L13 Exchange rate

Exchange rate

Value of one currency compared to another.

Nominal exchange rate:

How much foreign currency you can get for one unit of your own domestic currency e.g need 10 SEK tp buy 1 US dollar.

- Formula: e = Units of foreign currency / 1 unit of domestic currency

- E.g: Euro (0,088) / 1 Sek -> Means 1 sek is worth 0,088 euros. Inverse: SEK 11.41 / Euro 1.

Changes in exchange rate:

- If e increases (e.g. 1 sek = 0.095 euros) the domestic currency appreciates (can buy more euros with 1 sek)

- If 3 decreases (e.g. 1 SEK = 0.080 euros) the domestic currency depreciates (1 sek can buy fewer euros)

Flexible exchange rate

- When rate is determined by supply and demand in. the foreign exchange market and government do not interfere. E.g. USD to EUR, EUR to SEK.

Managed exchange rate

When government sometimes intervene to influence the rate with purpose of avoiding excessive fluctuations.

Fixed exchange rate

- Government intervenes actively to maintain fixed value for the exchange rate. Requires regular intervention e.g. buying or selling foreign currency.

Demand for sek

- Shows how much people want to buy SEK (demanded by people or businesses at different exchange rates.)

Demand for sek: Slope

- Slopes downward -> demand decreases when SEK becomes expensive. (exchange rate rises while quantity of SEK reduces) fewer people demand to buy since less appealing to exchange their euros for SEK since it costs more euro.

- The more expensive the SEK, the less demand. (higher exchange rate, people will exchange less because it costs more sek)

- Factors driving demand:

o International buyers demanding swedish goods and services they need SEK to pay for these. (exports)

o Swedish exporters selling using euros needs to exchange them to sek to cover costs.

Supply of SEK and slope

How much sek is being supplied in exchange for foreign currencies e.g. euro.

- Upward sloping because when supply increase, SEK becomes more expensive.

- The more expensive the SEK, the more supplied. (the more valuable sek is the more willing are they to trade to get something more.)

- Why people exchange sek?

o Swedes buy foreign things and need euros to pay. (imports)

o Foreign businesses earning SEK in Sweden and want to exchange to euros.

Equilibrium in foreign exchange market:

Point where demand equals supply is the exchange rate. The amount of swedish krona people want to buy = Amount being offered in exchange for euros

If the exchange rate is too high ->

- People in e.g. spain would demand less of SEK since it will cost more Euro to get more SEK (expensive), while the Swedish people domestically want to supply more because it is worth more euro, if they sell 1 SEK they will get more euro since SEK is more valuable.

If the exchange rate is too low ->

- Spanish people will buy more SEK since it costs less Euro (cheaper to exchange) to exchange so the demand increases, while for Swedish people they will supply and offer less because they will get less euro since it's not so valuable.

Changes in the exchange rates and curve shifts:

- E.g. if swedes demand more olive oil from abroad (import) they need euros, which increases demand for euros meaning supply for sek increases because to get the euros they need to sell more SEK. This causes depreciation meaning each SEK is worth less Euro.

Government actions to affect the exchange rate by either

Selling foreign reserves (appreciation) or buying foreign reserves (depreciation)

Buying foreign reserves

Central bank can weaken the SEK deliberately by buying Euros (foreign reserves) in exchange for selling SEK, which increases supply of SEK shifting right. As a result the SEK depreciates (weaker) and the central bank's reserves of Euro increases. Purpose: Stimulate economic growth for exports, deflation.

Selling foreign reserves

- Strengthen the SEK where the central bank instead sell foreign reserves (euro from their reserves) and buy SEK in return. -> increase demand for SEK shifting to the right. As a result SEK appreciates (stronger) and the central bank's reserves for euros decrease.

Real exchange rate

Compares price of goods and services in one country to another, adjusting for exchange rate. Help explain how expensive swedish goods are compared to foreign goods when converted into a common currency.

Formula: Real exchange rate

(SEK price of Swedish goods x nominal exchange rate) / Eur price of finnish goods

Real exchange rate appreciates (Swedish goods more expensive relative to foreign goods) if:

- Nominal exchange rate increases: SEK stronger than EUR, meaning 1 SEK gives more EUR since its more valuable

- Price level in Sweden Increases (domestic inflation): Swedish goods more expensive, raising prices in SEK

- Prices level in foreign countries decreases (foreign deflation): Foreign goods more cheaper , making Swedish goods more expensive.

GDP in an open economy - Beggar-Thy-Neighbor policy and reason for it:

- When government buy foreign reserves (euros) and supplies SEK to depreciate (weaken) the SEK in nominal and real exchange rate.

- Why?: A weaker SEK increases demand for Swedish goods for foreign buyers because it is cheaper and imports more expensive for swedes -> improves net exports.

- Effects on economy from deppreciation:

o Net exports increases (exports increase while imports decreases)

o Multiplier effect: Increased exports create more demand for swedish goods, which increases production leading to higher labor demand and reduces unemployment. This increases jobs and income, increasing consumption further, raising labor demand and economic growth. As a result: Increases the output (Y) GDP.