Foreign Exchange Market

Foreign Exchange Market(FOREX)

Most countries have their own currency that is used by people to buy and sell goods/services

Differing currencies do not stop people from buying and selling each other goods and services

As with any other good/service, currencies are subjected to supply and demand

The Foreign Exchange Market is not a “real” place (physically)

It is a composite representation of the world-wide trade of currencies between people, businesses, international financial institutions and the central banks of most countries

Foreign Exchange Market(FOREX)

Reasons for exchanging one currency for another

1. Change in preferences for a good/service

2. Change in the quality of a good/service

3. Change in relative price levels

4. Change in relative incomes (GDP)

5. Changes in relative interest rates

Foreign Exchange Market(FOREX)

When you think of currencies:

THINK DERSIRABILITY

Foreign Exchange Market(FOREX)

• Example: Assume Europeans are impressed by the latest computers made by Dell Computers. The quality is excellent and they like the variety of colors that they come in. Also assume the Euro-area countries are in the midst of an economic recovery AND the U.S. economy is in a recession which has depressed the average price level. – This example hits four of the factors that affect the exchange

rates between two currencies• Change in preferences (color of computers)• Change in quality (improved computers)• Change in relative Price Level (prices lower In U.S.)• Change in relative incomes (GDP)

– The average European has more income and will tend to purchase not only more European goods/services, but imports as well. In our case from the U.S.

Foreign Exchange Market(FOREX)

• Dell Computers have become more desirable for a variety of reasons, therefore the U.S Dollar has become more desirable as well.

• REMEMBER: DESIRABILITY!!!

Foreign Exchange MarketThe Market for EUROS

Demand for Euros

Supply of Euros

Qeuro*Quantity of Euros

Dollar PricePerEuro

(“How manyDollars does itTake to buy aEuro”)

$/Euro* ($1.00)

If Europeans want to buy U.S. Goods/Services they must give up their Eurosin order to obtain Dollars. Initially the SUPPLY of Euros is going to INCREASEin the Market for Euros.

“Take myEuros!

“Now we Have more

Euros!FOREX

“A”

Foreign Exchange MarketThe Market for EUROS

Demand for Euros

Supply of Euros

Qeuro*Quantity of Euros

Dollar PricePerEuro

(“How manyDollars does itTake to buy aEuro”)

Notice that the Dollar Price Per Euro is now lower than it was at theprevious equilibrium point. It NOW takes FEWER dollars to buy a Eurothan it did before. The Dollar has APPRECIATED in value relative to the Euro

“Take myEuros!

“Now we Have more

Euros!

Supply of Euros1

Qeuro1

FOREX

$/Euro* ($1.00)

$/Euro1 ($.50)

“A”

“B”

Foreign Exchange MarketThe Market for Dollars

Demand for $

Supply of $

Q$*Quantity of Dollars

Euro PricePerDollar

(“How manyEuros does itTake to buy aDollar”)

Euro/$* (€.1.00)

After the Europeans have given up their Euros, they are going to want (DEMAND) Dollars for those Euros. The DEMAND for the Dollar will INCREASE

“Give me $$$”

“Europeans are DEMANDING

Dollars from us!”

FOREX

“A”

Foreign Exchange MarketThe Market for Dollars

Demand for $

Supply of $

Q$*Quantity of Dollars

Euro PricePerDollar

(“How manyEuros does itTake to buy aDollar”)

Notice that the Euro Price Per Dollar is now higher than it was at theprevious equilibrium point. It NOW takes more Euros to buy a dollarthan it did before. The Euro has DEPRECIATED in value relative to the Dollar.

“Give me $$$”

D$1

Q$1

Euro/$1 (€2.00)

Euro/$* (€.1.00)

“A”

“B”

“Europeans are DEMANDING

Dollars from us!”

Foreign Exchange MarketEffect NOW on Exports and

Imports

The Dollar has APPRECIATED in value relative to the Euro. This means now it takes FEWER Dollars to buy a Euro than it did before (Americans have to give up fewer Dollars to buy the same amount of Euros than before). This means Europeans goods/service will be relatively LESS expensive for Americans to buy (like a sale) and IMPORTS from Europe will tend to INCREASE.

Foreign Exchange MarketEffect NOW on Exports and

Imports

The Euro has DEPRECIATED in value relative to the Dollar. This means now it takes MORE Euros to by a Dollar than it did before (Europeans have to give up more Euros to buy the same amount of Dollars than before). This means American goods and services will be relatively MORE expensive for Europeans to buy and EXPORTS to Europe will tend to DECREASE.

The Foreign Exchange MarketEffect NOW on Exports and Imports

The NET EXPORT N(x) Effect:Exports Decreasing and Imports Increasing

Net Exports are DECREASING

Therefore GDP is Decreasing

AD Shifts to the Left

AD DECREASES!!!!

