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Chapter 19

EC223 Chapter Notes - Chapter 19: Demand Curve, The Foreign Exchange, Foreign Exchange Market


Department
Economics
Course Code
EC223
Professor
Angela Trimarchi
Chapter
19

Page:
of 2
EC223 Chapter 19 The Foreign Exchange Market Week 11
Foreign Exchange Market
-The trading of currency and assets denominated in particular currencies takes place in the foreign
exchange market
-Transactions conducted in the foreign exchange market determines the rates at which currencies are
exchanged, which in turn determine the cost of purchasing foreign goods and financial assets
What are Foreign Exchange Rates?
-Spot transactions the immediate (two-day) exchange of assets
-Forward transactions the exchange of assets at some specified future date
-Appreciation when a currency increases in value
-Depreciation when a currency decreases in value
Why are Exchange Rates Important?
-They affect the relative price of domestic and foreign goods
-When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods
abroad become more expensive and foreign goods in that country become cheaper (holding domestic
prices constant in the two countries)
-When a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that
country become more expensive
How is Foreign Exchange Traded?
-Organized as an over-the-counter market in which several hundred dealers (mostly banks) stand ready
to buy and sell assets denominated in foreign currencies
-Because retail prices are higher than wholesale, when we buy foreign exchange, we obtain fewer units
of foreign currency per dollar than exchange rates in the box indicate
Exchange Rates in the Long Run
-Exchange rates are determined by the interaction of supply and demand
Law of One Price
-If two countries produce an identical good, and transportation costs and trade barriers are very low,
the price of the good should be the same throughout the world no matter which country produces it
Theory of Purchasing Power Parity (PPP)
-Exchange rates between any two currencies will adjust to reflect changes in the price levels of the two
countries
-An application of the law of one price
-The theory of PPP suggests that if one country’s price level rises relative to another’s its currency should
depreciate (the other country’s currency should appreciate)
-The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests
on the assumption that all goods are identical in both countries and that transportation costs and trade
barriers are very low
Factors that Affect Exchange Rates in the Long Run
-If a factor increases the demand for domestic goods relative to foreign goods, the domestic currency
will appreciate; if a factor decreases the relative demand for domestic goods, the domestic currency will
EC223 Chapter 19 The Foreign Exchange Market Week 11
depreciate
Relative Price Levels
-In the long run, a rise in a country’s price level causes its currency to depreciate, and a fall in the
country’s relative price level causes its currency to appreciate
Trade Barriers
-Increasing trade barriers cause a country’s currency to appreciate in the long run
Preferences for Domestic vs. Foreign Goods
-Increased demand for a country’s exports causes its currency to appreciate in the long run; conversely,
increased demand for imports causes the domestic currency to depreciate
Productivity
-In the long run, as a country becomes more productive relative to other countries, its currency
appreciates
Explaining Changes in Exchange Rates
Shifts in the Demand for Domestic Assets
Domestic Interest Rate
-An increase in the domestic interest rate shifts the demand curve for domestic assets to the right and
causes the domestic currency to appreciate
-A decrease in the domestic interest rate shifts the demand curve for domestic assets to the left and
causes the domestic currency to depreciate
Foreign Interest Rate
-An increase in the foreign interest rate shifts the demand curve to the left and causes the domestic
currency to depreciate; a fall in the foreign interest rate shifts the demand curve to the right and causes
the domestic currency to appreciate
Changes in the Expected Future Exchange Rate
-A rise in the expected future exchange rate, shits the demand curve to the right and causes an
appreciation of the domestic currency
-A fall in the expected future exchange rate, shifts the demand curve to the left and causes a
depreciation of the currency
-Summary table on p. 509 copy out for study notes!!!