ECON102 Chapter Notes - Chapter 25: Foreign Exchange Market, The Foreign Exchange, Currency Appreciation And Depreciation

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14 Feb 2016
Department
Course
Feb 3, 8 Lecture 10, 11 1
C25: The Exchange Rate and the Balance of Payments
The Foreign Exchange Market
To buy g/s in another country, we use currency of that country to make the transaction
Foreign currency: money of other countries (foreign bank notes, coins and bank deposits)
Foreign exchange market: market in which the currency of one country is exchanged for the
currency of another, where currencies are bought and sold
Made up of thousands of people (importers, exporters, banks, international investors and
speculators, international travellers, foreign exchange brokers)
Exchange rate: the price at which one currency exchanges for another currency in the foreign
exchange market
Price denoted in terms of $1 CAD
96 Yen per dollar, 70 euro cents per dollar
Price of one currency in terms of another
Currency depreciation: a fall in the value of one currency in terms of another currency, fall in the
exchange rate
Canada currency depreciated against US
Same loonie that used to get $0.95 in 2013, now gets $0.72 in 2016
Currency appreciation: a rise in the value of one currency in terms of another currency, rise in the
exchange rate
These terms apply to an exchange rate, which is "flexible" or "floating"
An Exchange Rate is a Price
Exchange is a price (the price of one currency in terms of another)
oDetermined in the foreign exchange market
oCanadian dollar demanded/supplied every day
oWith many traders and no restrictions, the foreign exchange market is a competitive
market (demand and supply determine the price)
The demand of one money Is the supply of another money
When someone holds the money of another country and wants to exchange it for Canadian
dollars, they demand Canadian dollars and supply the other country's money, and vice versa
oFactors that influence the demand for Canadian dollars also influence the supply of
foreign currency (EU euros, UK pounds, Japanese yen)
oFactors that influence the demand of another country's money also influence the supply
of Canadian dollars
Demand in the Foreign Exchange Market
People buy CAD dollars so that they can buy CAD g/s, or CAD assets (bonds, stocks,
businesses, houses)
Quantity of CAD dollars demanded: amount of Cad$ that traders plan to buy during a given
time period at a given exchange rate in the foreign exchange market
oDepends inversely on the exchange rate due to the exports effect and the expected
profit effect
Factors that influence the quantity demanded:
1. The exchange rate (movement along the curve)
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Feb 3, 8 Lecture 10, 11 2
These shift the curve
2. World demand for cad exports
3. Interest rate in the US and other countries
4. The expected future exchange rate
The law of demand of foreign exchange
Demand for dollars is a derived demand
People buy CAD dollars so that they can buy Canadian-produced g/s or Canadian assets
The law of demand: other things remaining the same, the higher the exchange rate (the higher the
price), the smaller is the quantity of Canadian dollars demanded in the foreign exchange market
Ex. if market price of CAD dollars rises from 100 yen to 120 yen, the quantity of CAD dollars
that people plan to buy in the foreign exchange market decreases
The exchange rate influences the quantity of Canadian dollars demanded for 2 reasons:
1. Exports effect
oThe larger the value of Canadian exports, the greater is the quantity of Canadian
dollars demanded on the foreign exchange market
Value of CAD exports depends on the prices of CAD g/s expressed in the
currency of the foreign buyer (which depends on exchange rate)
oThe lower the exchange rate, the greater is the value of Canadian exports, so the
greater is the quantity of Canadian dollars demanded
oEx. if price of Bombardier's airplane is 8M, and the exchange rate is 0.75 Euro/CAD
dollar, the price of the Airplane to European is 6M. If exchange rate falls to 0.60 Euro/CAD
dollar, the price falls to 4.8M. European decides to buy airplane and buys CAD dollars in
the foreign exchange market.
High
$1 CAD = $0.95 US
$1 USD = $$1.05 CAD
American can take $1 and only get 1.05
Low
1 CAD = 0.77 USD
1 USD = 1.30 CAD
But if exchange rate was low, US can get 1.30 for
every 1 USD
2. Expected profit effect
oThe larger the expected profit from holding CAD dollars, the greater is the
quantity of CAD dollars demanded in the foreign exchange market
Expected profit depends on exchange rate
The lower today's exchange rate, the larger is the expected profit from buying
CAD dollars today and holding it, so the greater is the quantity of Canadian dollars
demanded today
Example:
oIf a person can buy a Canadian dollar for $0.77 USD today, they will do so if they expect
the price to increase
oIf the exchange rate rises to $0.95 USD, they can sell the Canadian dollar and make a
profit
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Feb 3, 8 Lecture 10, 11 3
Demand Curve for Canadian Dollars
Y axis: exchange rate in foreign currency per Canadian dollar
X axis: quantity of Canadian dollars
Inverse relationship, downward sloping demand for CAD dollars
Supply in the Foreign Exchange Market
People sell CAD dollars and buy other currencies so that they can buy foreign-produced g/s
(CAD imports, assets, houses)
Quantity of Canadian dollars supplied: the amount that traders plan to sell during a given time
period at a given exchange rate in the foreign exchange market
oDepends positively on the exchange rate due to the imports effect and the expected
profit effect
Main factors
1. Exchange rate (movement along the curve)
These shift the curve
2. Canadian demand for imports
3. Interest rates in Canada and other countries
4. The expected future exchange rate
Law of supply of Foreign Exchange: the higher the exchange rate (the price), the greater the
quantity of Canadian dollars supplied in the foreign exchange market
Ex. if the exchange rate rises from 100 Yen to 120 Yen per Cad dollar, the quantity of CAD
dollars that people plan to sell in the foreign exchange market increases
Exchange rate influences the quantity of CAD dollars for 2 reasons
1. Imports effect
oThe larger the value of Canadian imports, the larger is the quantity of CAD dollars
supplied in the foreign exchange rate
Value of imports depends on the prices of foreign-produced g/s expressed in
CAD dollars (depends on exchange rate)
oThe higher the exchange rate, the lower the prices of foreign g/s (the greater is the
value of Canadian imports), so the greater is the quantity of Canadian dollars supplied
Exchange rate rises
oIf my CAD dollar can get me 0.95 USD goods, better than if I can only get 0.77 goods
2. Expected profit effect
oFor a given expected future Canadian dollar exchange rate, the lower the exchange
rate
oThe higher the exchange rate, the larger the expected profit from selling CAD dollars
and holding foreign currencies, so the greater the quantity supplied of CAD dollars in the
foreign exchange market
Supply Curve for Canadian Dollars
Y axis: exchange rate
X axis: quantity
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