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Foreign Exchange Markets and Exchange Rates: 

Foreign Exchange Markets and Exchange Rates Foreign Exchange Market The market in which one country’s currency is traded for another country’s currency Exchange Rate The amount of one country’s currency that is traded for one unit of another country’s currency The price of foreign currency in dollars

The Demand for British Pounds: 

The Demand for British Pounds The Demand for Pounds Curve Shifts in the Demand for Pounds Curve

The Demand for British Pounds: 

The Demand for British Pounds In our model of the market for pounds, we assume that American households and businesses are the only buyers. (people who has $ and wants pound in exchange)

The Demand for British Pounds: 

The Demand for British Pounds Why do Americans want to buy pounds (in exchange for $)? To buy goods/services from British firms (British…Jaguar? Franz Ferdinand?) To buy British assets (stocks, bond..)

The Demand for Pounds Curve: 

The Demand for Pounds Curve Demand Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that Americans will want to buy, during a given period, at each different exchange rate

The Demand for Pounds Curve: 

The Demand for Pounds Curve a a a Dollars per Pound (a) (b) Millions of British Pounds E D 300 200 A $2.25 1.50 £ Millions of British Pounds Dollars per Pound D 1 £ D 2 £ Fall in price of pound moves us rightward along demand for pounds curve Demand for pounds curve shifts rightward when: • U.S. real GDP • U.S. relative price level • U.S. tastes shift towards British goods • U.S. interest rate • Pound is expected to appreciate

The Demand for Pounds Curve: 

The Demand for Pounds Curve Price of pounds British goods cheaper to Americans Americans buy more British goods Quantity of pounds demanded

Shifts in the Demand for Pounds Curve: 

Shifts in the Demand for Pounds Curve Variables That Shift the Demand for Pounds Curve U.S. Real GDP Relative Price Levels Americans’ Tastes for British Goods Relative Interest Rates Expected Changes in the Exchange Rate

The Supply of British Pounds: 

The Supply of British Pounds The Supply of Pounds Curve Shifts in the Supply of Pounds Curve

The Supply for British Pounds: 

The Supply for British Pounds In our model, we assume that British households and businesses are the only suppliers.

The Supply of British Pounds: 

The Supply of British Pounds Why do British want to sell pounds (in exchange for $)? To buy goods/services from American firms (American…Cadillac? 50 Cents?) To buy American assets (stocks, bond..)

The Supply of Pounds Curve: 

The Supply of Pounds Curve Supply Curve for Foreign Currency A curve indicating the quantity of a specific foreign currency that will be supplied, during a given period, at each different exchange rate

The Supply of Pounds Curve: 

The Supply of Pounds Curve a a a Dollars per Pound Millions of British Pounds E S 400 300 F $2.25 1.50 £ Millions of British Pounds Dollars per Pound S 1 £ S 2 £ Rise in price of pound moves us rightward along supply of pounds curve Supply of pounds curve shifts rightward if: • British real GDP • U.S. relative price level • British tastes shift towards U.S. goods • U.S. interest rate • Pound is expected to depreciate (a) (b)

The Supply of Pounds Curve: 

The Supply of Pounds Curve Price of pounds U.S. goods goods cheaper to British Quantity of pounds supplied British buy more U.S. goods British need more dollars

Shifts in the Supply of Pounds Curve: 

Shifts in the Supply of Pounds Curve Variables That Shift the Supply of Pounds Curve Real GDP in Britain Relative Price Levels British Tastes for U.S. Goods Relative Interest Rates Expected Changes in the Exchange Rate

The Equilibrium Exchange Rate : 

The Equilibrium Exchange Rate Floating Exchange Rate An exchange rate that is freely determined by the forces of supply and demand.

The Equilibrium Exchange Rate : 

The Equilibrium Exchange Rate a a a Dollars per Pound Millions of British Pounds 300 $1.50 Dollars per Pound Millions of British Pounds 300 $2.00 1.50

The Equilibrium Exchange Rate : 

The Equilibrium Exchange Rate When the exchange rate floats - that is, when the government does not intervene in the foreign currency market - the equilibrium exchange rate is determined at the intersection of the demand curve and the supply curve.

