Module 42 the foreign exchange market

• 1. THE FOREIGN EXCHANGE MARKET MODULE 42

2. WHAT IS THE FOREIGN EXCHANGE MARKET?The foreignexchange market (currency, Forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the businesss income is in U.S. dollars. 3. THE FOREIGN EXCHANGE MARKET ISUNIQUE BECAUSE OF:Trading volumesThe extreme liquidity of the marketIts geographical dispersionIts long trading hours: 24 hours a day except on weekendsThe variety of factors that affect exchange ratesThe low margins of profit compared with other markets of fixed income (but profits can be high due to very large tradingvolumes) 4. THE FOREIGN EXCHANGE MARKET ISUNIQUE BECAUSE OF:Trading volumesThe extreme liquidity of the marketIts geographical dispersionIts long trading hours: 24 hours a day except on weekendsThe variety of factors that affect exchange ratesThe low margins of profit compared with other markets of fixed income (but profits can be high due to very large tradingvolumes) 5. THE ROLE OF THE EXCHANGERATEThe exchange rate, which is determined in the foreign exchange market ensures that the balance of payments really does balance.Exchange rates are the equilibrium prices for national currencies.An exchange rate shows how much of a nations currency is needed to purchase a unit of anothers currency. 6. UNDERSTANDING EXCHANGERATESInternationaltransactions require a market in which currencies can be exchanged for each other.This market is the foreign exchange market, and it establishes the exchange rates.The exchange rates are the prices at which currencies trade. 7. UNDERSTANDING EXCHANGE RATESExchange rates can be written in two ways:(exchanges as of May 9, 2012)U.S. dollarsYen EurosOne U.S. dollar1 79.62990.772900exchanged forOne yen0.0125583 1 0.00970430exchanged forOne euro1.29389103.047 1exchanged for 8. UNDERSTANDING EXCHANGE RATESWhen a currency becomes more valuable in terms of other currencies, economists say the currency appreciates.When a currency becomes less valuable in terms of other currencies, it depreciates.Movements in exchange rates, ceteris paribus, affect the relative prices of goods, services, and assets in different countries. 9. THE EQUILIBRIUM EXCHANGE RATEThe equilibrium exchange rate is the exchange rate at which the quantity of currency demanded in the foreign exchange market is equal to the quantity of currency supplied.Movements in the exchange rate ensure that changes in the financial account and the current account offset each other. 10. DOLLAR-YEN MARKETIn the dollar-yen market, the dollar price of a yen would be on the vertical axis and the quantity of yen would be on the horizontal axis. The intersection of the up-sloping supply of yen curve and down-sloping demand for yen would determine the dollar price of a yen. 11. DOLLAR-YEN MARKETIfUS demand for Japanese goods increased, more yen would be needed to pay for the goods, and so the demand for yen would increase.This change increases the dollar price of yen, which means there has been a depreciation of the US dollar relative to the yen. 12. DOLLAR-YEN MARKETConversely, if Japanese demand for US goods increased, more dollars would be needed to pay for the goods, and the supply of yen would increase. This change will decrease the dollar price of yen, which means there has been an appreciation of the US dollar relative to the yen. 13. CURRENCY APPRECIATION ANDDEPRECIATIONThe dollar price of foreign International value of the dollar fallscurrency rises(dollar depreciates) International value of foreignForeign currency price of currency risesdollar falls(foreign currency appreciates) 14. INFLATION AND REAL EXCHANGERATESTo take into account the effects of differences in inflation rates, economists calculate the real exchange rates, which are the exchange rates adjusted for international differences in aggregate price levels. 15. INFLATION AND REAL EXCHANGE RATES: AN EXAMPLE 16. INFLATION AND REAL EXCHANGE RATES: AN EXAMPLESuppose the Mexican peso depreciates against the U.S. dollar, with the exchange rate going from 10 pesos to 15 pesos per U.S. dollar, which is a 50% change.At the same time the prices in Mexico increase by 50%, so that the price index rises from 100 to 150. 17. INFLATION AND REAL EXCHANGE RATES: AN EXAMPLE 18. INFLATION AND REAL EXCHANGERATES: AN EXAMPLEIn this example, the peso has depreciated significantly in terms of the U.S. dollar, but the real exchange rate between the peso and the U.S. dollar has not changed at all.And because the real peso-U.S. dollar exchange rate has not changed, the nominal depreciation of the peso against the U.S. dollar will have no effect on the quantity of goods traded between the countries. 19. INFLATION AND REAL EXCHANGE RATES: AN EXAMPLEThe current account responds only to a change in the real exchange rate, not the nominal exchange rate.A countrys products become cheaper to foreigners only when that countrys currency depreciates in real terms. 20. PURCHASING POWER PARITYThe purchasing power parity between two countries is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. 21. PURCHASING POWER PARITYFor example, if the same basket of goods and services costs 800 pesos in Mexico and $100 in the U.S. the PPP would be: 800 pesos = $1008 pesos per $1 22. PURCHASING POWER PARITYNominal exchange rates almost always differ from purchasing power parities.Some of the differences are systematic: in general, aggregate price levels are lower in poor countries than in rich countries because services tend to be cheaper in poor countries. 23. PURCHASING POWER PARITYBut even among countries with roughly the same amount of economic development, nominal exchange rates vary quite a lot from the purchasing power parity.Over the long run, however, purchasing power parities are quite good at predicting actual changes in nominal exchange rates. 24. PURCHASING POWER PARITYIn particular, nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket.