Chapter 16 - Exchange rates and international Capital flows

Foreign Exchange Market

This is the global marketplace where one currency is traded for another. 

What is an example to foreign exchange market

Traveling to Mexico then swapping your U.S. dollars for Mexican pesos.

Exchange Rate

The price of one country’s currency in terms of another country’s currency

Example of a exchange Rate

If exchange rate is .95 cents of Euros per 1 American dollar. it means one U.S. dollar can buy 95 cents euros. 

Appreciating Currency

A currency appreciates when it gets stronger and can buy more of a foreign currency

Who benefits the most when a currency is appreciating?

Importers since foreign goods are cheaper and tourists going abroad since their money has more buying power

Who does not benefit when a currency is appreciating?

Exporters since their goods become more expensive for foreigners to buy

Depreciating Currency

A currency depreciates when it gets weaker and can buy less of a foreign currency

Who benefits from a currency depreciating?

Exporters, goods become cheaper for foreigners to buy

Who does not benefit from a currency depreciating?

Importers since foreign goods are more expensive and tourists money have less buying power

What causes exchange rates to change?

Rates of return, relative inflation, Expectations

Rates of return

If U.S. investments offer higher returns(high interest rates) investors in Mexico will demand more U.S. dollars to invest, strengthening the dollar

Relative Inflation

If a country has a higher inflation than another, the currencies buying power falls. This will lead to investors wanting to hold fewer pesos causing the peso to depreciate

Expectations

Investors hoping the currency will get stronger in the future, they will demand more of the currency now to profit later. This causes the currency to appreciate immediately. 

Purchasing Power Parity (PPP)

Long term exchange rate that would equalize the prices of internationally traded goods across countries

Example of PPP

A basket of goods that costs 100 dollars in the U.S. shoukd cost the equivalent amount in another currency. If it costs 80 pounds in the U.K, the Purchasing Power Parity exchange rate would be 1.25 per pound.

Exchange Rate polices

Floating Rate, Soft Peg, Hard peg, Merged Currency.

Floating Rate

Market decides the exchange rate

Soft Peg

The market usually decides but the central bank sometimes intervenes

Hard Peg

The central bank keeps the exchange rate fixed at an unchanging value

Merged currency 

The country adopts another currency

Floating Exchange Rate

A policy where a country lets supply and demand in the foreign exchange determine its currency’s value

Upsides to the floating exchange rate

Gives the country’s central bank flexibility to use monetary policy to fight inflation or recession

Downsides to floating exchange rate

It can lead to large unpredictable fluctuations that create risk for businesses involved in trade

Main Tradeoff 

To hold the peg, a country often has to give up using its monetary policy to fight domestic inflation or unemployment

What type of peg is a merged currency?

The most extreme form of a hard peg, where a nation gives up its own currency entirely and adopts the currency of another nation or group of nations

Dollarize

Country that is not the U.S dollar as its currency

Main participants in the foreign exchange market

• firms involved in international trade

• Tourists visiting other countries

• International investors buying ownership in a foreign firm

• International investors making purely financial investments

Hedge

Using a financial transaction as a way to protect yourself against risk

Example of hedge

A business can sign a contract that guarantees a specific exchange rate in the future to avoid losing money if the currency value changes