Study Notes on Foreign Exchange Rates and Economic Modelling

Previous discussion recap: Fixed exchange rates are determined by government, while floating rates are determined by market forces.
Next topic: Model to understand the differences between fixed and floating exchange rate systems.

Assertion: The foreign exchange market can be described with a supply and demand diagram.
- Axes:
- Horizontal: Quantity of foreign currency
- Vertical: Exchange rate
Notation:
- S: Supply of foreign currency
- d: Demand for foreign currency

Shape of Curves:
- Demand curve: Negative slope
- Supply curve: Positive slope
Complexities of Modelling:
- Demand's negative slope typically derived from consumer choice theory (indifference curves).
- Demand for foreign currency doesn't provide direct utility like goods do; hence, assumptions from product markets do not directly apply.
Supply side explanation:
- In product markets, positive slope in supply arises from higher marginal costs of production.
- Foreign exchange market supply: Marginal cost for foreign currency is close to zero due to computerized trading.

Let x be any traded good.
- p_x: Domestic price of x
- p_x^*: Foreign price of x
- Equilibrium condition: px = e × px^* where e: exchange rate.
- Consumers must be indifferent between domestic and foreign suppliers.
Equation explanation:
- Buying from a domestic supplier: Cost is p_x.
- Buying from a foreign supplier: Cost = px^* in foreign currency, which translates to e × px^* in domestic currency.
- In equilibrium: Domestic price (px) equals import cost of x (e × px^*).

Let S be domestic supply curve, positive slope.
Demand leads to equilibrium: If domestic price is below e × p_x^*, no imports occur, leading to domestic supply only.
- Thus, total supply curve (Stotal) consists of domestic supply (SD) until e × p_x^* and then becomes horizontal (foreign supply).

Consider depreciation: e1 to e2 affects import costs.
Resulting changes in supply curve and equilibrium quantity.
Documentation of the Import Substitution Effect which explains why depreciation leads to lesser imports and higher domestic supply:
- Domestic consumers buy less foreign as their currency depreciates.

Trade balance (X - M) is affected by imports and exports.
- When imports increase, trade balance worsens initially.
- Depreciation of currency usually stimulates exports, which could improve the trade balance but often not enough to offset initial worsening.
Marginal Propensity to Import:
- Refers to the fraction of additional income that is spent on imports.
- Impacts trade deficits and surpluses, stressing the importance for wealthy vs. poorer nations.

Increased foreign investments necessitate higher foreign currency demand, shifting the demand curve to the right, leading to depreciation.
This results in a pure depreciation effect that can improve the trade balance due to increased domestic exports and less imports.

Investment increases with GDP upsurge; decreases with higher interest rates due to opportunity costs.

Aggregate expenditure is equal to consumption (C), investment (I), government spending (G), and net exports (X - M).
Dynamics of government spending changes are typically constant within a simplified macroeconomic model.

Fixed exchange rate systems have a central parity condition set by government with permissible fluctuations (target zones).
Shifts in supply-demand may lead to the need for the government to intervene to maintain the exchange rate within the fixed zone.

Central banks defend their rates using reserves.
Issues arise if demand shifts lead to net losses of reserves without appropriate adjustments.

Expectations of currency depreciation lead to immediate shifts in supply and demand in foreign exchange markets.
Real-world examples illustrate the implications of these theoretical frameworks within currency markets, investments, and overall economic policies.