What Happens When Things Change?: 

What Happens When Things Change? How Exchange Rates Change over Time The Very Short Run: “Hot Money” The Short Run: Macroeconomic Fluctuations The Long Run: Purchasing Power Parity

What Happens When Things Change?: 

What Happens When Things Change? Appreciation An increase in the price of a currency in a floating-rate system Depreciation A decrease in the price of a currency in a floating-rate system

What Happens When Things Change?: 

What Happens When Things Change? When a floating exchange rate changes, one country’s currency will appreciate (rise in price) and at the same time, the other country’s currency will depreciate (fall in price).

How Exchange Rates Change Over Time: 

How Exchange Rates Change Over Time a a Dollars per Pound Years B E A C High ‘volatility’ in both short and long run

The Very Short Run (~ weeks): 

The Very Short Run (~ weeks) Relative interest rates and expectations of future exchange rates are the dominant forces moving exchange rates in the very short run. “Hot money” consists of funds that can be moved from one type of investment to another on very short notice. (by phone call…)

Hot Money in the Very Short Run: 

Hot Money in the Very Short Run a a a Dollars per Pound Millions of British Pounds per Month Q 2 $1.50 1.00 Q 1 “Rise in US interest rate”

The Short Run: (~few years) Macroeconomic Fluctuations: 

The Short Run: (~few years) Macroeconomic Fluctuations In the short run, movements in exchange rates are caused largely by economic fluctuations. All else equal, a country whose GDP rises relatively rapidly will experience a depreciation of its currency. A country whose GDP falls more rapidly will experience an appreciation of its currency.

Exchange Rates In The Short Run: 

Exchange Rates In The Short Run a a a Millions of British Pounds per Month Dollars per Pound Millions of British Pounds per Month Dollars per Pound 1.50 $1.80 (a) (b) 1.50 $1.80 US recovering while UK sluggish UK recovers too

Self-fulfilling prophecy: 

Self-fulfilling prophecy The idea that the something actually happens just because people believe it. (regardless of its basis) Ex. People expect British pound to appreciate soon  Sell $ and buy £  British pound will appreciate Ex. Contagion effect during Asian crisis

The Long Run: Purchasing Power Parity (relative price level): 

The Long Run: Purchasing Power Parity (relative price level) Purchasing Power Parity (PPP) Theory The idea that the exchange rate will adjust in the long run so that the average price of goods in two countries will be roughly the same

Purchasing Power Parity: 

Purchasing Power Parity Some Important Caveats Some Goods Are Difficult to Trade High Transportation Costs Artificial Barriers to Trade

Interdependent Markets: The Role of Arbitrage : 

Interdependent Markets: The Role of Arbitrage Arbitrage Simultaneous buying and selling of a foreign currency in order to profit from a difference in exchange rates.

Interdependent Markets: The Role of Arbitrage : 

Interdependent Markets: The Role of Arbitrage Bilateral Arbitrage Arbitrage involving one pair of currencies. Bilateral arbitrage ensures that the exchange rate between any two currencies is the same everywhere in the world.

Bilateral Arbitrage : 

Bilateral Arbitrage a a a Millions of British Pounds per Month Dollars per Pound Millions of British Pounds per Month Dollars per Pound (a) New York (b) London $1.50 1.20 1.50 $1.80 Buy £ Sell £ Using 120$, buy 100£ at NY. Sell 100£ in UK, get 180$.  60$ arbitrage!

Interdependent Markets: The Role of Arbitrage : 

Interdependent Markets: The Role of Arbitrage Triangular Arbitrage Arbitrage involving trades among three (or more) currencies

Triangular Arbitrage : 

Triangular Arbitrage Price of £ in $/ £ market : $1.80 Price of peso in $/peso market : $0.10 Price of £ in peso/ £ market : 10 peso You have $1.80 & want £. Option 1) Go to $/ £ market & get 1 £.

