Chapter 19:
The Foreign Exchange Market
- The Exchange Rate: The price of one currency in terms of another.
- The Foreign Exchange Market: The financial market where exchange rates are
determined.
- Exchange rates are important  affect our economy  imports and exports.
As our currency become cheaper  domestic goods cheaper and imported goods
expensive.
- As our currency become higher  domestic goods expensive and imported goods
cheaper.
- Exchange rates are highly volatile:
-
Euros to 1 USD
Source: http://www.x-rates.com/d/EUR/USD/graph120.html
Graph (1)
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U.S. Dollar to Kuwaiti Dinar Exchange Rate
Range: 1d 5d 3m 1y 2y 5y
Invert Currencies
Graph (2)
Japanese Yens to 1 USD (invert,data)
Source: http://www.x-rates.com/d/JPY/USD/graph120.html
Graph (3)
-
What factors explain the rise and fall of exchange rates?
Why exchange rates fluctuate from day to day?
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-
Foreign Exchange Market:
Trade between countries involves an exchange of different currencies and bank deposits
denominated in US dollars  In this market, exchange rates are determined  cost of
foreign goods and financial assets are set. (over-the-counter market)
- Two kinds of exchange rate transactions:
1. Spot transactions: immediate (2-day) exchange of bank deposits. (Spot exchange
rate)
2. Forward transactions: the exchange of bank deposits at some specified future date.
(Forward exchange rate)
-
When currency increases in value  appreciation
When currency falls in value  depreciation
Example: in 1999, the Euro = 1.18 $
in 2003, the euro = 1.08 $
The euro depreciated by 8%: (1.08 – 1.18) / (1.18)= - 0.08
Or
In 1999, $ = 0.85 euro
In 2003, $ = 0.93 euro
The $ appreciated by 9%: (0.93 – 0.85) / (0.85) = 9%
USD
1
0.574284
1.218
0.827883
1.30531
GBP
1.74129
1
2.1209
1.44159
2.27293
CAD
0.821018
0.471497
1
0.679706
1.07168
EUR
1.2079
0.693677
1.47122
1
1.57668
AUD
0.766101
0.439959
0.933111
0.634242
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Source: http://www.x-rates.com
- Why Exchange rates are important?
Because they affect the relative price of domestic and foreign goods and services. The
relative price (KD/$) is determined by:
1- The price of the Kuwaiti good in KD
2- The KD/$ exchange rate.
If price of good (X) = $350 in the U.S, and the exchange rate = 0.291 to the KD, good
(X) will costs (350 x 0.291) = KD 102
If the exchange rate is $0.3, then good (X) will cost (350 x 0.3) = KD 150
Thus, good X become expensive as the $ appreciates.
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If the price of a Kuwaiti good (Z) = KD200, and the exchange rate = $0.291, then its $
cost = $ 688 (200 / 0.291), but if the exchange rate is $0.3, then its $ cost = $666.
Thus, good Z become cheaper as the $ appreciates.
Result:
1. When a country’s currency appreciates, the country’s goods abroad become
more expensive (Exports) and foreign goods in that country become cheaper
(Imports).
2. When a country’s currency depreciates, the country’s goods abroad become
cheaper (Exports) and foreign goods in that country become expensive
(Imports).
Exchange Rates in the Long Run
Law of One Price:
If two countries produce identical good, and transportation costs are low, the price of the
good should be the same in all markets regardless which country produced it.
If American good costs ($1000) and identical Kuwaiti good costs (KD 300), for the law
of one price to hold, the exchange rate must be ($0.3 per KD: 1000/300)
If instead, the Kuwaiti good is cheaper, say (KD 250 = $833), then demand will increase
on the Kuwaiti good (and no demand on American good).
For the American good to be sold again in the market, exchange rate must adjust so the
price of the 2 goods is the same: e=$0.25
Theory of Purchasing Power Parity (PPP):
Exchange rate between two countries will adjust to reflect changes in the price levels of
the two countries. It is an application of the law of one price to national price levels rather
than individual prices.
In the above example, as the price of Kuwaiti good falls, for the law of one price to hold,
the exchange rate must be ($0.25), meaning that the KD must depreciate by (15%).
Thus, as the price level in one country rises relative to the other, its currency should
depreciate (other country’s currency should appreciate)
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Factors Affecting the Exchange Rates in the Long Run
1. Relative Price Level: PPP when prices of American good rise, the demand for
American goods falls and the $ tend to depreciate  increase the demand for the
American goods.
Result: in the LR, a rise in a country's relative price level causes its currency to
depreciate, and a fall in the country's relative price level causes its currency to
appreciate.
2. Trade Barriers: Such as tariffs and Quotas on foreign goods. This will increase
the demand for domestic goods, so its currency appreciates.
Result: In the long run, increasing trade barriers cause a country's currency to
appreciate, and reducing trade barriers cause a country's currency to depreciate.
3. Preferences for Domestic vs. Foreign Goods: As foreign consumers prefer our
goods (domestic goods), the demand for our goods increases and our exports
increase. Thus our currency appreciates
Result: In the long run, increased demand for a country's exports causes its
currency to appreciate, and increased demand for imports causes the domestic
currency to depreciate.
4. Productivity: if one country becomes more productive, production cost and price
falls, increasing demand for domestic goods, and the domestic currency
appreciates.
Result: in the long run, as a country becomes more productive, its currency
appreciates, and as other countries become productive, domestic currency
depreciates.
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