SAY WHAT?????

The Foreign Exchange MarketEffect NOW on Exports and Imports

• IT SEEMS SELF-DEFEATING!!!

• Well…It is!

• Foreigners BUY more U.S. made Computers (which is an export) but in the process they APPRECIATE the currency which makes the everything else (including Dell computers) eventually more expensive….Welcome to the world of the FOREX!!

Foreign Exchange MarketThe Interest Rate Effect

• Interest rates affect the value of a currency in the Foreign Exchange Market.

• In the FOREX, we think of interest rates in terms of SAVING and/or INVESTING.

• Money (financial capital) does not care about national boundaries.

• It wants to go where it can grow the biggest (in terms of Rate of Return)

• It will seek the place with the highest interest rate, regardless of the currency that the interest rate is available.

Foreign Exchange MarketThe Interest Rate Effect

• Example: Assume the Interest Rates on savings/investing in the U.S. is higher than the Interest Rates in Europe.

• Europeans want to put their money where it can grow the biggest.

• But they have Euros?? What to do??

• They exchange their Euros for Dollars in the FOREX

Foreign Exchange MarketThe Market for EUROS

Demand for Euros

Supply of Euros

Qeuro*Quantity of Euros

Dollar PricePerEuro

(“How manyDollars does itTake to buy aEuro”)

$/Euro* ($1.00)

If Europeans want to invest in U.S. FINANCIAL ASSETS which are now more DESIRABLE! They must give up their Euros in order to obtain Dollars. Initially the SUPPLY of Euros is going to INCREASE in the Market for Euros.

“Take myEuros!

“Now we Have more

Euros!

FOREX

“A”

Foreign Exchange MarketThe Market for EUROS

Demand for Euros

Supply of Euros

Qeuro*Quantity of Euros Euros

Dollar PricePerEuro

(“How manyDollars does itTake to buy aEuro”)

Notice that the Dollar Price Per Euro is now lower than it was at theprevious equilibrium point. It NOW takes FEWER dollars to buy a Eurothan it did before. The Dollar has APPRECIATED in value relative to the Euro

“Take myEuros!

“Now we Have more

Euros!

Supply of Euros1

Qeuro1

FOREX

“A”

“B”$/Euro* ($1.00)$/Euro1 ( $.50)

Foreign Exchange MarketThe Market for Dollars

Demand for $

Supply of $

Q$*Quantity of Dollars

Euro PricePerDollar

(“How manyEuros does itTake to buy aDollar”)

Euro/$* (€1.00)

After the Europeans have given up their Euros, they are going to want (DEMAND) Dollars for those Euros. The DEMAND for the Dollar will INCREASE

“Give me $$$”

“Europeans are DEMANDING

Dollars from us!”

FOREX

“A”

Foreign Exchange MarketThe Market for Dollars

Demand for $

Supply of $

Q$*

Quantity of Dollars

Euro PricePerDollar

(“How manyEuros does itTake to buy aDollar”)

Notice that the Euro Price Per Dollar is now higher than it was at theprevious equilibrium point. It NOW takes more Euros to buy a dollarthan it did before. The Euro has DEPRECIATED in value relative to the Dollar.

“Give me $$$”

D$1

Q$1

Euro/$* (€1.00)

Euro/$1 (€2.00) “A”

“B”

“Europeans are DEMANDING

Dollars from us!”

Foreign Exchange MarketEffect NOW on Exports and

Imports

The Dollar has APPRECIATED in value relative to the Euro. This means now it takes FEWER Dollars to buy a Euro than it did before (Americans have to give up fewer Dollars to buy the same amount of Euros than before). This means Europeans goods/service will be relatively LESS expensive for Americans to buy (like a sale) and IMPORTS from Europe will tend to INCREASE.

Foreign Exchange MarketEffect NOW on Exports and

Imports

The Euro has DEPRECIATED in value relative to the Dollar. This means now it takes MORE Euros to by a Dollar than it did before (Europeans have to give up more Euros to buy the same amount of Dollars than before). This means American goods and services will be relatively MORE expensive for Europeans to buy and EXPORTS to Europe will tend to DECREASE.

Foreign Exchange MarketEffect NOW on Exports and Imports

The NET EXPORT N(x) Effect:Exports Decreasing and Imports Increasing

Net Exports are DECREASING

Therefore GDP is Decreasing

AD Shifts to the Left

AD DECREASES

Say What….Again!!

