1. M42: The Foreign Exchange Market

2. CA = -FA Movement of G&S Movement of Capital
We know that the balance of payments account nets out to 0. But what ensures that it really does? What ensures that they actually offset each other?
The answer lies in the role of the exchange rate, determined in the foreign exchange market.

3. “But it is incorrect to say that a trade deficit causes a capital account surplus, that is, a net increase in foreign ownership of United States assets.  Both the trade deficit and the capital account surplus reflect underlying economic conditions.”

5. Understanding Exchange Rates (CDN EXAMPLE)
Suppose you are travelling to Mexico and you wish to buy a t-shirt. The price of the t-shirt is Mexican pesos. You have Canadian dollars in your pocket, but you must pay the Mexican shirt manufacturer in the currency that is most helpful to her, the peso.
How does a Canadian get pesos? He must exchange Canadian dollars for pesos in the foreign exchange market.
How many Mexican pesos does one Canadian dollar get on the foreign exchange market? It depends on the exchange rate.
March 2018: 1 CDN = pesos

6. Understanding Exchange Rates
$1 = pesos So how much does the shirt cost in $ CDN in March 2018? (Cost of shirt pesos) $187.5/14.69 = $12.76 CDN
So if you were in Mexico, and wanted to buy some Canadian dollars, you would need 15 pesos to do so. If you only had 1 peso, you could buy 1/ = $0.06 Canadian.
How to calculate? Foreign currency/dollar

7. Understanding Exchange Rates
The exchange rate is just a price.
In this case, pesos is the price of a Canadian dollar.
How are prices determined?
Supply and Demand

8. Understanding Exchange Rates
March 2016:
$ = 13.2
pesos
How much was the shirt (187.5 pesos) then?
187.5/13.2 = $ CDN
=187.5/13.2 = $14.21

10. Currency Appreciation
The CDN $ is worth more now than it was in March 2016 in terms of Mexican Pesos.
The CDN $ has appreciated in value.
Depreciation is the opposite scenario.
The Mexican Peso has depreciated in value.
In Feb 2018, pesos bought dollars.
In March 2016, pesos bought dollars.

11. The Equilibrium Exchange Rate (BACK TO THE US)
The price of currency, or the exchange rate, is determined in the market with the forces of supply and demand. If I want pesos, I demand them. In order to acquire pesos, I must supply dollars to the exchange market. When Canadians want more pesos, they must supply more dollars.
Foreign currency/ dollar
US dollars on the x axis if it is the market for US dollars

12. Downward Dog Demand

13. Upward Supply

14. Strong dollar or weak dollar?

15. Xn?

16. The Exchange Rate and Net Exports
As the price of a USD falls (depreciates) it takes fewer Pesos to buy one US dollar.
Consumers in Mexico will find US goods to be less expensive.
US exports to the Mexico will rise.
Dollar depreciates > Xn increases (X increase, M decrease)
Dollar appreciates > Xn decreases (X decrease, M increase)

17. The Exchange Rate and Net Exports
As the price of a USD$ rises (appreciates) it takes more Pesos to buy one US dollar.
Consumers in Mexico will find US goods to be more expensive.
US exports to the Mexico will fall.
How are imports affected?
Imports vice-versa --- fall in depreciation --- more expensive to buy US goods, rise in appreciation --- cheaper to buy US goods.

18. What Causes Shifts?
What would cause the demand for US $ to shift to the right?
Mexican consumer have more income to spend? Maybe they spend it on financial investments in US? --- how are these investments paid for? With US$. Demand for US $ therefore increases.
As demand for US $ shifts to the right, equilibrium prices rises and the dollar appreciates. What happens when the dollar appreciates? Imports rise/exports fall/ net exports decreases (enters a deficit).

19. Balance of Payments
An increase in capital flows into the US leads to a stronger dollar, which then creates a decrease in US exports. A decrease in capital flows into the US leads to a weaker dollar, which then creates an increase in US exports.

20. Real Exchange Rate = foreign currency per US $ *(PUS)/(Pforeign)
Real Interest Rate
The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level in those nations.
Real Exchange Rate = foreign currency per US $ *(PUS)/(Pforeign)

21. Real Exchange Rate = foreign currency per US $ *(PUS)/(Pforeign)
Real Interest Rate
Real Exchange Rate = foreign currency per US $ *(PUS)/(Pforeign)
1 USD = 12.5 Mexican Pesos
Example 1: No difference in aggregate price levels between US and Mexico.
RER = 12.5*100/100 = 12.5 pesos per dollar
Example 2: Mexico experiences 10% inflation.
RER = 12.5*100/110 = 11.4 pesos per dollar
RER = 12.5*100/100 = 12.5 pesos per dollar
RER = 12.5*110/100 = 11.4 pesos per dollar
If Mexico experiences inflation, while the US does not, even if the nominal exchange rate does not change, in real terms, the USD buys fewer Mexican goods.

