Intro to Economics - Foreign Exchange

7/31/2019 Intro to Economics - Foreign Exchange

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Foreign Exchange

Dr. Katherine Sauer

A Citizens Guide to Economics

ECO 1040


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Overview:

I. CurrencyII. Foreign Exchange

III. Types of Exchange Rates


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I. Currency

Currency is a unit of exchange. It is exchanged for:- goods

- services

- other currency

Most countries have control over the supply and

production of their own currency.

Usually Central Banks or Ministries of Finance control

the currency.


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There are about 175 currencies in current circulation.

There are about 195 countries in the world.

- several countries use the same currency

ex: the euro is used by Portugal, Spain, France,

Italy, Ireland, Belgium, Luxembourg, Germany,Netherlands, Austria, Slovenia, Slovakia, Finland,

Malta, Greece and Cyprus

- some countries use another nations currencyex: Panama and El Salvador use the US dollar as

legal tender


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Several countries use the same name for their currency:

dollar

United States

Belize

CanadaHong Kong

peso

Philippines

Uruguay

Mexico

To avoid confusion, the ISO 4217 classification system is

used. (three letter currency code)

USD

BZD

CADHKD

PHP

UYU

MXN


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II. Foreign Exchange

When making international transactions (like payingfor imports or buying foreign assets), currencies are

exchanged as well.


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A. Exchange Rate Basics

The foreign exchange rate (exchange rate, forex rate,FX rate) specifies how much one currency is worth in

terms of another currency. (abbreviated e)

1. The current exchange rate is also called the spot rate.


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Example Spot Rates:

USD GBP EUR

USD 1.0000 1.5421 1.2889

GBP 0.6485 1.0000 0.8357

EUR 0.7759 1.1966 1.0000

July 25,2010oanda.com

With 1 US dollar you could get how many British pounds?

0.6485

With 1 British pound you could get how many US dollars?1.5421

(actually just the reciprocal 1/1.5421 = 0.6485)

You could getthis amount of

this currency

With one of this currency


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2. Using exchange rates to convert prices into another currency:

On June 18, 2007, our meal in Vienna, Austria cost19.70 and

the exchange rate was 1 USD = 0.73169EUR.

How many US dollars did it cost?

19.70 x 1$ . = $

0.73169

$26.92


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On August 3, 2005 in Nice, France a kilo of peppers cost2.20.

The exchange rate was 1 EUR = 1.19501 USD.

How much did a kilo of peppers cost in US dollars?

2.20 x 1.19501$ =

1 $2.63


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Salzburg, Austria

June 2007

1$ = 0.74270euro1 x 1$ = $1.35

0.74270


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Prague, Czech Republic

June 2007

1$ = 21.3830 koruna

(CZK)20kc x $1 = $0.94

21.3830kc


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B. Exchange Rate Fluctuations

When one unit of currency A can buy more of currency

B, then currency A has appreciated versus currency B.

When one unit of currency A can buy less of currency B,then currency A has depreciated versus currency B.


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For example:

7/25/2009 1 USD = 0.718692 EUR

7/25/2010 1 USD = 0.790398 EUR

Has the US dollar appreciated or depreciated versusthe euro over this time?

dollar has appreciated versus the euro

the euro has depreciated versus the dollar


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Some implications of an appreciating currency:

- import more (currency is strong, buying power is strong)

- export less

- trade balance changes: more of a deficit or less of a

surplus

- travel abroad is cheaper

Some implications of a depreciating currency:

- import less

- export more

- trade balance changes: less of a deficit or more of asurplus

- travel abroad is more expensive


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Economists dont believe that appreciating/depreciating

currencies are inherentlygood or bad it depends on

the circumstances.


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III. Types of exchange rates

floating(aka flexible): the currencys value isdetermined by market forces

fixed(aka pegged): the currencys value is set at a fixed

value of another currency

pegged float: the currencys value is kept within a

certain range of predetermined values with another

currency


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The Foreign Exchange Market for British pounds

(exchange rate between $ and )

Demand for for foreign exchange

- investors who have $ and wish to buy -denominated

assets

- investors who are selling $-denominated assets and

wish to convert back to

- US importers of British goods (have $ but need to pay

for the order in )


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Supply of for foreign exchange

- Investors who have and wish to buy $-denominated

assets

- Investors who are selling denominated assets and

wish to convert back to $

- British importers of US goods (have but need to

pay in $)

- government policy (Central Banks or Ministries of

Finance), and bank practices


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the Foreign Exchange Market for British pounds

e $/

Q for forex

The notation e$/ indicates

the exchange rate in termsofdollars per pound.

