2. International Finance and the Foreign Exchange Market

3. Foreign Exchange Market Market where different currencies are traded, one for another. The exchange rate enables people in one country to translate the prices of foreign goods into units of their own currency. An appreciation of a nation’s currency will make foreign goods cheaper. A depreciation of a nation’s currency will make foreign goods more expensive.

4. Foreign Exchange Market $5.3 trillion per day. Currency% of Daily Share US dollar87.0% Euro33.4% Japanese yen23.0% British pound11.8% Australian dollar8.6% Swiss franc5.2% Canadian dollar4.6% Mexican peso2.5% Chinese yuan2.2%

5. Number of 1 country’s currency that is equal to 1 unit of another country’s $1 = 0.6292 € $1 = 0.5051 £ 1€ = 1.5892 $ 1£ = 1.9797 $ $1 = 0.755 € $1 = 0.6787 £ 1€ = 1.3245 $ 1£ = 1.4734 $

6. Currency Last Trade U.S. $¥en ¥en 12/04 Euro Euro 12/04 Can $ Can $ 12/04 U.K. £ U.K. £ 12/04 Aust $ Aust $ 12/04 SFranc SFranc 12/04 U.S. $10.0093281.2220.77051.7330.74030.7894 ¥en107.2113182.59185.879.3684.62 Euro0.81810.00763210.63031.4180.60570.6458 Can $1.2980.012111.58612.2490.96081.025 U.K. £0.5770.0053820.70530.444610.42720.4555 Aust $1.3510.01261.6511.0412.34111.066 SFranc1.2670.011821.5480.9762.1950.93781

7. Currency $ Appreciate / Depreciate Yahoo April 2008Yahoo April 2005 Yahoo Mar 2004 Yahoo Dec 2003 Text Oct 2002 U.S. $111 1 1 ¥en103.21107.293105.6107.2123.3 Euro0. 62920. 76890.82370.81811.01 Can $1.01971.2441.311.2981.5987 U.K. £0.50510.52320.55060.5770.6391 Aust $1.05611.29431.3371.3511.84 SFranc1.01251.18791.2871.2671.49

8. Currency Last Trade U.S. $1 ¥en 1:09pm¥en 1 Euro 1:09pmEuro 1 Can $ 1:09pmCan $ 1 U.K. £ 1:09pmU.K. £ 1 Aust $ 1:09pmAust $ 1 SFranc 1:09pmSFranc U.S. $ 4/08 10.0096891.58920.97081.97970.94680.9877 U.S. $ 5/3 10.0090771.1950.72621.7740.720.7696 U.S. $ 12/04 10.0093281.2220.77051.7330.74030.7894 U.S. $ 10/02 10.008110.99010.62551.56480.5450.74

9. Currencies 1.Everyone has their own. dollar, peso, pound, … 2. Use someone else’s – Dollarize Ecuador, El Salvador, and Panama 3. Use a common currency - European Union euro

10. Exchange Rate Regimes 1. Three major types of exchange rate regimes: a. flexible (floating) rates (US and 40% of all), b. Merged currency (unified currency), and, c. pegged exchange rates 1) hard peg – government sets a fixed rate 2) soft peg – market determines rate, but government may intervene. 2. Examples of a merged currency (unified) : Nations of the European Union have recent adopted a unified currency system. A country can also use a currency board to unify its currency with another. The currencies of Hong Kong, El Salvador, and Panama are unified with the U.S. dollar. The Gold Standard

11. d. Devaluation – change rate a. $1 = 1/35 oz of Gold b. 4 German marks = 1/35 oz of Gold c. $1 = 4 German marks The Gold Standard

12. flexible to fixed

17. pegged

19. strange?

25. Determinants of the Exchange Rate flexible rate system - the exchange rate is determined by supply and demand. The dollar demand for foreign exchange originates from American demand for foreign goods, services, & assets (real or financial). The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners.

