The Foreign Exchange Market AKA the “FOREX” In yesterday’s lesson we saw that the market for loanable funds shows us how financial capital flows into or out of a nation’s financial account. Goods and services also flow, but this flow is tracked as balance of payments into and out of the current account. We’ve also learned that a county’s balance of payments on the current account plus its balance of payments on the financial account add up to zero: a country that receives net capital inflow (positive financial account) must run a matching current account deficit, and a country that generates net capital outflow (negative financial account) must run a matching current account surplus. So given that the financial account reflects the movement of capital and the current account reflects the movement of goods and services, what ensures that the balance of payments really does balance? That is, what ensures that the two accounts actually offset each other? The answer lies in the role of the exchange rate, which is determined in the foreign exchange market.

The Foreign Exchange Market Goods produced within a country must be paid for with that country’s currency International transactions require a market Foreign exchange market—market where currencies can be exchanged for each other This market determines exchange rates—the prices at which currencies trade The foreign exchange market is, in fact, not located in any one geographic spot. Rather, it is a global electronic market that traders around the world use to buy and sell currencies.

Understanding Exchange Rates As of 6PM, Jan. 6, 2014, US$1 exchanged for €.73367 or US$1.36301 exchanged for €1 When a currency becomes more valuable (expensive) in terms of other currencies, it appreciates When a currency’s value falls, it depreciates Exchange rates affect relative price, thus impacting trade For example, at that time US$1 exchanged for €.73367, so it took €.73367 o buy $1 Similarly, it took US$1.36301 for €1. These two numbers reflect the same rate of exchange between the euro and the US dollar: 1/1.36301= .73367 When discussing movements in exchange rates, economists use specialized terms to avoid confusion. Suppose, for example, that the value of €1 went from $1 to $1.25, which means that the value of US$1 went from €1 to €0.80 (because 1/1.25=.80). In this case, we would say that the euro appreciated and the US dollar depreciated. Movement in exchange rates affect the relative prices of goods, services, and assets in different countries. For example, suppose the rice of an American hotel room is $100 and the price of a French hotel room is €100. If the exchange is €1=$1, these hotel rooms have the same price. If the exchange rate is €1.25=$1, the French hotel room is 20% cheaper than the American hotel room. If the exchange rate is €0.80=$1, the French hotel room is 25% more expensive than the American hotel room.

Modeling Foreign Exchange Rates FOREX is governed by supply and demand Let’s graph the mMarket for the US dollar… Demand slopes downward because higher price means less money demanded (i.e., higher priced American products would mean fewer European purchasers) Supply slopes upward because higher price means greater willingness to supply (i.e., relatively cheaper European goods will cause Americans to put more dollars on the market to exchange) If I want euros, I demand them. And in order to acquire euros, I must supply dollars to the exchange market. So when Americans demand more euros, they must supply more dollars. The unit on the x-axis is the quantity of US dollars supplied and demanded. The unit on the y-axis is the price of US dollars, measured in euros per dollar. Note: If you have trouble remembering what goes over what, an easy way to remember how to label the y-axis is to think of the notation typically used: (foreign currency)/dollar. The dollar goes in the denominator or “below” the “/”. The dollars are also the unit on the x-axis, which is “below” the graph. Think: “What goes below goes below.” If it’s the market for dollars, dollars are on the x-axis and in the denominator. Why does the Demand for dollars slope downward? As the price of a dollar falls (its value depreciates) it takes fewer euros to buy one dollar Consumers in Europe will find US goods to be less expensive US exports to Europe will rise, and more dollars will be demanded to pay for those goods Why does the Supply of dollars slope upward? As the price of a dollar rises (its value appreciates) one dollar buys more euros Consumers in the US will find European-made goods to be less expensive US imports from Europe will rise, and more dollars will be supplied to pay for those goods

Equilibrium Exchange Rate Rate at which quantity demanded of a currency = quantity supplied Demand shifts can cause the exchange rate to appreciate or depreciate Any change in Financial account creates an equal and opposite reaction in the current account, maintaining CA + FA = 0 Movements in the exchange rate ensure that FA and CA offset one another Summary: An increase in capital flows into the US leads to a stronger dollar, which then creates a decrease in US net exports A decrease in capital flow into the US leads to a weaker dollar, which then creates an increase in US net exports The equilibrium exchange rate is €.95 euros per US dollar. Now, suppose the demand for US dollars increases. Maybe European consumers have more money to spend and some of that additional income is being spent on financial investment in America. The payments from those European citizens will flow into the US financial account. (Draw a rightward shift of the D curve) As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. It will now cost more than €.95 to buy one US dollar. Because the US dollar has appreciated against the euro, American consumers will increase purchases of goods and services from Europe. More US dollars will be supplied and will flow out of the US current account. Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied. This tells us that any increase in the US balance of payments on the financial account is exactly offset by a decrease in the US balance of payments on the current account.

Inflation & Real Exchange Rate Appreciation/depreciation can be exaggerated due to differences in inflation rates Real exchange rates: exchange rates adjusted for international differences in aggregate price levels Real XR = XR (X per Y) ● Price LevelY/Price LevelX (i.e., Mexican pesos per $1U.S. X PLUS/PLMex) Current account responds only to changes in Real XR, not nominal The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level of those nations. To take account of the effects of differences in inflation rates, economists calculate real exchange rates: exchange rates adjusted for international differences in aggregate price levels. Ex: Suppose that the exchange rate we are looking at is the number of Mexican pesos per US dollar. Let Pus and Pmex be indexes of the aggregate price levels in the United States and Mexico, respectively. Ex. 1: There is no difference in aggregate price levels between the US and Mexico in the base year. Real exchange rate = 12.5 x (100/100) = 12.5 pesos per dollar Ex. 2: Suppose the Mexican economy has suffered 10% aggregate inflation and Pmex = 110 Real exchange rate = 12.5 x (100/110) = 11.4 pesos per dollar So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each US dollar will buy fewer pesos and thus fewer Mexican goods. (To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate.)

Purchasing Power Parity PPP is the nominal exchange rate at which a given basket of goods would cost the same in two countries Comparing PPP to XR over time reveals the impact of inflation The relationship between PPP and exchange rate reveals the relative cost of living in each country The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. Suppose, for example, that a basket of goods and services that cost $100 in the US costs 1,000 pesos in Mexico. Then the purchasing power parity in 10 pesos per US dollar: at that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries.

Key Concepts When a country’s currency appreciates, exports fall and imports rise When a country’s currency depreciates, exports rise and imports fall