ECON 1010 Lecture Notes - Lecture 5: Crawling Peg, Interest Rate Parity, Arbitrage

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13 Sep 2016

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Econ1010 chapter 25: the exchange rate and the balance of payments . Canadian tire imports snow blower -> pays yen. China airline buys an airplane -> pays canadian. Foreign currency the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. Foreign exchange market the market where the currency of one country is exchanged for the currency of another. Dealers around the world are in continual contact by telephone and computer. Exchange rate the price at which one currency exchanges for another currency in the foreign exchange market. A rise in the exchange rate -> appreciation of the dollar. A fall in the exchange rate -> depreciation of the dollar. Foreign exchange market has many traders and no restriction on who may trade -> the foreign exchange market is a competitive market. In a competitive market, demand and supply determine the price.

Related Questions

Assume that the U.S. dollar and the Japanese yen are the only two currencies in the world.

a. A bilateral nominal exchange rate S is the spot (now) exchange value of one currency in terms of the other and S can be written as dollars per 1 yen or yen per 1 dollar. If S = yen/1 dollar = 76.92 then the inverse 1/S gives dollars per 1 yen where 1/S = 1/(yen/1 dollar) = 1/76.92 = .013. If the 1/S increases to .014, has the dollar appreciated (1 dollar is worth more yen) or depreciated (1 dollar is worth less yen)? Explain.

b. Changes in demand and supply in the foreign exchange (FX) market determine the value of floating exchange rates S. If S is expressed as S = yen/1 dollar, then we have the FX market in terms of the demand and supply of dollars. (If S = dollars/1 yen, then we get the FX market in terms of the demand and supply of yen. Note also that no matter which currency the FX market is expressed, it is still an FX market where dollars are exchanged for yen. This means that an upward-sloping supply of dollars curve is exactly the same as a demand for yen curve and a downward-sloping demand for dollars curve is exactly the same as a supply of yen curve). Using S = yen/1 dollar and the FX market in terms of the demand and supply of dollars, an increase in S (dollar appreciation) leads to an increase in the number of dollars supplied (increase in the quantity of yen demanded). For dollar demand (or the supply of yen), an increase in S (dollar appreciation) leads to a decrease in the number of dollars demanded (or an increase in the number of yen supplied). The dollar demand curve shifts to the right if more yen are offered for dollars at any exchange rate S. An increase in dollar demand is caused mostly by private sector transactions in the current and capital accounts. Either an increase in demand for U.S. goods (merchandise trade in the current account) or an increase in demand for U.S. stocks and bonds (capital account inflows) will shift the dollar demand curve to the right. If private transactions in the current and capital accounts also cause shifts in the dollar supply curve, what are the corresponding factors that would lead to an increase in dollars supplied (yen demanded) at any exchange rate S?

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ECON 1010 Lecture Notes - Lecture 5: Crawling Peg, Interest Rate Parity, Arbitrage

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