Foreign Exchange MarketBottom Line

• What causes the Dollar to Appreciate (INCREASE the DEMAND for $’s)– Preferences for U.S. made Goods/Services– Improved Quality of Goods/Services– Lower Price Level in U.S relative to other

countries– Foreign Incomes increase (GDP increases)– Higher Interest Rates in U.S. relative to other

countries (U.S. Financial Assets more desirable)

Foreign Exchange MarketBottom Line

• What causes the Dollar to Depreciate (INCREASE the SUPPLY of $’s)

– Preferences for Foreign Made Goods/Services– Improved Quality of Foreign Made Goods/Services– Lower Price Level in Foreign Countries relative to

U.S.– U.S. incomes increase (U.S. GDP Increases)– Higher Interest Rates in Foreign Countries relative to

the U.S. (Foreign Financial Assets more desirable)

FOREX – Example

Assumption – Mercedes Benz makes cars in both the U.S. and Germany. Lets say that yesterday the exchange rate between the $ and the € is $1.00 equals € 1.00. To buy a Mercedes costs $50,000 or € 50,000. You are indifferent to who sells you the car. In the paper today you find out the U.S. interest rate relative to the interest rate in Europe is LOWER. You check the FOREX and you find out that the exchange rate is now USD/EURO is $1.35 (dollar price (cost) per euro is $1.35). Use the following worksheet to graph what happened in the FOREX market and answer the questions that follow.

USD $50,000 = EURO €50,000

Exchange Rate was $1.00 = €1.00

Exchange Rate is now

or

How much does that Mercedes cost now in each currency for an American to buy and a German to buy?

If you are a German and you convert your Euros to Dollars that Mercedes will cost you:

If you are an American and you convert your Dollars to Euros that Mercedes will cost you:

Where do Americans want to buy their Mercedes?

Where do Germans want to buy their Mercedes?

What happens to Exports from U.S

What happens to Imports to U.S.

USD $50,000 = EURO €50,000

Exchange Rate was $1.00 = €1.00

Exchange Rate is now

$1.35 = € 1.00 (dollar price (cost) per euro is $1.35)or

€.74 = $1.00 (euro price (cost) per dollar is €.74)

How much does that Mercedes cost now in each currency for an American to buy and a German to buy?

If you are a German and you convert your Euros to Dollars that Mercedes will cost you:

$50,000 = No. of Euros needed x $1.35 (for each Euro exchanged he can get $1.35)$50,000 / $1.35 = No. of Euros needed

€ 37,037If you are an American and you convert your Dollars to Euros that Mercedes will cost you:

€ 50,000 = No. of Dollars needed x €.74 (for each Dollar exchanged he can get €.74) € 50,000 / €.74= No. of Dollars needed

$67,567Where do Americans want to buy their Mercedes?

In U.S.Where do Germans want to buy their Mercedes?

In U.SWhat happens to Exports from U.S

What happens to Imports to U.S.

FOREX – Example

Assumption – Mercedes Benz makes cars in both the U.S. and Germany. Lets say that yesterday the exchange rate between the $ and the € is $1.00 equals € 1.00. To buy a Mercedes costs $50,000 or € 50,000. You are indifferent to who sells you the car. In the paper today you find out the U.S. interest rate relative to the interest rate in Europe is HIGHER. You check the FOREX and you find out that the exchange rate is now USD/EURO is $.75 (dollar price (cost) per euro is $.75). Use the following worksheet to graph what happened in the FOREX market and answer the questions that follow.

USD $50,000 = EURO €50,000

Exchange Rate was $1.00 = €1.00

Exchange Rate is now

or

How much does that Mercedes cost now in each currency for an American to buy and a German to buy?

If you are a German and you convert your Euros to Dollars that Mercedes will cost you:

If you are an American and you convert your Dollars to Euros that Mercedes will cost you:

Where do Americans want to buy their Mercedes?

Where do Germans want to buy their Mercedes?

What happens to Exports from U.S

What happens to Imports to U.S.

USD $50,000 = EURO €50,000

Exchange Rate was $1.00 = €1.00

Exchange Rate is now

$.75 = € 1.00 (dollar price (cost) per euro is $.75)or

€.1.33 = $1.00 (euro price (cost) per dollar is €.1.33)

How much does that Mercedes cost now in each currency for an American to buy and a German to buy?

If you are a German and you convert your Euros to Dollars that Mercedes will cost you:

$50,000 = No. of Euros needed x $.75 (for each Euro exchanged he can get $.75$50,000 / $.75 = No. of Euros needed

€ 66,667If you are an American and you convert your Dollars to Euros that Mercedes will cost you:

€ 50,000 = No. of Dollars needed x €1.33 (for each Dollar exchanged he can get €1.33) € 50,000 / €1.33= No. of Dollars needed

$37,594Where do Americans want to buy their Mercedes?

In Germany.Where do Germans want to buy their Mercedes?

In Germany

What happens to Exports from U.S?

What happens to Imports to U.S?