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 £ .7578 1.32 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

What if US inflation was 5% higher? Real Exchange Rates What if US inflation was 5% higher? 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 Worksheet Problems Above are the major exchange rates (maybe copied from XE.com) for 4/1/2019. They are - U.S. Dollar (USD), Euro (EUR), British Pound (GBP), Japanese Yen (JPY), Indian Rupee (INR), Australian Dollar (AUD) and Canadian Dollar (CAD). There are two lines for each pair of currencies. The top line shows the amount of that column currency that you can buy with one unit of the row currency (e.g. one U.S. dollar buys 64.8847 Indian rupees; or you can also say that it takes 64.8847 rupees to buy one dollar). The second line shows this the other way around (e.g. one Indian rupee buys 0.0153 U.S. dollars; or it costs $0.0153 to buy one rupee). Since all four of the row currencies are also included in the column currencies, part of the table is repetitive.

#1a. Since April of 2015 there has been an increase in Canadian preference for European goods, causing the exchange rate to change by 7% to the value(s) shown above. Draw the graph of the foreign exchange market from the Canadian perspective showing what has happened between 2015 and 2019. #1b. Repeat exercise #1a, except show this from the European perspective. #2a. Since October of 2014 Britain has experience a rate of inflation that is 3% more than that in the U.S. If the “relative purchasing power parity” holds, show how the exchange rate has changed from 2014 to 2019 from the British perspective. #2b. Repeat exercise #2a, except show this from the U.S. perspective. #3a. In early April of 2019 the Japanese will begin imposing tariffs on goods shipped there from Australia. Consequently the AUD is expected to depreciate by 6% over the next two years. Show what we expect to be happening in the foreign exchange market from 2019 to 2021 from the Australian perspective. #3b. Repeat exercise #3a, except show this from the Japanese perspective.

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