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Chapter 2

Study guide - Chapter 2 Exchange Rates and Foreign Exchange Market: An Asset Approach

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Simon Fraser University
ECON 345
David Cox

Chapter 2 Exchange Rates + Foreign Exchange Market: An Asset Approach Exchange rate the price of one currency in terms of another o Is also an asset price the principles governing the behaviour of other asset prices also govern the behaviour of exchange rates o A way of transferring purchasing power f present into future o Dollareuro exchange rate closely tied to ppls expectations about the FUTURE level of that rate Goal: understand role of exchange rates in international trade + how exchange rates are determined Exchange Rates + International Transactions Exchange rates allow us to compare the prices of diff countries goods + services (compare w relative price) Exchange rate can be quoted in 2 ways o Direct dollars per foreign currency (ex: $0.05 per yen) o Indirect foreign currency units per dollar (ex: 121yen per $1) Domestic + Foreign Prices If we know exchange rate bw 2 currencies, we can compute relative price of one countrys export in terms of anothers money Changes in E = depreciation or appreciation Depreciation makes its goods cheaper for foreigners Appreciation - makes goods more expensive for foreigners When one currency depreciates against another, the second currency must simultaneously appreciate against the first *When a countrys currency depreciates, foreigners find its exports are cheaper, domestic residents find imports more expensive! (vice versa) Exchange Rates + Relative Prices Imports + exports demands (like demands for all goods + services) are influenced by RELATIVE prices Must translate to common currency when comparing Ex: $75 sweater, $45 jeans in US; 50 pounds sweater, 30 pounds jeans in Britain o Price of sweaters in terms of jeans in US = 7545 = 1.67 pairs of jeans per sweater o Price of sweaters in terms of jeans in Britain = 5030 = 1.67 pairs of jeans per sweater When E change, assume that price remains the same (ex: $45 jeans) relative price changes as exchange rate changes! *All else equal, an APPRECIATION of a countrys currency RAISES relative price of its exports + LOWERS the relative price of its imports (vice versa) The Foreign Exchange Market E determined by the interaction of households, firms, financial institutions that buy + sell foreign currencies to make international payments Foreign exchange market - the market in which international currency trades take place The Actors 1. Commercial banks Exchange of bank deposits denominated in diff currencies www.notesolution.com
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