Chapter 9

After studying this chapter, you will be able to: ◆ Explain how the exchange rate is determined ◆ Explain interest rate parity and purchasing power parity ◆ Describe the alternative exchange rate policies and explain their effects © 2022 Pearson Canada The Foreign Exchange Market To buy goods and services produced in another country, we need that country’s money. ▪ Foreign bank notes, coins, and bank deposits are called foreign currency. ▪ The foreign exchange market is the market in which one country's currency is exchanged for another's currency. ▪ The price at which one currency exchanges for another is called a foreign exchange rate. ▪ A fall in the value of one currency in terms of another currency is called currency depreciation. ▪ A rise in the value of one currency in terms of another currency is called currency appreciation. © 2025 Pearson Canada The Foreign Exchange Market An Exchange Rate Is a Price ▪ An exchange rate is the price of one currency in terms of another. ▪ Like all prices, an exchange rate is determined in a market—the foreign exchange market. ▪ The Canadian dollar is demanded and supplied by thousands of traders every hour of every day. ▪ With many traders and no restrictions, the foreign exchange market is a competitive market. © 2025 Pearson Canada The Foreign Exchange Market The Demand for One Money Is the Supply of Another Money ▪ When people holding one currency want to exchange it for Canadian dollars, they demand Canadian dollars and supply that other country’s currency. ▪ So, the factors influencing the demand for Canadian dollars also affect the supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese yen. ▪ And the factors that influence the demand for another country’s money also affect the supply of Canadian dollars. © 2025 Pearson Canada The Foreign Exchange Market Demand in the Foreign Exchange Market ▪ People in other countries buy Canadian dollars to buy Canadian-produced goods and services, Canadian exports, or Canadian assets. ▪ Many factors influence traders' buying plans in the foreign exchange market, one of which is the exchange rate. ▪ The quantity of Canadian dollars demanded is the amount that traders plan to buy at a given exchange rate during a given time. © 2025 Pearson Canada The Foreign Exchange Market The Law of Demand for Foreign Exchange ▪ The demand for dollars is a derived demand. ▪ Other things remain the same: as the exchange rate rises, the quantity of Canadian dollars demanded in the foreign exchange market decreases. © 2025 Pearson Canada The Foreign Exchange Market The exchange rate influences the quantity of Canadian dollars demanded for two reasons: ▪ Exports effect ▪ Expected profit effect © 2025 Pearson Canada The Foreign Exchange Market Exports Effect ▪ As the value of Canadian exports increases, the quantity of Canadian dollars demanded by buyers of Canadian exports on the foreign exchange market increases. ▪ The lower the exchange rate, the greater the value of Canadian exports and the greater the quantity of Canadian dollars demanded. © 2025 Pearson Canada The Foreign Exchange Market Expected Profit Effect ▪ The larger the expected profit from holding Canadian dollars, the greater the quantity of Canadian dollars demanded today. ▪ The lower today’s exchange rate, other things remaining the same, the greater the expected profit from buying Canadian dollars and the greater the quantity of Canadian dollars demanded today. The idea here is that you think if the exchange rate is low today, it will go UP in the future. © 2025 Pearson Canada The Foreign Exchange Market The Demand Curve for Canadian Dollars Figure 9.1 illustrates the demand curve for Canadian dollars on the foreign exchange market. © 2025 Pearson Canada The Foreign Exchange Market Supply in the Foreign Exchange Market ▪ The quantity of Canadian dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate. ▪ This quantity depends on many factors, but the main one is the exchange rate. © 2025 Pearson Canada The Foreign Exchange Market The Law of Supply of Foreign Exchange ▪ Other things remain the same, the higher the exchange rate, the greater the number of Canadian dollars supplied in the foreign exchange market. ▪ The exchange rate influences the quantity of Canadian dollars supplied for two reasons: ✓ Imports effect ✓ Expected profit effect © 2025 Pearson Canada The Foreign Exchange Market Imports Effect ▪ The higher the value of Canadian imports, the higher the quantity of Canadian dollars supplied on the foreign exchange market. ▪ The higher the exchange rate: ✓ the greater the value of Canadian imports, ✓ the greater the quantity of Canadian dollars supplied. © 2025 Pearson Canada The Foreign Exchange Market Expected Profit Effect ▪ For a given expected future Canadian dollar exchange rate, the lower the current exchange rate: ✓ the greater the expected profit from holding Canadian dollars and ✓ the smaller the quantity of Canadian dollars supplied on the foreign exchange market (don’t sell now). © 2025 Pearson Canada The Foreign Exchange Market Supply Curve for Canadian dollars Figure 9.2 illustrates the supply curve of Canadian dollars in the foreign exchange market. © 2025 Pearson Canada The Foreign Exchange Market Market Equilibrium Figure 9.3 shows how demand and supply in the foreign exchange market determine the exchange rate. © 2025 Pearson Canada The Foreign Exchange Market • If the exchange rate is too high, a surplus of Canadian dollars drives it down. • If the exchange rate is too low, a shortage of Canadian dollars drives it up. • The market is pulled (quickly) to the equilibrium exchange rate at which there is neither a shortage nor a surplus. © 2025 Pearson Canada Exchange Rate Fluctuations Changes in the Demand for Canadian dollars ▪ A change in any influence on the quantity of Canadian dollars people plan to buy, other than the exchange rate, changes the demand for Canadian dollars. These other influences are: ▪World demand for Canadian exports ▪ The Canadian interest rate relative to the foreign interest rate ▪ The expected future exchange rate © 2025 Pearson Canada Exchange Rate Fluctuations World Demand for Canadian Exports ▪ At a given exchange rate, if world demand for Canadian exports increases, the demand for Canadian dollars increases. The Canadian Interest Rate Relative to the Foreign Interest Rate ▪ Canadian interest rate differential = The Canadian interest