1. The Foreign Exchange Market
Chapter 17
The Foreign Exchange Market

2. Definitions Exchange Rate:
The price of one currency in terms of another currency.
Foreign Exchange Market:
A market in which trading of currency and bank deposits denominated in particular currencies takes place.
Currency Appreciation: the increase in its value.
Currency Depreciation: the fall in its value.

3. What Are Foreign Exchange Rates?
There are 2 kinds of exchange rate transactions:
1. Spot Transactions: involve the immediate (two-day) exchange of bank deposits.
2. Forward Transactions: involve the exchange of bank deposits at some specified future date.
There are 2 kinds of exchange rates:
1. Spot Exchange Rate: is the exchange rate for the spot transaction.
2. Forward Exchange Rate:  is the exchange rate for the forward transaction.

4. How is Foreign Exchange Traded?
The foreign exchange market is organized as an over the counter market.
There are several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies.

5. Better to buy which good?
Why Are Exchange Rates Important? Because they affect the relative price of domestic and foreign goods, and therefore affecting preferences for domestic and foreign goods. Example: Assume the price of the European good is 2 Euros.
Year
Price :
Kuwaiti good
Exchange rate of Euro
Price:
European good in KW
Better to buy which good?
2000
700 Fils
285 Fils
_____ Fils
_________
2008
425 Fils

6. When currency appreciates, the country's goods abroad (its exports) become more expensive and foreign goods in that country (its imports) become cheaper.
↑ in EXR → ↓ Exports and ↑ Imports
When currency depreciates, the country's goods abroad (its exports) become cheaper and foreign goods in that country (its imports) become more expensive.
↓ in EXR → ↑ Exports and ↓ Imports
Result: Net Exporting countries prefer low EXR, while net importing countries prefer high EXR.

7. Factors Affecting Exchange Rates in the Long Run 1
Factors Affecting Exchange Rates in the Long Run 1. Relative Price Level A rise in a country's price level (relative to the foreign price level) causes its currency to depreciate. 2. Trade Barriers (Tariffs and Quotas) Tariffs and quotas cause a country's currency to appreciate in the long run.

8. 3. Preferences for Domestic versus Foreign Goods
Increased demand for imports causes the domestic currency to depreciate.
Increased demand for a country's exports causes its
currency to appreciate.
4. Productivity
As a country becomes more productive (relative to the
other country) its currency appreciates.

9. Response of the Exchange Rate
 Factor
Change in Factor
Response of the Exchange Rate
Domestic Price Level ↑
Trade Barriers
Import Demand
Export Demand
Productivity

10. Exchange Rate of the Euro vs the Dollar (2004-2008)