Econ Chapter 16 Foreign Exchange Market

Foreign exchange market

We call the market in which people or firms use one currency to purchase another currency the foreign exchange market.

Dollarize

that is, to use the U.S. dollar as their currency.  

Soft peg

the name for an exchange rate policy where the government usually allows the market to set exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market. 

Hard peg

hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. A central bank can implement soft peg and hard peg policies.

Appreciating

When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, we refer to it as appreciating or “strengthening.”

Depreciating

When the exchange rate for a currency falls, so that a currency trades for less of other currencies, we refer to it as depreciating or “weakening.”

Speculation

is the act of buying or selling an asset with the expectation of profiting from its short-term price fluctuations, taking on a high level of risk for a potential high reward.

-This shift is primarily going to impact financial investors.

Speculation example:

• Girl thinks pound will increase in price; so she buys pounds

• Pounds do go up

Purchasing power parity

• We call the exchange rate that equalizes the prices of internationally traded goods across countries the purchasing power parity (PPP) exchange rate.

• Iphone example

Who are the groups of individuals that interact with the foreign exchange market?

There are four primary groups that interact with the foreign exchange market: 

1. Firms that are involved in international trade of goods and services.  

2. Tourists visiting other countries 

3. International investors buying ownership (or part-ownership) of a foreign firm 

4. International investors making financial investments that do not involve ownership.

Why is the U.S. dollar considered a benchmark currency?

• The U.S. dollar is the most prominent benchmark currency because it’s a very stable currency, older than many competitors, and it comes from a large country with an even larger economy

What are the factors that will shift the foreign exchange market?

• Relative interest rates  

• Relative inflation  

• Economic performance  

• Changing preferences  

• Expectations about future exchange rates

Who benefits from a stronger U.S. dollar versus who benefits from a weaker dollar?

When the U.S. Dollar Is Strong (Appreciates)

1. U.S. Importers Foreign goods become cheaper → cost of imports ↓.

2. U.S. Consumer Cheaper imported goods (electronics, clothes, cars, etc.) → purchasing power ↑.

3. U.S. Travelers Abroad Their dollars stretch further → travel is cheaper.

4. Foreign Firms Selling to the U.S. Their products become cheaper for Americans → foreign exports ↑.

Who Is Hurt by a Strong Dollar?

• U.S. exporters (their goods become more expensive abroad)

• U.S. tourism industry (traveling to the U.S. becomes expensive for foreigners)

• U.S. firms competing with cheap imports

How does speculation work, and how do people incur loss or profit when conducting Speculation?

Speculation is when investors buy or sell a currency because they expect its future value to change.
They are not buying the currency to purchase goods—only to make financial gains.

Speculators try to profit from expected appreciation or depreciation in currency values.

What are some real-world complications that keep purchasing power parity from providing a complete explanation of exchange rates?

PPP is imperfect because:

1. Many products are non-tradable

2. Differences in products and preferences exist across countries

3. Trade barriers (tariffs, quotas) distort prices

These factors prevent exchange rates from always reflecting the relative purchasing power of currencies.

How does the foreign exchange market correct itself over time as currencies appreciate or Depreciate?

Appreciation makes exports fall and imports rise, which lowers demand for the currency and causes depreciation; depreciation makes exports rise and imports fall, which increases demand for the currency and causes appreciation.

How do changes in monetary policy influence the foreign exchange market?

Monetary policy → changes in interest rates → changes in capital flows and currency demand → currency appreciation or depreciation → affects net exports and aggregate demand.