Lesson 1

🔑 Key Concepts

1. Definition

• Hard Currency:

  • Currency of a strong geopolitical nation.

  • Stable in value, does not depreciate or fluctuate greatly.

  • Preferred for international trade and commerce.

  • Considered low-risk for investment and exchange.

• Soft Currency:

  • Currency of a politically or economically weak country.

  • Unstable and volatile, often fluctuates in value.

  • High-risk for international trade and investment.

  • May be used for trade, but less commonly and with more caution.

🌍 Usage in International Trade

• International trade often requires using a currency that is fixed or trusted.

• Hard currencies are chosen to avoid the risk of sudden depreciation or loss.

• Example: If a deal is made in U.S. dollars and the dollar suddenly weakens, the seller loses value.

⚠ Risks Involved

• With soft currencies, the value might change drastically, creating uncertainty in trade.

• These currencies are less preferred, but can yield high profits if their value increases unexpectedly.

📊 Examples

💡 Exam Tip (UPSC or Economics Exams):

• Hard vs. Soft Currency is a frequently asked topic.

• Focus on:

  • Stability and trustworthiness of the issuing country.

  • Usage in global trade.

  • Risk vs. return comparison.

📝 Summary

• Hard Currency = Stable, Strong Nation, Low-Risk, Preferred for trade.

• Soft Currency = Unstable, Weak Nation, High-Risk, Less preferred but sometimes used.

🔑 Core Concepts

• The Foreign Exchange Market is where currencies are bought and sold.

• It determines the exchange rate: the price of one currency in terms of another (e.g., how many euros per dollar).

📉📈 Basic Graph Setup

• X-axis: Quantity of a currency (e.g., U.S. dollars)

• Y-axis: Exchange rate (e.g., € per $)

• Demand Curve: Downward sloping

  • Shows the relationship between exchange rate and quantity demanded of the currency.

• Supply Curve: Upward sloping

  • Represents how much of the currency is being supplied at various exchange rates.

🤔 Who Demands and Who Supplies Currency?

• Foreigners demand your currency to:

  • Buy your goods/services (exports)

  • Travel to your country

  • Invest in your country

• You supply your own currency when:

  • You buy foreign goods/services (imports)

  • You travel abroad

  • You invest in foreign assets

📌 Example:

• In the market for U.S. dollars:

  • Demand is by Europeans (to buy U.S. goods, services, or assets)

  • Supply is by Americans (to buy European goods, travel, or invest abroad)

🔁 Exchange Rate Movements

• If demand for dollars increases, the dollar appreciates (gains value).

• If demand for dollars decreases, the dollar depreciates (loses value).

• Appreciation of a currency means it becomes more valuable compared to another.

• Depreciation means it becomes less valuable.

🚨 Important:

📈📉 Effects of Appreciation & Depreciation

• Depreciation of a country’s currency:

  • Increases exports (foreign buyers can afford more)

  • Decreases imports (domestic buyers find foreign goods more expensive)

  • Net exports rise, increasing aggregate demand.

  • Exporters usually prefer a weaker (depreciated) currency.

• Appreciation of a country’s currency:

  • Decreases exports (more expensive for foreigners)

  • Increases imports (cheaper for domestic consumers)

  • Net exports fall, decreasing aggregate demand.

🔄 Four Shifters of the Foreign Exchange Market

These cause shifts in demand or supply for a currency:

1. Tastes and Preferences

   • More foreigners wanting your country’s goods = ↑ Demand for your currency

   • E.g., more European tourists visiting the U.S. = ↑ demand for USD → Appreciation

2. Incomes (Relative)

   • If other countries’ incomes fall, they’ll buy fewer of your goods = ↓ demand for your currency → Depreciation

   • Example: A recession in Europe = ↓ demand for USD

3. Price Levels (Relative Inflation Rates)

   • If your country has higher inflation, your goods are less attractive.

     • ↓ Demand for your currency

     • ↑ Supply of your currency (to buy cheaper foreign goods)

     • Double shift: demand ↓, supply ↑ → Depreciation

4. Interest Rates (Relative)

   • If your interest rates rise:

     • Foreigners want to buy your bonds/assets

     • ↑ Demand for your currency → Appreciation

     • Your citizens invest more at home = ↓ supply of your currency → Double shift, both reinforcing appreciation

📚 Scenarios Reviewed in the Video

🧠 Tips for AP Macro/IB/College Econ

• Always ask: “Who needs to exchange money?”

• Consider both sides (demand & supply) when analyzing currency shifts.

• Appreciation/depreciation impacts exports, imports, AD, and GDP.

• Know the double shift effect: Inflation and interest rate changes often affect both demand and supply simultaneously.

🔑 Key Terms Recap

• Exchange Rate: The price of one country’s currency in terms of another (e.g., how many yuan for a dollar).

• Appreciation: A currency increases in value relative to another.

• Depreciation: A currency decreases in value relative to another.

🔄 TWO Types of Exchange Rate Systems

1. 🪙 Floating Exchange Rate

• Definition: An exchange rate determined entirely by market forces (supply & demand).

• How it works:

  • If demand for a currency increases → it appreciates.

  • If supply increases or demand falls → it depreciates.

• No government interference.