26. Quantity of foreign exchange (pounds) Q1Q1 $1.50 $1.80 Dollar price of foreign exchange (for pounds ) a Foreign Exchange Market Equilibrium S (sales to foreigners) If incomes increase in the United States, U.S. imports of foreign goods and services will grow. The increase in imports will increase the demand for pounds in the foreign exchange market causing the dollar price of the pound to rise from $1.50 to $1.80. D1D1 Q2Q2 D2D2 b

27. Demand for Foreign Currencies 1.Foreign Direct Investment. buying a foreign firm (InBev) 2. Portfolio Investment a. purely financial by individual investors b. taking advantage of changing exchange rates c. Taking advantage of higher interest rates.

28. Demand for Foreign Currencies Demand for the US dollar comes from… Supply of the US dollar comes from… A U.S. exporting firm that earned foreign currency and is trying to pay U.S.-based expenses A foreign firm that has sold imported goods in the United States, earned U.S. dollars, and is trying to pay expenses incurred in its home country Foreign tourists visiting the United States U.S. tourists leaving to visit other countries Foreign investors who wish to make direct investments in the U.S. economy U.S. investors who want to make foreign direct investments in other countries Foreign investors who wish to make portfolio investments in the U.S. economy U.S. investors who want to make portfolio investments in other countries

29. A Strong Dollar Favors, or A Weak Dollar Favors: 1.A US exporting firm? 2.A foreign firm exporting to the US? 3. A US tourist abroad? 4.A foreign tourist in the US? 5.A US investor abroad? 6. A foreign investor in the US?

30. Changes in the Exchange Rate Determinants: 1. A change in interest rates, or an expected change in interest rates (relative to rates abroad). a. High rates attract money b. Currency appreciates 2. A change in the inflation rate in one country. a. Higher rate decreases demand b. Lower demand - depreciation 3.Purchasing Power Parity. a. Exchange rates make it cheaper to buy the same product in a particular country at lower cost. b. Causes a demand for that currency 4. Changes in incomes and tastes

31. Quantity of foreign exchange (pounds) Q 1 $1.50 Dollar price of foreign exchange (for pounds ) Inflation With Flexible Exchange Rates S1S1 If the price level in the U.S. increased by 50 % … the U.S. demand for British goods (and pounds) would increase (relatively cheap). D1D1 D2D2 a $2.25 S2S2 Since U.S. exports to Britain would decline and thereby cause the supply of pounds to fall. These forces would cause the dollar to depreciate relative to the pound. b

32. Labatt’s beer is produced in Canada. In 1990, in Ontario, a six-pack of Labatt’s beer sold for $6.60 Canadian. Across the border in Michigan, a six pack of the same beer was on sale for $2.75 U.S. At the time, the exchange rate was $0.75 U.S. = $1.00 Canadian.

33. In Ontario, $6.60 Canadian. In Michigan, $2.75 U.S. $0.75 U.S. = $1.00 Canadian. 1. How much would it cost in U.S. currency to buy the beer in Ontario? 2. How much would it cost in Canadian currency to buy the beer in Michigan? 3. Is there an arbitrage opportunity? 4. Where would you buy and where would you sell? 5. How much profit could you expect on a six-pack? $6.60 x.75 = $4.95 US $2.75 /.75 = $3.67 Can Buy in Michigan, sell in Ontario $4.95 - $2.75 = $2.20 US ($2.93 Canadian)

34. Peso – Appreciation or Depreciation? 1.The US reduces tariffs on Mexican products. 2.Mexico encounters severe inflation. 3.Deteriorating political relations reduce American tourism in Mexico. 4.The US economy moves into a severe recession 5. A bartender puts a lime in a Corona and beer sales jump 6.The Mexican government encourages American firms to invest in Mexican oil fields 7.A large federal government budget deficit raises interest rates in the US

35. Euro – Appreciation or Depreciation? 1.An American importer purchases a shipload of Bordeaux wine. 2.BMW decides to build an assembly plant in LA 3.A CVCC student decides to spend a year studying at the Sorbonne. 4.A Spanish manufacturer exports machinery to Morocco on an American freighter. 5. The US incurs a balance of payments deficit in its transactions with Belgium. 6.A US government bond held by an Italian citizen matures. 7.It is widely believed that the international value of the Euro will fall in the near future.

