Exchange Rates and International Capital Flows

There are over 150 different currencies globally.
Some smaller economies adopt the currency of another country for stability.
Multiple countries can utilize a single currency (example: the Euro).
For international transactions, households or firms often exchange one currency for another.
Exchange rates can fluctuate rapidly due to market dynamics.

The exchange rate is defined as the price of one unit of a country's currency expressed in terms of another country's currency.
A foreign exchange market is where participants use one currency to purchase another, incorporating elements of demand, supply, and price.

Demand and supply in these markets are interrelated. When a person or firm demands one currency, they must supply another currency concurrently, highlighting mutual dependence.
Major market participants include:
1. Firms involved in international trade: Companies importing/exporting goods and services.
2. Tourists: Individuals traveling abroad.
3. International investors (ownership): Those acquiring ownership or partial ownership of foreign companies.
4. International investors (financial investments): Investors making financial investments that do not confer ownership.

The demand for foreign currencies is derived demand, indicating that it is dependent on the demand for foreign goods and services or foreign capital.
An increase in demand for foreign goods leads to a proportional increase in foreign currency demand to facilitate payment for those goods.

The supply of foreign currency comes from foreigners wishing to purchase exports of a particular country.
The more U.S. products desired by foreigners, the greater the supply of their currencies they will provide in exchange for U.S. dollars to make these purchases.

Just as in traditional markets, the equilibrium price (exchange rate) for a foreign currency is determined by the supply and demand interaction in the currency markets.

The dynamics in demand and supply curves are influenced by various factors leading to shifts in these curves due to changes in tastes for goods, income levels, relative real interest rates, relative inflation rates, and speculation.

Increased U.S. Incomes Example:
- An increase in U.S. incomes typically leads to more imports from Europe, thus raising the demand for Euros.
- As demand increases, the demand curve shifts rightward, resulting in a higher exchange rate for Euros.

In the short run: Exchange rates are affected by speculators seeking to invest in strengthening currencies, creating a self-fulfilling prophecy.
In the relatively short run: Differences in rates of return (especially higher interest rates) lead to an increased demand for a currency, strengthening it as more foreign investments are attracted.
In the medium run: Inflation rates play a role; countries with higher inflation experience less demand for their currencies and thus face depreciation.

To assess appreciation or depreciation of an exchange rate, compare two time periods.
If a US citizen pays more for Euros than in previous days/weeks, the US dollar has depreciated against the Euro, and vice versa.

Central banks monitor exchange rates for:
- Their impact on aggregate demand in the economy.
- The potential disruption of international trade caused by significant fluctuations in exchange rates.
- The risk of recession if international capital moves to other countries due to unfavorable exchange rates.

Types of exchange rate systems:
- Floating Exchange Rates: Market-determined without direct intervention.
- Soft Exchange Rate Pegs: Currency value managed with market forces, with possible government intervention to stabilize.
- Hard Exchange Rate Pegs: Set rates, often fixed to another currency, with stringent government controls.
- Merging Currencies: When currencies become identical to those of another nation.