Exchange Rate and Currency Markets Notes

Exchange Rate

• Definition: The amount of domestic currency required to purchase $1.00 of foreign currency.

  • Example: In 2010, the exchange rate between the US and Jamaica was 87:1, meaning it took 87 Jamaican Dollars to buy one US Dollar.

  • January & February 2015 average rates: 115.32 & 115.7 respectively.

Major Types of Currencies

• United States Dollar: {$US}

• Pound Sterling: {£}

• Euro Dollar: {€}

• Canadian Dollar: {$}

Types of Exchange Rate System

• Floating Exchange Rate System:

  • Determined by market demand and supply.

• Managed Exchange Rate System (dirty float):

  • Government intervenes to stabilize or influence the exchange rate.

• Fixed Exchange Rate System:

  • Government seeks to maintain a constant currency value against another (Historic example: the gold standard).

Nominal Exchange Rate

• Definition: The official quoted exchange rate (e.g., 2 dollars for 1 pound).

  • It reflects the number of foreign currency units received for a specific amount of domestic currency.

  • Does not account for purchasing power differences between currencies.

Real Exchange Rate

• Definition: Nominal exchange rate adjusted for price levels.

  • Formula: $Real\,Exchange\,Rate = \frac{Nominal\,Exchange\,Rate}{P/P<em>}$ where $P$ = domestic price level, $P</em>$ = foreign price level.

  • Purchasing Power Parity (PPP): if holds true, $q$ (real exchange rate) equals 1.

Trade-Weighted Exchange Rate

• Evaluates a country's currency strength by weighting it based on the amount of trade with each partner.

  • A country trading primarily with Japan would see its currency's value against the yen take precedence in the overall evaluation.

Foreign Exchange Fluctuations (1990 – 2010)

• Average annual $J/US$ exchange rates:

  • 1990: 7.18

  • 2000: 43.32

  • 2005: 62.50

  • 2010: 88.49

Types of Currency Market

1. Spot Market:

   • Immediate transactions, recorded by the second business day.

2. Forward Market:

   • Transactions executed at a specified future date.

Participants in the Exchange Market

• Spot Market:

  • Commercial banks

  • Brokers

  • Customers of banks

• Forward Market:

  • Arbitrageurs

  • Traders

  • Hedgers

  • Speculators

Market Dynamics in Foreign Exchange

• Demand for US Dollars:

  • Jamaican dollar holders acquire US dollars.

• Supply of US Dollars:

  • US dollar holders exchange for Jamaican dollars.

Equilibrium Exchange Rate

• Occurs when quantity demanded equals quantity supplied for a foreign currency.

Factors Affecting Exchange Rates

1. Differentials in Inflation:

   • Lower inflation leads to stronger currency value.

2. Differentials in Interest Rates:

   • Higher interest rates attract capital, can increase currency value.

3. Current-Account Deficits:

   • A deficit indicates spending exceeds earnings from trade.

4. Public Debt:

   • Higher national debt can lead to depreciation.

5. Terms of Trade:

   • Changes in trade balance affect exchange rates directly.

6. Political Stability:

   • Stability enhances investor confidence and currency strength.

Economic Effects of Exchange Rates

• Currency Depreciation:

  • Raises import prices, lowers export prices in foreign currencies.

  • Can stimulate the economy by making exports more competitive.

• J-Curve Effect:

  • The trade balance may worsen initially after currency depreciation before improving.

Balance of Trade and Exchange Rates

• Defined as: $balance\,of\,trade = (Dollar\,price\,of\,exports * quantity\,of\,exports) - (Dollar\,price\,of\,imports * quantity\,of\,imports)$.

• Balance of trade reacts to currency depreciation over time.

Trade and Exchange Rates in a Two-Country Economy

• Prices and conditions in each country impact trade flows and demand.

• Examples show how exchange rates affect exports and imports based on comparative advantage.