Foreign Exchange Markets ECO 473 - Money & Banking - Dr. D. Foster

Perspective! The U.S. We want to buy foreign exchange. We don’t really want the “money.” We want the goods/services/financial assets We pay $ to get foreign exchange. When the $ appreciates, we can buy more . . . i.e. the price is lower. When the $ appreciates, the £ depreciates. When $ depreciates … price is higher.

Perspective! The U.S. We demand foreign exchange - £, Ұ, € $ (per £) The market for pounds (£) E = $2 Demand shows: our demand for British goods and services (our imports) E = $1 D £ At higher prices… it takes more dollars to buy a pound, British goods are more expensive, the dollar is depreciating (and the £ is appreciating). At lower prices … Q£

Perspective! The U.S. $ (per £) What would shift the demand for British pounds? The market for pounds (£) The Fed may buy pounds! A change in our tastes and preferences for their goods. A change in our income. A change in trade restrictions. A change in monetary policy... D’£ D £ D”£ Q£

Perspective! The U.S. Foreigners supply foreign exchange - £, Ұ, € S £ Q£ E = $2 E = $1 Supply shows: British demand for dollars to buy our goods (our exports). To acquire $ they must supply £. The market for pounds (£) At higher prices… pounds buy more dollars, American goods are cheaper, the dollar is depreciating (and the £ is appreciating). At lower prices …

Perspective! The U.S. S £ $ (per £) Q£ S’£ What would shift the supply of British pounds? S’£ A change in their tastes and preferences for our goods. A change in their income. A change in trade restrictions. A change in monetary policy... The Fed may sell pounds! The market for pounds (£)

Perspective! The U.S. $ depreciates; the price rises; we buy less $ appreciates; the price falls; we buy more D £ S £ $ (per £) Q£ E Equilibrium in the market for pounds (£) Exchange rate changes as S & D change . . .

Perspective! The U.S. Q - What if we want less British goods? A - Increase Demand; E rises; $ depreciates E’ S’ A - Increase Supply; E falls; $ appreciates E’ D’ A - Decrease Demand; E falls; $ appreciates D £ S £ $ (per £) Q£ E Q - What if our incomes rise? Q - What if Brits want more US goods?

Perspective! Britain They want to buy foreign exchange ($). They don’t really want the “money.” They want our goods/services/financial assets They pay £ to get $ (foreign exchange). When the £ appreciates, they can buy more . . . i.e. the price is lower. When the £ appreciates, the $ depreciates. When £ depreciates … price is higher.

Exchange rate changes as S & D change . . . Perspective! Britain £ depreciates; the price rises; we buy less D $ S $ £ (per $) Q$ 1 𝐸 $ appreciates £ appreciates; the price falls; we buy more $ depreciates Exchange rate changes as S & D change . . .

Perspective! Britain Q - What if we want less British goods? A - Increase Demand; 1/E rises; $ appreciates 1/E’ D’ 1/E’ S’ A - Increase Supply; 1/E falls; $ depreciates 1/E’ S’ A - Decrease Supply; 1/E rises; $ appreciates Q - What if U.S. incomes rise? D $ S $ £ (per $) Q$ 1/E Q - What if Brits want more US goods?

Current Exchange Rates

Current Exchange Rates D $ S $ £ (per $) Q$ $ (per £) S £ .7221 1.385 D £ Q£

Real Exchange Rates Nominal: What we see reported. SFr/US $: 2013 – 1.229 2014 – 1.171 Nominal %Δ: – 4.72% (1.171−1.229) 1.229

Real Exchange Rates Nominal: What we see reported. Real: Adjusted for price level changes. Real = Nominal*(CPIUS/CPISFr) SFr/US $: 2013 – 1.229 2014 – 1.171 CPI (Swiss): 2013 - 100 2014 - 102 CPI (US): 2013 - 100 2014 - 103 1.1825 Nominal %Δ: – 4.72% Real %Δ: – 3.785% (1.171−1.229) 1.229 1.171∗ 103 102 (1.1825−1.229) 1.229

Real Exchange Rates Who’s perspective? Draw it out . . . SFr/$ S$ And, the $ is . . . So, the SFr is . . . . . . appreciating in value. 1.229 1.171 . . . depreciating in value.

Foreign Exchange Markets ECO 473 - Money & Banking - Dr. D. Foster