International Finance and the Foreign Exchange Market

Number of 1 country’s currency that is equal to 1 unit of another country’s $1 = € $1 = £ 1€ = $ 1£ = $

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.

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. $ ¥en Euro Can $ U.K. £ Aust $ SFranc

U.S. $ 4/ U.S. $ 3/ U.S. $ 12/ Currency Last Trade U.S. $ 5/04 U.S. $1 ¥en110.2 Euro Can $1.377 U.K. £ Aust $1.389 SFranc1.299

Currency $ Appreciate/ Depreciate Yahoo April 2005 Yahoo Mar 2004 Yahoo Dec 2003 Text Oct 2002 U.S. $ ¥en Euro Can $ U.K. £ Aust $ SFranc

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. $ 5/ U.S. $ 12/ U.S. $ 10/

Exchange Rate Regimes Three major types of exchange rate regimes: flexible (floating) rates, fixed-rate (unified currency), and, pegged exchange rates. Examples of a fixed rate (unified) system: 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.

Pegged Exchange Rate Regimes Pegged exchange rate system: a country commits to using monetary and fiscal policy to maintain the exchange-rate value.

flexible to fixed

pegged

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.

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 $ $2.75 = $2.20 US ($2.93 Canadian)

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.

Quantity of foreign exchange (pounds) Q $1.20 $1.50 $1.80 Dollar price of foreign exchange (for pounds ) Foreign Exchange Market Equilibrium S (sales to foreigners) Excess demand for pounds Excess supply of pounds The vertical axis – dollar price for 1 British pound. The horizontal axis - pounds exchanged Equilibrium exchange rate of $1.50 = 1 English pound. A price of $1.80 = 1 pound would lead to an excess supply of pounds... causing the dollar price of the pound to fall (depreciate). A price of $1.20 = 1 pound would lead to an excess demand for pounds … causing the dollar price of the pound to rise (appreciate). D (purchases from foreigners) e

Changes in the Exchange Rate Determinants: 1.A change in national income (relative to trading partners) people buy more, or less of everything. 2.A change in the inflation rate in one country. a. Higher rate decreases demand b. Lower demand - depreciation 3.A change in interest rates (relative to rates abroad). a. High rates attract money b. Currency appreciates 4. Changes in tastes

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

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

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

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.

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

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.

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 of current account transactions: Merchandise trade (import and export of goods) Service trade (import and export of services) Income from investments Unilateral transfers (gifts to and from foreigners)

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.

Current account: 1. U.S. merchandise exports 2. U.S. merchandise imports 3. Balance of merchandise trade (1 + 2) 4. U.S. service exports 5. U.S. service imports 6. Balance on service trade (4 + 5) 7. Balance on goods and services (3 + 6) 8. Income receipts of Americans from abroad 9. Income receipts of foreigners in the U.S. 10. Net income receipts (8 + 9) 11. Net unilateral transfers 12. Balance on current account ( ) Debits Balance deficit (-) / surplus (+) Credits Continued on next page … U.S. Balance of Payments, 2003 * Source: Figures are in Billions of Dollarshttp://

12. Balance on current account ( ) Debits Balance deficit (-) / surplus (+) Credits Capital account: 13. Foreign investment in the U.S. (capital inflow) 14. U.S. investment abroad (capital outflow) 15. Balance on capital account ( ) 16. U.S. official reserve assets 17. Total ( ) Source: Figures are in Billions of Dollarshttp:// U.S. Balance of Payments, 2003 * Official Reserve Transactions: Current account: Foreign official assets in the U.S Balance, Official Reserve Account ( )

Capital Flows and the Current Account

Under a flexible exchange rate system the inflow and outflow of capital will exert a major impact on the current account and trade balances. The figures for the U.S. (above) illustrate this linkage. Leading Trading Partners of the U.S Current Account as % of GDP surplus (+) or deficit (-) Net Foreign Investment as % of GDP surplus (+) or deficit (-)

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.