Foreign Exchange Market (FOREX, FX)

How many can you name? On the poster, write as many names of foreign currencies that you know

Foreign exchange market Definition = a market in which various national currencies are exchanged for one another The equilibrium prices in these markets are called exchange rates The rates at which the currency of one nation can be exchanged for the currency of another nation

Foreign exchange market Two things to keep in mind: 1) It is a competitive market The market is characterized by large numbers of buyers and sellers dealing in standardized products (American dollar, European euro, British pound, Japanese yen) 2) It links all domestic prices with foreign prices Consumers only need to multiply the foreign product price by the exchange rate Example = if the U.S. dollar to Japanese yen exchange rate is $0.01 per yen, then a TV priced at ¥20,000 will cost $200 20,000 * 0.01

Foreign exchange market

Mr. clifford Mr. Clifford

Depreciation vs. appreciation Depreciation = a decrease in the value of a currency (weak dollar) Example = an increase in the demand for Japanese goods (Toyota cars) here in America will increase the demand for yen and raise the dollar price of the yen. Our dollar has depreciated in value because it can buy fewer yen (the Toyota cars have become more expensive to U.S. buyers) Appreciation = an increase in the value of the currency (strong dollar) Example = an increase in Japanese demand for American goods (Ford trucks) will increase the demand for dollars and raise the yen price of our dollar The decrease in the dollar price of the yen means it takes fewer dollars to buy more yen

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Fixed vs. floating rates Fixed rate = the exchange rate stays the same In the past the rate was set by gold (Gold Standard) Central banks set the rate – rarely worked Used until WWI Floating rate = based on supply and demand for each currency The International Monetary Fund (IMF) regulates monetary stability and helps promote foreign trade

Assumptions Assumptions related to exchange rates: If the demand for a nation’s currency increases (all else equal), that currency will appreciate. If demand declines, it will depreciate. If the supply of a nation’s currency increases, that currency will depreciate. If supply decreases, that currency will appreciate. If a nation’s currency appreciates, some foreign currency depreciates relative to it. Determinants of exchange rates: Consumer Tastes Relative Income Relative Inflation Speculation

Relative income When one nation’s macroeconomy is strong and incomes are rising, ceteris paribus, demand for all goods increases, domestically and abroad Ex: if Europeans are enjoying economic growth and the US is in recession, the relative buying power of European Citizens is growing. They will increase their consumption of domestic and US made goods. (demand for USD increases, USD appreciates) Ex: England encounters a recession, reducing its imports, while US real output and real income surge, increasing US imports (British pound appreciates, USD depreciates.

Relative prices (inflation) If one nations’ price level is rising faster than that of another nation, consumers seek the goods that are relatively less expensive. Switzerland experiences a 3% inflation rate compared to Canada’s 10% rate (Swiss franc appreciates; Canadian dollar depreciates). If European inflation is higher than inflation in the US, American-made goods are a relative bargain to German consumers and the dollar appreciates. (Another reason for the Fed to keep inflationary pressure low!)

speculation Foreign currency is traded as an asset and investors seek to profit from buying currency at a low rate and selling it at a high rate Ex: If it appears that future US interest rates will fall relative to the rates in Japan, the Yen begins to look like a great investment (speculators increase demand for Japanese assets, thus appreciating the Yen and depreciating USDs) Ex: Currency traders believe South Korea will have much greater inflation than Taiwan (South Korea won depreciates; Taiwan dollar appreciates) Ex: Currency traders think Finland’s interest rates will plummet relative to Denmark’s rates (Finland’s markka depreciates; Denmark’s Krone appreciates)