Triangular Arbitrage : 

Triangular Arbitrage Option 2) Go to $/peso market & get 18 pesos. Then go to peso/ £ market and get 1.8 £. Everybody will choose option 2.

Triangular Arbitrage : 

Triangular Arbitrage - Demand for peso in $/peso mkt ↑  Peso appreciates against $ (0.1 0.125 $/peso) - Demand for £ in peso/£ mkt ↑  £ appreciates against peso (10 12 peso/£) - Demand for £ in $/ £ mkt ↓  £ depreciates against $ (1.8  1.5$/£) No chance for triangular arbitrage now.

Triangular Arbitrage : 

Triangular Arbitrage Triangular arbitrage ensures that the price of a foreign currency is the same whether it is purchased directly - in a single foreign exchange market - or indirectly, by buying and selling a third currency.

Government Intervention in Foreign Exchange Markets: 

Government Intervention in Foreign Exchange Markets Managed Float : band system Fixed Exchange Rates

Managed Float: 

Managed Float A policy of frequent central bank intervention to move/control the exchange rate. (ex. Fix daily fluctuation range)

Fixed Exchange Rate: 

Fixed Exchange Rate A government-declared fixed exchange rate maintained by central bank intervention in the foreign exchange market.

Fixed Exchange Rate: 

Fixed Exchange Rate a a a Millions of Baht per Month Dollars per Baht (a) $0.06 400 0.04 0.02 100 Millions of Baht per Month Dollars per Baht (b) $0.06 400 0.04 0.02 100 Thai gov’t fixes exchange rate at 0.04$ per Baht

Fixed Exchange Rate: 

Fixed Exchange Rate When a country fixes its exchange rate below the equilibrium value, the result is an excess demand for the country’s currency. To maintain the fixed rate, the country’s central bank must sell enough of its own currency to eliminate the excess demand.

Fixed Exchange Rate: 

Fixed Exchange Rate When a country fixes its exchange rate above the equilibrium value, the result is an excess supply of the country’s currency. To maintain the fixed rate, the country’s central bank must buy enough of its own currency to eliminate the excess supply.

Foreign Currency Crises, the IMF, and Moral Hazard: 

Foreign Currency Crises, the IMF, and Moral Hazard Millions of Baht per Month Dollars per Baht 400 $0.04 0.02 1 0 0 Before crisis fixed Devaluation

Foreign Currency Crises, the IMF, and Moral Hazard: 

Foreign Currency Crises, the IMF, and Moral Hazard Devaluation A change in the exchange rate from a higher fixed rate to a lower fixed rate.

Foreign Currency Crisis: 

Foreign Currency Crisis A foreign currency crisis arises when people no longer believe a country can maintain a fixed exchange rate above the equilibrium rate: the supply of the currency increases, demand for it decreases, and the country must use up its reserves of dollars and other key currencies even faster in order to maintain the fixed rate.

Moral Hazard: 

Moral Hazard Occurs when a decision maker (firm, individual, government) expects to be rescued in the event of an unfavorable outcome, and then changes its behavior so that the unfavorable outcome is more likely.

Exchange Rates and the Macroeconomy: 

Exchange Rates and the Macroeconomy Exchange Rates and Spending Shocks Exchange Rates and Monetary Policy

Exchange Rates and Spending Shocks: 

Exchange Rates and Spending Shocks A depreciation of the dollar causes net exports to rise - a positive spending shock that increases real GDP in the short run. An appreciation of the dollar causes net exports to drop - a negative spending shock that decreases real GDP in the short run.

Exchange Rates and Monetary Policy: 

Exchange Rates and Monetary Policy Monetary policy has a stronger effect when we include the impact on exchange rates and net exports, rather than just the impact on interest-sensitive consumption and investment spending.

Exchange Rates and Monetary Policy: 

Exchange Rates and Monetary Policy Money supply Interest rate a and I P Real GDP U.S. assets less attractive Decreased supply and increased demand for foreign currency Dollar depreciates Net exports Net Effect: GDP  even more when exchange rate’s effect on net exports is included

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