36. Balance of Payments Imports create a demand for foreign currency (and a supply of the domestic currency) and are recorded as a debit item. Exports create a supply of foreign currency (and demand for the domestic currency) and are recorded as a credit item. Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners

37. Balance of Payments Under a pure flexible rate system, the foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits.

38. Balance of Payments Current account transactions: all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period Four categories: Merchandise trade (import and export of goods) Service trade (import and export of services) Income from investments Unilateral transfers (gifts to and from foreigners)

39. Balance of Payments Capital account transactions: transactions that involve changes in the ownership of real and financial assets The capital account includes both direct investments by foreigners in the U.S. and by Americans abroad, and, loans to and from foreigners. Under a pure flexible-rate system, official reserve transactions are zero; therefore: a current-account deficit implies a capital-account surplus. a current-account surplus implies a capital-account deficit.

40. Monetary Policy & the Exchange Rate An unanticipated shift to a more restrictive monetary policy will: raise the real interest rate, reduce the rate of inflation, and, at least temporarily, reduce aggregate demand and the growth of income; causing an appreciation in domestic currency. the currency appreciation (with shift the current account toward a deficit). An unanticipated shift to more expansionary monetary policy will cause the opposite: lower interest rates, and, an outflow of capital; leading to a currency depreciation, and, a shift toward a current account surplus.

41. 1.A depreciation in the value of the U.S. dollar would a.encourage foreigners to travel on American owned airlines. b.make U.S. goods more expensive to foreign consumers. c.decrease the number of dollars it takes to buy a Swiss franc. d. make it more expensive for U.S. citizens to travel abroad. 2. A nation’s trade deficit will tend to expand when a.its economy is expanding. b.its economy is shrinking. c.its investment environment is less attractive to foreigners. d.both b and c above are true. 3. Under a system of flexible exchange rates, an increase in demand for a nation’s currency in the foreign exchange market will a.cause the nation’s currency to appreciate. b.make it more expensive for the nation to import goods. c.cause the nation’s balance on current account to shift toward a surplus. d.make it less expensive for foreigners to buy the nation’s goods.

42. 4.Under a system of flexible exchange rates, which of the following will most likely cause a nation’s currency to appreciate on the foreign exchange market? a.a decrease in domestic interest rates b.an increase in foreign interest rates c.domestic inflation of 10 percent while the nation’s trading partners are experiencing stable prices d.stable domestic prices while the nation’s trading partners are experiencing 10 percent inflation 5.Suppose a German-produced car becomes very popular in the United States. This would tend to a.affect the U.S. balance of payments but not the balance of trade. b.reduce any existing balance of trade deficit in the United States. c.increase a balance of trade surplus in the United States. d.increase a balance of trade deficit in the United States.

43. 6.If the dollar price of the euro goes from $1 to 90 cents, the euro has a.appreciated, and Europeans will find U.S. goods cheaper. b.appreciated, and Europeans will find U.S. goods more expensive. c.depreciated, and Europeans will find U.S. goods cheaper. d.depreciated, and Europeans will find U.S. goods more expensive.

44. Which of the following would cause the American demand for foreign exchange (pounds) to shift from D 1 to D 2 ? a.an increase in the U.S. real interest rate b.higher inflation in Britain than in the United States c.higher income growth in Britain than in the United States d.an increased level of vacation travel to Britain by Americans Which of the following would cause the demand for foreign exchange (pounds) to shift from D 1 to D 2 ? a.an increase in the real interest rate in Britain relative to the US b.higher inflation in Britain than in the United States c.higher income growth in Britain than in the United States d.an increase in the number of British citizens vacationing in the US