Foreign Exchange Rates: Determination and Changes J.D. Han King’s University College

Relationship between FOREX rates and Trade, or/and Capital Flows A third ‘Exogenous Variable’ affect both Trade/Capital Flows and FOREX rates. The two affect each other. We can apply Supply/Demand, and P/Q to FXrates/Trade or/and Capital Flows

Recall that Supply of FOREX comes from Exports(X) and Capital Inflows(CI): S(X, CI) Demand of FX comes from Imports(M) and Capital Outflows(CO): D(M, CO) Price of FX is FX Rates (E* or S*)

(The) FX rate is defined as How much domestic currency per one unit of foreign currency. - Direct or European Quotation eg) for Canada, U.S. $1 costs Cdn $1.01. Cdn 1.01/ U.S. 1 = 1.01 Eg) for China, U.S. $1 costs 7 Yuan 7 Yuan/ U.S. 1 = 7

Suppose that Exports rise rapidly: Is this due to a government’s manipulation of FX rate? Is this due to a change in a Exogenous Variable? eg) Japan of the 1980s China of the 2000s

In the Short-run, A change in FX rates affects Supply and Demand of FX such as X, M, CI, and CO. The economy will get out of equilibrium. However, eventually there will be adjustments back to equilibrium: FX rates and S/D change again.

When a government devaluate its currency? First, FX rates goes up; and exports go up as well: FX rates and X move in the same direction. Then, excess supply of FOREX will push E down and X down as well back to the equilibrium: FX rates and X eventually reverse the initial move. Still FX rates and X are moving in the same direction. D (M, CO) S (X, CI) E* E’ ES

In the Long-run, A change in a Third ‘Exogenous’ variable takes place. It affects Supply and Demand for FOREX via Trade/Capital Flows It affects Price of FOREX or FOREX rates In the process to equilibrium, FOREX rates and Trade/Capital Flows interact.

If a country has technical innovations, which improve the quality of exports. World demand for this country’s exports rise; More exports means the supply of FOREX rises, FX rate (E or S) falls. Note that X up and E down. FX rates and X are moving in the opposite direction over time. S (X, CI) S’ (X’, CI) D (M, CO) E’ E

In the above graph, FX rates go up and X increases. This movement is in line with market fundamentals.

Dynamic Path of changing FX rates Even changes due to Market Fundamentals can be clouded by Overshooting/Undershooting of FX rates. Overshooting/undershooting happens due to different adjustment speeds in the FX (rate) market(agile) and the Trade/Goods market(slow). *Note: the circled part is “Undershooting” below:

* The opposite is “Overshooting”

Some more advanced thoughts…… If we start from the equilibrium, a change in price has a impact on Q but only in the short-run. If there is a change in a underlying variable other than price, supply or demand will change and thus P and Q changes at the same time. Invariably, one exogenous changes of one direction will be followed by the changes of the opposite direction. They are offsetting each other. The degree of offsetting depends on parameters of the economic system. In the normal case, usually, the second is not so large as the first: no full offsetting impact. In extreme cases, there may be no offsetting or there may be a full offsetting.

(Key Question) 1. What causes exchange rates to fluctuate. 2 (Key Question) 1.What causes exchange rates to fluctuate? 2. How do you predict exchange rates (and their changes) in SR and LR respectively? 3. What is the ‘correct or equilibrium exchange rate’? 4.What are the benefits of having flexible exchange rates as opposed to not having ones (using the big country’s currency)?