• Self-correcting: The market naturally adjusts based on trade, investment flows, etc.

✅ Advantages:

• Reflects true market value.

• Automatically adjusts to economic conditions.

• No need for large foreign currency reserves.

❌ Disadvantages:

• Can cause instability for exporters/importers due to unpredictable currency fluctuations.

• May lead to inflation or recession if exchange rates change rapidly.

2. 🏛 Fixed Exchange Rate

• Definition: A system where a country’s government or central bank sets (or "pegs") its currency’s value to another currency (like the U.S. dollar or the euro).

• The government intervenes to keep the exchange rate at a specific value or within a desired range.

🧠 Why fix exchange rates?

• To provide stability in international prices.

• To protect exports by keeping currency artificially low.

• To build investor confidence in a stable currency system.

⚙ How a Country Maintains a Fixed Exchange Rate

📉 Scenario: Dollar is appreciating too much against the yuan

• The U.S. doesn’t want this because:

  • Strong dollar → U.S. exports become expensive → China buys less.

  • Could hurt American businesses and reduce net exports.

🧰 Government Tools to Bring Dollar Back Down:

1. Lower Interest Rates:

   • ↓ Capital inflow (investors look elsewhere)

   • ↓ Demand for dollars

   • → Dollar depreciates

2. Buy Foreign Currency (e.g., yuan):

   • Increases supply of dollars in the foreign exchange market

   • → Dollar depreciates

3. Foreign Exchange Controls (Restrictions):

   • Limit who can buy/sell dollars

   • For example, ban Chinese investors from buying U.S. assets

   • ↓ Demand for dollars

   • → Dollar depreciates

🎯 Goal:

⚖ Floating vs Fixed – Comparison

📦 Real-World Examples

• Floating Exchange Rate Countries:

  • United States

  • Canada

  • United Kingdom

• Fixed Exchange Rate Countries:

  • Hong Kong (pegs to the U.S. dollar)

  • Argentina

  • Bulgaria

• Managed Float (Hybrid):

  • Some countries allow floating within a target range and intervene when necessary.

💡 Why It Matters in Business and Policy

• If you sign a long-term contract in foreign currency, and the exchange rate changes drastically:

  • You could lose money if your currency weakens.

  • Companies hedge against this risk (e.g., through forward contracts).

• Governments must decide:

  • Is it better to let the market decide the currency’s value?

  • Or should they intervene to support trade and financial stability?

🔚 Final Thoughts

• The choice between floating and fixed depends on:

  • How open the country is to international trade

  • The size of its currency reserves

  • Economic policy goals (e.g., inflation control, export competitiveness)

Let me know if you’d like:

• Diagrams to go with this explanation

• Practice questions

• A printable version or flashcards to study from

1. Describe the concept of an exchange rate and how they are determined

An exchange rate is the price of one country’s currency in terms of another, such as how many Canadian dollars it takes to buy one U.S. dollar.

Exchange rates are determined by supply and demand in the foreign exchange (forex) market:

• If demand for a currency increases, the currency appreciates.

• If supply increases or demand falls, the currency depreciates.
  In a floating exchange rate system, the market (without government interference) sets the exchange rate based on these forces.

2. Explain the difference between a hard and a soft currency

• A hard currency is one that is widely accepted, stable, and trusted for international transactions (e.g., U.S. dollar, Euro). It is usually from a country with a strong economy and stable government.

• A soft currency is from a country with unstable economic conditions or weak international trust, and it may be subject to high inflation or strict controls (e.g., Venezuelan bolívar, Argentine peso).

3. List the 4 shifters of currency demand

1. Changes in consumer tastes (e.g., more foreigners wanting Canadian goods)

2. Relative income levels (e.g., higher Canadian income = more imports = more demand for foreign currency)

3. Relative inflation rates (lower inflation → more purchasing power → higher foreign demand for currency)

4. Relative interest rates (higher interest rates → more capital inflow → higher demand for the currency)

4. Explain the difference between a floating rate and a fixed rate system including the 3 ways governments try to control rates as well as 3 country examples for each system

Floating Exchange Rate:

• Set by market forces (supply & demand)

• No government interference

• Self-adjusting to economic changes

• Examples: United States, Canada, United Kingdom

Fixed Exchange Rate:

• Government or central bank pegs the currency to another (e.g., the USD)

• Actively manages the exchange rate using policy tools

• Keeps currency stable, often to support exports

• Examples: Hong Kong, Argentina, Bulgaria

3 Ways Governments Try to Control Exchange Rates (in a fixed system):

1. Lower interest rates: Decreases demand for currency → currency depreciates

2. Buy foreign currency: Increases domestic currency supply → currency depreciates

3. Foreign exchange controls: Limits how much or what kind of assets foreigners can buy → reduces demand

5. Discuss the changes in demand for the Canadian dollar

The demand for the Canadian dollar can increase when:

• Foreigners buy more Canadian exports (e.g., oil, lumber)

• Interest rates in Canada rise (making Canadian assets more attractive)

• Foreign investment flows into Canada (FDI or portfolio investment)

• Canada has lower inflation compared to other countries

The demand can decrease if:

• Canada's interest rates fall

• Inflation rises

• Imports increase while exports decline

• Global investors prefer other currencies or economies