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EC140 (329)
Chapter

25. Exchange Rates.docx

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Department
Economics
Course
EC140
Professor
Rizwan Tahir
Semester
Winter

Description
Chapter 25 - Currencies and exchange rates  Whenever people buy things from another country, they used the currency of that country to make the transaction  foreign currency: money of other countries; notes, coins, bank deposits  exchange rate: price at which one currency exchanges for another currency in the exchange market - quantity of foreign money that we can buy with our dollar changes when the dollar appreciates or depreciates  To determine whether a change in the exchange rate changes what we earn from exports and pay for imports, distinguish between the monomial and the real exchange rate. - Nominal exchange rate: value of the Canadian dollar expressed in units of foreign currency per Canadian dollar. Measures how much of one money exchanges for a unit of another. - Real exchange rate: relative price of Canadian-produced goods to foreign-produced goods. It is a measure of the quantity of the real GDP of other countries that a unit of Canadian real GDP buys.  RER = E(P/P*); E is yuan/dollar (nominal), P is Canadian price level, and P* is Chinese price level - Real exchange rate changes if the nominal exchange rate changes and price levels remain constant Canadian-Dollar effective exchange rate index (CERI)  Average of the exchange rates of the Canadian dollar against the US dollar, the European Union euro, Japanese yen, UK pound, Chinese yuan, and Mexican peso.  Each currency gets a weight that represents the importance of the currency in Canada’s international trade  We can see that nominal and real exchange rates moved in the same direction, but the nominal exchange rate appreciated by less and depreciated by more than the real exchange rate. The absence of a gap between the real and nominal exchange rate results from the fact that the inflation rates in Canada and other countries were similar. Foreign exchange market  where currency of one country is exchanged for the currency of another - importers, exporters, banks, international travellers, specialist traders ; foreign exchange brokers  because the market has many traders and no restrictions on who may trade, it is a competitive market  demand and supply determine the price Demand  the demand for one money is the supply of another money  people buy Canadian dollars in the foreign exchange market so that they can buy Canadian produced goods and services (exports), and assets (bonds, stocks, businesses, and real estate) so that they can keep part of their money in a Canadian dollar bank account  Quantity of Canadian dollar demanded in the foreign exchange market is the amount that traders plan to buy during a given time period at a given exchange rate. This quantity depends on: 1. exchange rate  movement along the curve 2. world demand for Canadian exports: rise in world demand = rise in demand for Canadian dollars 3. interest rates in Canada and other countries: the higher the interest rate that people can earn on Canadian assets compared with foreign assets, the more Canadian assets they buy - Canadian interest rate differential: what matters isn’t the level of interest rate, but the Canadian interest rate minus the foreign interest rate  the larger the differential, the more demanded 4. the expected future exchange rate: a rise in expected future exchange rate increases demand  A change in the exchange rate, others remaining the same, brings a change in the quantity of Canadian dollars demanded and a movement along the demand curve  X axis = quantity, y axis = exchange rate The law of demand for foreign exchange  shows how exchange rate is determined relationship between quantity of Canadian dollars demanded, and the exchange rate when the other 3 influences remain the same  Other things remaining the same, the higher the exchange rate, the smaller is the quantity of Canadian dollars demanded in the foreign exchange market.  The exchange rate influences the quantity of Canadian dollars demanded for 2 reasons 1. Exports effect: the larger the value of Canadian exports, the larger the quantity of Canadian dollars demanded. The value of Canadian exports depends on the prices of Canadian goods expressed in the currency of the foreign buyer, and these prices depend on exchange rate. 2. Expected profit effect: the larger the expected profit from holding Canadian dollars, the greater is the quantity of Canadian dollars demanded in the foreign exchange market. The expected profit depends on exchange rate  lower the exchange rate, the larger the expected profit. Supply  People sell Canadian dollars and buy other currencies so that they can buy foreign-produced goods and services  Canadian imports  They also sell Canadian dollars for foreign currencies so they can buy foreign assets (ex: bonds)  Quantity of Canadian dollars supplied in foreign exchange market = amount that traders play to sell during a given time period at a given exchange rate. This quantity depends on 1. The exchange rate  change means a change in QS and a movement along the supply curve 2. Canadian demand for imports: rise in demand for imports means rise in supply of Canadian $ 3. Interest rates in Canada and other countries  rising interest of other countries means better to save somewhere else than in Canada, so sell Canadian currency for foreign currency - The larger the differential (demand for foreign assets = small), the less supplied (more demanded) 4. The expected future exchange rate: expecting lower exchange rate = rise in supply of Canadian $ The law of supply  Others remaining the same, the higher the exchange rate, the greater the quantity of Canadian dollars supplied in the foreign exchange market  Exchange rate market influences the quantity supplied for 2 reasons 1. Imports effect: the larger the value of Canadian imports, the larger the quantity of Canadian dollars supplied. But the value of imports depends on the prices of foreign produced goods expressed in Canadian dollars, and these prices depend on exchange rate. The higher the exchange rate, lower the prices of foreign produced goods (relative to Canadian) and the greater Canadian imports. So if exchange rate rises, quantity Canadian dollars supplied rises. 2. Expected profit effect: higher the exchange rate, the larger the expected profit from selling the Canadian dollars and holding foreign currencies  greater quantity Canadian dollars supplied Equilibrium  Depends on how the Bank of Canada and other central banks operate  Exchange rate acts as a regulator of the quantities demanded and supplied  If the exchange rate is too high, there is a surplus  QS > QD  An increase in the supply of the dollar will shift the curve to the right, and the value of the dollar depreciates  and vice versa  Foreign exchange market is constantly pulled to its equilibrium by the forces of supply and demand The capital service account in Canada’s BOP is the section of the current account which records income paid to foreign owners of assets in Canada and income received by Canadians for assets located abroad Exchange rate expectations  Changes in exchange rate occur in part because the exchange rate was expected to change  Information about forces that influence the value of one money relative to the value of another 1. Interest rate parity: equal rates of return - Definition of what money is worth is what it can earn - Exchange rate expectations are taken into account before buying foreign currency - If for a few seconds, a higher return is available in Toronto than Tokyo, the demand for Canadian dollars increases and the exchange rat
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