. o Why?  If I know the exchange rate is going up, I want to hold my $CA  Thus, I would not be in the market to sell $CA - Figure shows how the supply curve of Canadian dollars shifts in response to o Changes in Canadian demand for imports o The Canadian interest rate differential o Expectations of future exchange rates. Exchange Rate Expectations - The actual exchange rate changes when it is expected to change. o Investors try to profit from buying currency at a low price today, and selling it at a higher rate later. o Or buy selling currency at a high price today, and buying it back later at a low price. - Actual exchange rates will adjust immediately to changes in expectations, as people try to profit using the strategies above - Expectations create self-fulfilling prophecies Arbitrage - People also act on their expectations as they try to profit through “arbitrage” o Buying at a low price in one market, and selling at a high price in another. 6 EC140 March 26 and 28 2013h - Often involves people trying to: o Borrow in one currency and lending in another o Buy goods in one currency and selling in another - People automatically take advantage of opportunities so that arbitrage does not exist (if you can do it, it’s already been done) - The actions of people seeking arbitrage profits will eventually bring about two important economic phenomena o Interest rate parity o Purchasing power parity Interest Rate Parity - Interest rate parity: indifference to interest rates available on deposits in two countries, i.e. equal rates of return - Ex: Suppose the annual interest rate in a CA bank account is 5%, and 10% in a US bank account o For this to occur, people must expect the $CA to appreciate by 5%  Earn 5% on the $CA bank account, plus 5% from appreciation of currency, for a total return of 10% o If people didn’t expect the exchange rate to change, money would flow to the US - The idea is equal expected rates of return Purchasing Power Parity - Purchasing Power Parity (PPP): When two quantities of money can buy the same quantity of goods and services, which means equal value of money. - For example suppose that one Big Mac costs $5 in Canada, and 10 shekels in Israel. PPP implies that o If I convert my $5 to shekels, I should be able to get exactly one Big Mac i
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