In-Depth Notes on Exchange Rates and FOREX

Exchange Rates

• Definition: Most countries have their own currency, necessitating the trading of currencies for international purchases and trade.

• Trading Currencies: Involves buying one currency with another.

• Exchange Rate: The price of one currency expressed in terms of another.

• Price Variation:

  • Prices fluctuate based on supply and demand.

  • Changes over time, leading to volatility.

  • Volatility complicates financial planning.

• Independence of Exchange Rates: Exchange rates often behave independently from other countries' exchange rates.

Key Concepts

• Reciprocal Exchange Rate: Understanding appreciation and depreciation.

  • Appreciation: Strengthening of currency, requiring less to buy foreign currency.

  • Depreciation: Weakening of currency, requiring more to purchase foreign currency.

Foreign Exchange Markets (FOREX)

• Overview:

  • The largest financial market globally, with over $5 trillion exchanged daily.

  • Daily trades in stock markets are valued at approximately $84 billion.

• Participants:

  • Banks, central banks, investment managers, multinational corporations, individual investors.

• Trading Activities:

  • Direct purchase of goods/services in other countries.

  • Direct or portfolio investments in foreign countries.

Market Equilibrium

• Determination of Exchange Rate:

  • Exchange rate in the market is set where supply equals demand.

  • Equal opposite reactions in the demand-supply relationship.

Factors Impacting Demand for CAD

1. Exports Demand:

   • Reduced exports lower demand for CAD due to decreased trading activity.

   • Tariffs can negatively impact CAD by causing decreased exports.

2. Interest Rates:

   • Canadian interest rates compared to foreign ones affect demand.

   • Higher foreign rates attract investments, increasing demand for CAD as foreign investors seek bonds.

3. Inflation Rate:

   • Higher Canadian inflation reduces purchasing power, leading to decreased demand for CAD.

4. Rate of Return on Canadian Assets:

   • A higher return on Canadian stocks and housing may increase demand for CAD.

5. Expected Future Exchange Rate:

   • Anticipating the currency's appreciation leads to increased current demand to avoid future costs.

Factors Affecting Supply of CAD

1. Demand for Imports: Increased demand for imports decreases supply of CAD.

2. Interest Rates:

   • Higher foreign yields decrease demand for CAD.

3. Inflation Rate:

   • Similar effects as above apply to supply.

4. Rate of Return of Canadian Assets: Higher returns abroad can decrease CAD supply.

5. Expected Future Exchange Rate:

   • Similar expectations influence supply decisions.

Economic Insights

• Current Trends: CAD has depreciated by 7% since September.

  • Impacts include decreased US demand for Canadian goods, which affects CAD negatively.

  • A weaker dollar facilitates exports but makes imports expensive.

  • CAD depreciation can increase vulnerability of Canadian companies to foreign takeovers.

• Tariff Impacts: Tariffs on US imports increase costs, leading to a leftward shift in the SRAS curve and potential decline in GDP.

• Fiscal Policies: Canadian fiscal policy has struggled, particularly regarding timing of interventions and their implications for national debt and future taxation.