As the value of e$/

increases,

the is appreciating

against the $.

As the value of e$/

decreases,

the is depreciating

against the $.


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D

e $/

Q for forex

D slopes downward

because as the depreciates, it is

cheaper to buy using

$ (as the price of a

falls, the quantity

demanded of it rises).

S is vertical becausethere is a certain

quantity of available

for foreign exchange at

any given time.

S

the Foreign Exchange Market for British pounds


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1. Floating Exchange Rates (flexible)

D

e $/

e*

Q for forex

The intersection of the

supply and demand for

determines the exchange

rate.

S


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When supply or demand changes, so does a floating

exchange rate.

D1

e $/

e1

e2

Q for forex

Suppose that $-denominated

assets are paying a higherreturn than -denominated

assets.

- D will decrease aspeople sell assets in

favor of $ assets

- the exchange rate falls( depreciates vs the $)

S

D2


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2. Fixed (Pegged) Exchange Rates

Flexible (floating) exchange rates fluctuate with market

forces and may be quite volatile.

To reduce the uncertainty associated with a floating forex

rate, a country might choose to peg its currency to acertain value.


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The main benefit of a pegged exchange rate is stability.

- investors are more certain of a return

- import/export transactions have less risk

The drawback of a pegged exchange rate is it causes a

lack of flexibility for other policies.

- the Central Bank / Ministry of Finance has to

take steps to maintain the peg

- need to have reserves of the currency you arepegging to


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A pegged rate higher than the market rate:

Dkroon

eeuro/kroon

e1

Qd Qs

Suppose Estonia pegs the

kroon to the euro at a rate ofe1.

- at e1, Qs > Qd which

means there is a surplus of

kroon in the market

- normally, the kroon would

depreciate

-the Estonian Central Bank

must intervene to keep the

kroon from depreciating

Skroon

Qkroon

Surplus of kroon

overvalued


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The Estonia Central Bank must use its reserve of euros to buy

up the surplus of kroon.

- needs to be willing to do so at the fixed exchange rate

Dkroon

eeuro/kroon

e1

Qd Qs

Skroon

Qkroon

Surplus of kroon

- The Central Bank ends

up with more kroon

- Depletes reserves of

euros

Pull kroon out of the

market

Put euros into the

market


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Implications:

An overvalued currency can lead to a trade deficit:

- decreases exports (they are more expensive)

- increases imports (they are cheaper)

- It benefits imports at the expense of exports

The Central Bankreduces its foreign exchange reserves.

If a currency is overvalued for a long period of time,

then a balance of payments crisis could be on thehorizon.

- run out of reserves

- cant pay for imports


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Options if running out of foreign reserve currency:

- borrow foreign exchange from another central bank orthe IMF to maintain the peg

- re-set the peg to a lower level, more consistent with the

market rate

- allow the exchange rate to depreciate down to the

market level


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Ifinvestors think that a currency will be devalued, they

may sell all of their assets in that currency.

- the demand for currency falls- more pressure on the peg.

- market equilibrium is even further below

the peg

- the surplus is larger- A government may be forced to devalue the

currency.

- self-fulfillingprophecy

The investors could then move back into the currency, but

since it has depreciated, they can buy much more of it.


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A pegged rate lower than the market rate:

D

e$/

e1

Qs Qd

Suppose China pegs the

yuan to the US dollar at arate of e1.

- at e1, Qd > Qs which

means there is a shortage

of yuan in the market

- normally, the yuan

would appreciate

- to keep the currency

from appreciating, the

central bank must intervene

S

Q

shortage of yuan

undervalued


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D

e$/

e1

Qs Qd

S

Q

shortage of yuan

The Central Bank must put yuan into the market.

- will be spending yuan to buy up dollars

- needs to be willing to do so at the fixed exchange rate

- China ends up with more

reserves of dollars

Pull dollars out of the

market

Put yuan into the

market


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Implications:

An undervalued currency can lead to a trade surplus:

- increases exports- decreases imports

- It benefits exports at the expense of imports

The government will increase its foreign currency

reserves.

If a currency is undervalued for a long time, then thegovernment may be forced to expand the domestic

money supply to get more domestic currency.

- domestic inflation


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If currency speculators think that the government may re-

value the currency, then hot money may flow into the

country.- increases demand for the currency

- the peg is now even further below market

equilibrium

- more of a shortage- need more domestic currency

- inflation increases

- the government re-sets the peg higher, or lets the

currency float

- speculators make a profit


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What did you learn today?

Please explain 2 concepts from todays class.

Intro to Economics - Foreign Exchange

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