22. 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. >>12.5 pesos worth of goods with no inflation >>11.4 pesos word of goods with 10% inflation

23. Purchasing Power Parity
Big mac is $1 in USA and 10 pesos in Mexico
PPP is 10 pesos per 1 USD.

25. The Three Most Important Factors Affecting Exchange Rates
Differences in growth rates or income.
Differences in inflation.
Differences in real interest rates.

26. M42 Summary
Foreign currencies are exchanged because foreign goods and services are exchanged. The market for a currency (like the US dollar) operates with the forces of supply and demand.
When the dollar can buy more of a foreign currency, it is said that the dollar has appreciated in value (it has become stronger).
When a dollar can buy less of a foreign currency, it is said that the dollar has depreciated in value (it has become weaker).
Movements in the exchange rate ensure that changes in the financial account and the current account offset each other.
The real exchange rate is the nominal exchange rate adjusted for international differences in aggregate price levels.

27. M43: Exchange Rate Policy and Macroeconomic Policy

28. The exchange rate between two currencies is set by __________ and _________.
Supply and demand

29. Is the CDN gov’t okay with that?

30. Is the US govt ok with that?

31. Is China ok with that?

32. Why might a government want to control it’s exchange rate?
Increase/decrease exports/imports

33. Can the government control it’s own exchange rate. If so how
Can the government control it’s own exchange rate? If so how? If not, why not?

34. Exchange Rate Regimes

35. Our Focus Fixed Exchange Rates Floating Exchange Rates
Gov’t keeps the exchange rate stable against some other currency, or near a particular target.
Ex. Hong Kong, $7.80 HK= $1 US
Floating Exchange Rates
Gov’t lets the exchange rate go wherever the market takes it.
Ex. Canada, Britain, USA
HK fixed exchange rate:

36. Let’s Fix the Exchange Rate
The small nation of Tigardo decides to fix their currency at a rate of $2 US for every 1 tigre.
The current equilibirum exchange rate is ….
What can the
government do?

37. Fixing the Exchange Rate
If there is a surplus
The government can:
Buy up the surplus of tigres in the foreign exchange market (exchange market intervention).
Shift supply and demand curve through the central bank.
Impose restrictions on the right of individuals to buy foreign currency.
Buy up surplus --- what is needed for this? Stocks of foreign currencies.
Central bank --- increase demand by increasing interest rate --- attract foreign investors.
Restrictions to buy foreign currency --- reduces supply

38. Let’s Fix the Exchange Rate

39. Fixing the Exchange Rate
If there is a shortage
The government can:
Sell tigres in the foreign exchange market (exchange market intervention).
Shift supply or demand curve through the central bank.
Impose restrictions on the right of foreigners to buy tigres.
Sell off tigre –how? --- buy foreign assets and currencies
Central bank --- decrease demand by decreases interest rate --- reduce capital inflow, Also increase supply, as citizens looks to invest overseas – capital outflow.
Restrictions to buy tigre --- reduce demand

40. So what should we do? Fixed or floating?

41. Advantages in Stability
Fixed Exchange Rates:
Provide stability in foreign transactions.
Provide stability in terms of inflation.
Inflation --- can’t dramatically increase the money supply (i.e. to pay down debt)

42. Disadvantages in Costs
Fixed exchange rates:
Require large quantities of foreign reserves on hand.
Limit the ability of monetary policy to tackle domestic economic fluctuations and manage the inflation rate.
Distort incentives and create substantial costs in terms of red tape and corruption.
That currency is usually a low-return investment --- even large reserves can be exhausted when there are large capital outflows out of a country.
3. Creates substantial costs in

43. M43 Summary
The exchange rate for a nation’s currency can be influenced by government policy.
If the fixed rate is above the market equilibrium rate, there is a surplus of that nations currency in the foreign exchange market. There are typically three ways in which the government can reduce the price to reach the target exchange rate.
If the fixed rate is below the market equilibrium, there is a shortage of that nation’s currency in the foreign exchange market. There are three ways in which the government can increase the price to reach the target exchange rate.
There are some advantages to a fixed exchange rate, but there are also disadvantages. Nations like the US and Canada have determined that a floating exchange rate policy is superior to the fixed exchange rate policy.