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EC223 (81)
Chapter 19

Chapter 19 EC223.docx

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Angela Trimarchi

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
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