Exchange Rates and International Capital Flows

Overview of the Foreign Exchange Market

• Definition of Foreign Exchange Market: This is the global market in which individuals and entities use one currency to purchase another currency.

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

• Market Scale and Importance:

  • The foreign exchange market is the largest market in the world economy.

  • In $2019$, the daily trading volume was approximately $\$5.3 \text{ trillion}$.

  • For context, the U.S. Real GDP in $2019$ was approximately $\$21.4 \text{ trillion}$ per year.

• Dollarization: A phenomenon where a country that is not the United States chooses to use the U.S. dollar (USD) as its official currency.

Demanders and Suppliers of Currency

• There are four primary groups of participants in foreign exchange markets:

  • Firms in International Trade: Companies that import and export goods and services across borders. These firms often face a mismatch: their production costs (workers, suppliers, and investors) are measured in the currency of the nation where production occurs, while their revenues are measured in the currency of the nation where the sales take place.

  • Tourists: Individuals visiting foreign countries who must exchange their home currency for the local currency to pay for expenses.

  • International Investors (Direct): Investors seeking ownership or part-ownership (at least $10\text{\%}$) of a foreign firm.

  • International Investors (Financial/Portfolio): Investors making financial investments that do not involve management responsibility or ownership.

International Financial Investment and Risk Management

• Foreign Direct Investment (FDI): This involves purchasing at least $10\text{\%}$ of a firm or starting a new enterprise in another country.

• Portfolio Investment: A purely financial investment in another country without any management responsibility (e.g., buying foreign stocks or bonds).

• Hedging: The practice of using a financial transaction as protection against risk. A common example is guaranteeing a specific exchange rate for a future date to avoid losses from currency fluctuations.

• Exchange Rate Expectations: Portfolio investors often attempt to benefit from expected movements in exchange rates. Expectations of a currency's future value are a primary driver of current demand and supply in the market.

Market Participants and Currency Value Fluctuations

• Foreign Exchange Dealers: Banks and other financial firms that trade foreign exchange in the "interbank market." There are roughly $2,000$ such firms worldwide. In the U.S. economy, there are fewer than $100$ foreign exchange dealers.

• Appreciating (Strengthening): This occurs when the exchange rate for a currency rises, meaning the currency is worth more in terms of other currencies.

• Depreciating (Weakening): This occurs when the exchange rate for a currency falls, meaning the currency is worth less in terms of other currencies.

• Inverse Relationship: The depreciation of one currency corresponds to the appreciation of another. For example, if the U.S. dollar weakens against the Canadian dollar, the Canadian dollar is simultaneously strengthening against the U.S. dollar.

Demand and Supply Shifts in Foreign Exchange Markets

• Expectation-Driven Shifts:

  • Demand: Increases when there is a belief that a currency's value will rise in the future.

  • Supply: Increases when there is an expectation that a currency's value will decline.

• Equilibrium: The equilibrium exchange rate ($E$) is found at the intersection of the demand ($D$) and supply ($S$) curves.

  • On a graph for the U.S. dollar relative to the Mexican peso, the horizontal axis measures the quantity of U.S. dollars, and the vertical axis measures the price of U.S. dollars in pesos.

  • Conversely, on a graph for the Mexican peso, the horizontal axis measures the quantity of pesos, and the vertical axis measures the price of pesos in U.S. dollars.

• Response to Future Expectations: If an announcement suggests the Mexican peso will strengthen in the future:

  • Demand for pesos shifts to the right ($D_0 \rightarrow D_1$) as investors buy in anticipation of appreciation.

  • Supply of pesos shifts to the left ($S_0 \rightarrow S_1$) as current holders become less likely to sell.

  • Both shifts cause an immediate appreciation of the currency.

Factors Influencing Exchange Rates

• Relative Rates of Return:

  • Investment funds move toward countries with relatively high rates of return and flee countries with low rates of return.

  • If U.S. interest rates (rates of return) increase, the demand for U.S. dollars shifts right ($D_0 \rightarrow D_1$), and the supply shifts left ($S_0 \rightarrow S_1$). This leads to a stronger equilibrium exchange rate ($E_1$).

• Relative Inflation:

  • If a country has high inflation compared to others, the purchasing power of its currency erodes. This discourages people from holding that currency.

  • High inflation in Mexico would lead to a shift in demand for pesos from $D_0 \rightarrow D_1$ (a decrease) and an increase in supply from $S_0 \rightarrow S_1$. Both movements cause the currency to depreciate.

• Purchasing Power Parity (PPP):

  • Arbitrage: The process of buying and selling goods across borders to profit from price differences.

  • PPP Exchange Rate: The rate that equalizes the prices of internationally traded goods across different countries. It is used for international comparisons of GDP and as a long-term indicator for where exchange rates may trend over time.

Macroeconomic Effects and Central Bank Concerns

• Central banks monitor exchange rates for two main reasons:

  1. Exchange rate movements affect the quantity of aggregate demand in the economy.

  2. Substantial fluctuations can disrupt international trade and destabilize the national banking system.

• Banking System Risks:

  • Financial institutions often measure international loans in large "hard" currencies (U.S. dollars, Euros, Japanese yen).

  • Banks may borrow in a foreign currency but lend in their domestic currency. If the domestic currency weakens significantly, the bank may find itself unable to repay the foreign-denominated loans, leading to economic destruction.

Exchange Rate Policies and Regimes

• Floating Exchange Rates: The market determines the currency's value. Roughly $40\text{\%}$ of countries, including the U.S., use this policy. The primary concern is that rates can experience high volatility in short periods.

• Soft Peg: An exchange rate policy where the market usually sets the rate, but the central bank intervenes if the rate moves too rapidly in one direction.

• Hard Peg: The central bank sets a fixed, unchanging value for the exchange rate.

  • If a peg is set below equilibrium (e.g., $30\text{ cents/real}$ when equilibrium is higher), quantity demanded will exceed quantity supplied.

  • If a peg is set above equilibrium (e.g., $40\text{ cents/real}$), quantity supplied will exceed quantity demanded.

• Merged Currency: When a nation adopts another nation's currency (or a shared group currency). This eliminates foreign exchange risk but requires the nation to give up control over its own domestic monetary policy.

International Capital Flows and Tobin Taxes

• International Capital Flows: Capital that moves across national borders as either portfolio or direct investment.

• Tobin Taxes: Proposed taxes on international capital flows intended to reduce the volume of such flows. The goal is to minimize the likelihood of large, sudden exchange rate movements that could lead to macroeconomic disaster.

• Practical Difficulty: National governments impose taxes, which makes global implementation of a Tobin tax difficult as it faces coordination challenges between independent nations.

Historical Case Study: U.S. Dollar vs. Japanese Yen

• Even "stable" exchange rates show significant variance over time:

  • 2000–2007: Relatively stable rate.

  • 2007–2012: The Yen appreciated more than $25\text{\%}$ relative to the USD.

  • 2013: The Yen depreciated drastically by about $14\text{\%}$.

  • End of 2014: Another depreciation of approximately $14\text{\%}$.

  • 2016–2020: The Yen appreciated by about $13\text{\%}$, moving from $118\text{ yen/dollar}$ to $103\text{ yen/dollar}$.