Exchange rates and FX markets: an asset approach

Why do people want assets if they can’t consume them?

• Assets allow you to save for the future - transfer wealth into future

• prestige as well, owning property

• saving for retirement

How do people judge which assets to hold?

1. Return

• how much money/value do I expect to make

• higher return → generally more attractive

2. Risk

• most people are risk averse, so two investments with similar expected returns, people generally prefer the less risky one

3. Liquidity

• The ability to convert the asset into other assets or consumption.

• bonds vs art

• cash vs equities → cash is more valuable because it’s more liquid

what are the three uses of money??

1. store of value: as an asset there is no return but it’s liquid

• money has 0 nominal return, if inflation is positive, the real value falls

1. unit of account: the standard by which all other assets/incomes are measured

2. medium of exchange: avoid barter (need for trading goods)

Hyperinflation

when inflation rates become extremely high, a currency begins to lose its functions as money.

1. if inflation is very high, money no longer effectively stores value

2. when inflation is very high, firms and individuals may stop using it for accounting purposes. May switch to another currency.

3. if money has little (and unstable) value, economic actors may no longer find it useful for exchange.

What about foreign currency?

Foreign currency can also be an asset

Why might someone hold a foreign currency?

for example euros

1. return: influenced by exchange-rates can fluctuates, inflation

2. risk: exchange rates can fluctuate

3. liquidity: some currencies are much easier to buy/sell than others

Relative prices of currencies

Price of one currency measured in another currency

Direct vs Indirect

Direct FX price: my currency/their → higher number means there needs to be more of my currency to equalize to one of their. ex. $/euro = 1.94 means I need 1.94 dollars to get 1 euro back.

Indirect FX prices: their currency/mine. higher number means my currency is more valuable since they need more of their currency to get only one of mine. For example, euro/$ = 1.23, this means one dollar will get more than one euro.

Bid-ask price

“bid price” = what the seller receives

“ask price” = what the buyer pays

“bid - ask spread” - reflects transactions costs

• ex. if seller wants 1.22 - 1.20 = 0.02 → the 0.02 represents transaction cost

• larger number can indicate market disruptions

Why do we care about foreign exchange rates? and the value of foreign goods

because it allows us to see the prices in out home currency.

for example. If a wool sweater from edinburgh cost GBP 50 and the exchange rate is USD 1.25/GBP. from this i know that more USD is needed so we must multiply.

• 50 × 1.25 = $60.50

But what happens when my currency appreciates?

that means the USD/GBP goes down → 1.15USD/GBP and the price goes to $57.50

when the dollar appreciates → foreign goods are cheaper

when the dollar depreciated → foreign goods become more expensive

exchange rates and the value of home goods

$50 american jeans

if the exchange rate is 1.25USD/GBP = 50/1.25 = 40 GBP

if the exchange rate decreases meaning the dollar appreciates to 1.15USD/GBP then the new cost is 43.48 GBP

when the dollar appreciates → american goods become more expensive abroad

when the dollar depreciates → my goods become cheaper abroad

Depreciation vs Devaluation

Depreciation is market-driven decline

devaluation = policy-driven decline

CA and depreciation

When your currency depreciates, your home goods are cheaper for foreigners. Meaning that there’s more demand from abroad → exports increases. X increases and M decreases. CA balance improves

when your currency appreciates, your home goods are more expensive for foreigners. meaning demand decreases → exports decrease. X decrease and m increase because foreign goods are more cheaper sp CA declines

Can a country manage their exchange rate regimes?

1. Floating: the currency freely fluctuates according to supply/demand

2. Fixed: sometimes called “pegged”- against a single currency

3. Crawling peg: the currency depreciates along a predetermined path. Often used for inflation differentials

4. Band: the currency is allowed to freely fluctuate within certain parameters.

5. managed float (aka “dirty float'“)

6. No separate currency