rate - the foreign interest rate. ▪ If the Canadian interest differential rises, the demand for Canadian dollars increases. © 2025 Pearson Canada Exchange Rate Fluctuations The Expected Future Exchange Rate ▪ At a given current exchange rate, if the expected future exchange rate for Canadian dollars rises, the demand for Canadian dollars today increases, and the demand curve for Canadian dollars shifts rightward. © 2025 Pearson Canada Exchange Rate Fluctuations Figure 9.4 shows how the demand curve for Canadian dollars shifts in response to changes in ▪ Canadian exports ▪ The Canadian interest rate differential ▪ The expected future exchange rate © 2025 Pearson Canada Exchange Rate Fluctuations Changes in the Supply of Canadian Dollars ▪ A change in any influence on the quantity of Canadian dollars people plan to sell, other than the exchange rate, changes the supply of dollars. ▪ These other influences are ▪ Canadian demand for imports ▪ The Canadian interest rates relative to the foreign interest rate ▪ The expected future exchange rate © 2025 Pearson Canada Exchange Rate Fluctuations Canadian Demand for Imports ▪ At a given exchange rate, if the Canadian demand for imports increases, the supply of Canadian dollars on the foreign exchange market increases, and the supply curve of Canadian dollars shifts rightward. The Canadian Interest Rate Relative to the Foreign Interest Rate ▪ If the Canadian interest differential rises, the supply of Canadian dollars decreases, and the supply curve of Canadian dollars shifts leftward. © 2025 Pearson Canada Exchange Rate Fluctuations The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for Canadian dollars rises, the supply of Canadian dollars today decreases, and the supply curve for dollars shifts leftward. © 2025 Pearson Canada Exchange Rate Fluctuations Figure 9.5 shows how the supply curve of Canadian dollars shifts in response to changes in ▪ Canadian demand for imports ▪ The Canadian interest rate differential ▪ The expected future exchange rate © 2025 Pearson Canada Exchange Rate Fluctuations Changes in the Exchange Rate If demand for Canadian dollars increases and supply does not change, the exchange rate rises. If demand for Canadian dollars decreases and supply does not change, the exchange rate falls. If supply of Canadian dollars increases and demand does not change, the exchange rate falls. If supply of Canadian dollars decreases and demand does not change, the exchange rate rises. © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals Arbitrage ▪ Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market. ▪ Arbitrage in the foreign exchange market and international loans and goods markets achieves four outcomes: ✓ The law of one price ✓ No round-trip profit ✓ Interest rate parity ✓ Purchasing power parity © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals The Law of One Price ▪ The law of one price states that if an item can be traded in more than one place, the price will be the same in all locations. No Round-Trip Profit ▪ A round trip is using the currency A to buy currency B, and then using B to buy A. ▪ Arbitrage removes profit from all transactions of this type. © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals Interest Rate Parity ▪ A currency is worth what it can earn. ▪ The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. ▪ When the rates of returns on two currencies are equal, interest rate parity prevails. ▪ Interest rate parity means equal interest rates when exchange rate changes are taken into account. ▪ Market forces achieve interest rate parity very quickly. © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals Purchasing Power Parity A currency is worth the value of goods and services that it will buy. The quantity of goods and services that one unit of a particular currency will buy differs from the quantity of goods and services that one unit of another currency will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity (or PPP), which means equal value of money. © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals The Expected Future Exchange Rate An expectation is a forecast. Exchange rate forecasts, like weather forecasts, are made over horizons that run from a few hours to many months and perhaps years. But exchange rate forecasts are hedged with a lot of uncertainty, there are many divergent forecasts, and the forecasts influence the outcome. The dependence of today’s exchange rate on forecasts of tomorrow’s exchange rate can give rise to exchange rate volatility in the short run. © 2025 Pearson Canada Arbitrage, Speculation, and Market Fundamentals Exchange Rate Volatility An exchange rate might rise one day and fall the next, as news about the influences on the exchange rate change the expected future exchange rate. The influences of expectations and the constant arrival of news about the influences on supply and demand, make changes in the exchange rate impossible to predict. But trends around which the exchange rate fluctuates are predictable and depend on market fundamentals. © 2025 Pearson Canada Exchange Rate Policy Three possible exchange rate policies are ▪ Flexible exchange rate ▪ Fixed exchange rate ▪ Crawling peg Flexible Exchange Rate A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank. © 2025 Pearson Canada Exchange Rate Policy Fixed Exchange Rate A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply. A fixed exchange rate requires active intervention in the foreign exchange market. © 2025 Pearson Canada Exchange Rate Policy Figure 9.6 shows how the Bank of Canada can intervene in the foreign exchange market. Suppose that the target is 90 US cents per Canadian dollar. If the demand for Canadian dollars increases, the Bank sells Canadian dollars to increase supply to keep the exchange rate at the target. © 2025 Pearson Canada Exchange Rate Policy If demand for Canadian dollars decreases, the Bank of Canada buys Canadian dollars to decrease supply to keep the exchange rate at the target. Persistent intervention on one side of the foreign exchange market cannot be sustained. © 2025 Pearson Canada Exchange Rate Policy Crawling Peg A crawling peg is an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market. China is a country that operates a crawling peg. A crawling peg works like a fixed exchange rate except that the target value changes. The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate