AP/ECON A MONETARY ECONOMICS I: FINANCIAL MARKETS AND INSTITUTIONS Fall 2016 Topic 4: Foreign Exchange/Session 4A Course Director: Prof. Brenda Spotton Visano © Brenda Spotton Visano 2016

Session 4A: Agenda Review of Foreign Exchange basics Policy Options –Flexible (Floating) –Fixed Exchange Rates Fundamentals of FX value –Purchasing Power Parity? –Interest Rate Parity? 1 more Policy Option –Monetary Union © Brenda Spotton Visano

FX as a “price” of the C$ September 26, 2016 (closing prices):  $US = 1C$ or $C = 1US$  € = 1C$ Appreciation or “strengthening” of the C$ against the US$ → 1C$ buys more US$ ↔ it takes fewer C$ to buy 1US$ ↔ 1US$ buys fewer C$ For example: 0.90 $US = 1C$ ↔ 1.11 $C = 1US$ and the US$ has “weakened” or depreciated against the C$ Q: What if in the (spot) currency markets 1.3C$ = 1US$ AND 2€ = 1US$ AND 2€ = 1C$? Calculate the arbitrage profits from a trilateral exchange of these 3 currencies. © Brenda Spotton Visano

C$ Exchange Rate Index (CERI) The Canadian-dollar effective exchange rate index is a weighted average of bilateral exchange rates for the Canadian dollar against the currencies of Canada's major trading partners. The six foreign currencies in the CERI are the U.S. dollar, the European Union euro, the Japanese yen, the U.K. pound, the Chinese yuan, and the Mexican peso. An increase in the index represents an effective appreciation of the Canadian dollar, while a decrease represents a depreciation of the Canadian dollar. © Brenda Spotton Visano

What determines the (external) price of the C$? Which market? Which countries are Canada’s major trading partners? Supply of C$ in FX market: by whom? …for what? Demand for C$ in FX market: by whom? …for what? © Brenda Spotton Visano

Supply of C$ in FX market By whom? …for what? Canadians to purchase foreign produced goods and service (Merchandise Trade imports of motor vehicles and parts, consumer goods, electronic and electrical equipment and parts) Canadians to purchase foreign financial products (stocks and bonds) Bank of Canada to stabilize external value of C$ © Brenda Spotton Visano

Demand for C$ in FX market By whom? …for what? Foreigners to purchase Canadian goods and service (Merchandise Trade exports of energy products, motor vehicles and parts, metals & minerals) Foreigners to purchase Canadian financial products (stocks and bonds) Bank of Canada to stabilize external value of C$ © Brenda Spotton Visano

Exchange Rate Policies A Current Account (CA) Deficit current exchange rates: S of C$ > D for C$ from CA transactions alone with no offsetting private market financial transactions, EITHER foreign currency price of C$ falls → and C$ depreciates (flexible ER policy) OR Bank of Canada intervenes by buying C$ to prevent the depreciation of C$ (fixed ER policy) © Brenda Spotton Visano

Grounding external value of C$ Is there a fundamental value of the C$? If trade in goods and (non-financial) services dominates: Purchasing Power Parity (PPP) If private market financial transactions dominate: Interest Rate Parity (IRP) (And the two may be related…) © Brenda Spotton Visano

Purchasing Power Parity (PPP) Law of one price in goods and services → Real Exchange Rate = 1 → prices of same goods traded across national boundaries with different currencies are the same when quoted in one currency Q: Apples produced and sold in Canada cost 1C$ per apple; Apples produced and sold in the US cost 1US$ per apple; the FX 1C$ = 0.75 US$. Explain how arbitrage in apples might result in PPP. Assumptions? © Brenda Spotton Visano

(Uncovered) Interest Rate Parity Law of one price applied to interest rates: lending rates on funds borrowed across national boundaries in different currencies are the same when quoted in one currency Q: Stephen Poloz will pay (or charge) you an interest rate of 10% to borrow (or lend) 1000$C for 1 year; Janet Yellen will pay (or charge) you an interest rate of 5% to borrow (or lend) 1000$US for 1 year; the FX 1C$ = 0.75 US$. Explain how arbitrage in loanable funds might result in IRP. Assumptions? © Brenda Spotton Visano