Exchange Rates

Exchange RatesExchange RatesWhat is an exchange rate?What is an exchange rate?

What types of rates exist, and how are they What types of rates exist, and how are they different?different?

How would you graph supply and demand for a How would you graph supply and demand for a currency?currency?

Why would exchange rates change?Why would exchange rates change?

Current Exchange Rates

Appreciation of the dollar Appreciation of the dollar –an increase –an increase in the value of the dollar relative to in the value of the dollar relative to the currency of another nationthe currency of another nation dollar buys more foreign stuffdollar buys more foreign stuff

Depreciation of the dollar Depreciation of the dollar – a – a decrease in the value of the dollar decrease in the value of the dollar relative to another currencyrelative to another currency dollar buys a smaller amount of foreign dollar buys a smaller amount of foreign

currency and thus foreign goodscurrency and thus foreign goods

Floating Exchange RatesFloating Exchange Rates

Market Exchange Rates determined Market Exchange Rates determined by Supply and Demandby Supply and Demand

Items requiring foreign exchange:Items requiring foreign exchange: ServicesServices TourismTourism Business tripsBusiness trips Currency speculatorsCurrency speculators Set-up a manufacturing companySet-up a manufacturing company

An OverviewAn Overview

Suppose:Suppose: Canadian DollarsCanadian Dollars Mexican PesosMexican Pesos

IF Mexican importers demand IF Mexican importers demand Canadian goods they must pay for Canadian goods they must pay for the goods in Canadian dollars, the goods in Canadian dollars, therefore, an increase in demand for therefore, an increase in demand for Canadian dollars.Canadian dollars.

Q of C$

PesoPriceofC$

D1D2 for C$

Downward Sloping DemandDownward Sloping Demand

The lower the price of The lower the price of the C$ the more will the C$ the more will be demandedbe demanded

The cheaper the C$ is The cheaper the C$ is to Mexican traders the to Mexican traders the cheaper are Canadian cheaper are Canadian goods, services and goods, services and assets. Therefore the assets. Therefore the demand curve for the demand curve for the dollar will slope dollar will slope downward.downward.

Canadian Dollar Exchange Canadian Dollar Exchange RateRate

Peso Price of C$

Q of C$

D by Mexico

Upward Sloping SupplyUpward Sloping Supply Supply of C$ into foreign Supply of C$ into foreign

exchange markets comes exchange markets comes from Canadians wishing to from Canadians wishing to buy Mexican goods, buy Mexican goods, services and assetsservices and assets

The higher the C$/peso The higher the C$/peso exchange rate the more exchange rate the more pesos will be bought and pesos will be bought and the more dollars will be the more dollars will be supplied.supplied.

This is because the price of This is because the price of Mexican goods, services Mexican goods, services and assets are cheaper in and assets are cheaper in Canadian dollars the Canadian dollars the higher is the price of the higher is the price of the C$.C$.

Exchange Rate for Exchange Rate for Canadian $Canadian $

Peso Price of C$

Q of C$

S by Canada

Equilibrium Exchange RatesEquilibrium Exchange Rates A= Equilibrium exchange rate,A= Equilibrium exchange rate,

DDC$C$ = S = S C$C$

If exchange rate is below If exchange rate is below equilibrium, at C$1 =90 equilibrium, at C$1 =90 pesos then D>S, shown as B-pesos then D>S, shown as B-C.C.

Dealers wanting to earn Dealers wanting to earn commission by exchanging commission by exchanging money will have to raise the money will have to raise the offer price for the C$ to offer price for the C$ to encourage greater supply and encourage greater supply and reduce the excess demand. reduce the excess demand. This would continue until This would continue until equilibrium was reached.equilibrium was reached.

In practice the process is very In practice the process is very rapid, they adjust to small rapid, they adjust to small gaps in rates minute by gaps in rates minute by minute.minute.

Exchange Rate for Exchange Rate for Canadian $Canadian $

Peso Price of C$

Q of C$

S of C$ by Canada

D of C$by Mexico

100

90

80

A

B C

Floating Exchange RatesFloating Exchange Rates

Suppose there is an Suppose there is an increase in demand increase in demand for British goods. for British goods. This means that This means that foreigners need foreigners need pounds and the pounds and the need for pounds need for pounds drives up the drives up the exchange rate.exchange rate.

The reverse is true The reverse is true as well.as well.

Exchange rates for British Exchange rates for British Sterling (Pounds)Sterling (Pounds)

Currency TermsCurrency Terms

Appreciate = A rise in the exchange Appreciate = A rise in the exchange rate is called appreciation.rate is called appreciation.

Depreciation = A fall in the exchange Depreciation = A fall in the exchange rate is called depreciation.rate is called depreciation.

Peso priceOf C$

Quantity of C$

D1 of C$

D2 of C$

S1 of C$

S2 of C$

A fall in demand of C$ is shown As a shift in the demand curveFrom D1 to D2. An increase inSupply is shown as a movementFrom S1 to S2. In both cases the exchange rate Of the C$ will fall, or depreciate(Conversely, the peso has Appreciated).

A

B

C

Fixed Exchange RatesFixed Exchange Rates Suppose there is an Suppose there is an

increase in demand for increase in demand for British Sterling= D1 to British Sterling= D1 to D2, thus increasing D2, thus increasing exchange rate.exchange rate.

British authorities will British authorities will then tap into their then tap into their currency reserves and currency reserves and sell more sterling, thus sell more sterling, thus increasing supply from increasing supply from S1 to S2, and S1 to S2, and maintaining fixed maintaining fixed exchange rate.exchange rate.

Determinants of Foreign Exchange Determinants of Foreign Exchange Rates Rates

TTaste and Preferencesaste and Preferences Increase taste for German cars = increase demand for Euro, Increase taste for German cars = increase demand for Euro,

therefore euro appreciatestherefore euro appreciates RRelative Interest Rateselative Interest Rates

Canada offers high interest rates = increased demand for C$ Canada offers high interest rates = increased demand for C$ therefore C$ appreciatestherefore C$ appreciates

IIncome, real Incomencome, real Income If GDP increases then increased M, increase supply of their If GDP increases then increased M, increase supply of their

currency, therefore their currency depreciates currency, therefore their currency depreciates PPrices levels, relative Price Levelsrices levels, relative Price Levels

If a country has high inflation, consumers in that country will If a country has high inflation, consumers in that country will increase M because M is relatively cheaper, increase supply increase M because M is relatively cheaper, increase supply currency to buy M- currency depreciatescurrency to buy M- currency depreciates

SSpeculation –peculation – If speculators think the currency will do well then buy low and If speculators think the currency will do well then buy low and

sell high. If speculators think $ is overvalued and is due for a sell high. If speculators think $ is overvalued and is due for a fall, people holding $ will rush to sell and the supply of $ will fall, people holding $ will rush to sell and the supply of $ will increase - $ depreciatesincrease - $ depreciates

China, A Currency Manipulator?