Section 4.6
The “Forex” is a market for banks to buy and
sell currencies.
Households and firms buy currencies from
banks, which charge a commission.
The "Forex" markets are centered in Zurich,
New York, Frankfurt, London and Tokyo.
over $3 trillion worth of currency is
exchanged daily.
An exchange rate is the price of one currency
expressed in terms of another.
Fixed - one currency is fixed in value
against another through government
intervention in currency markets.
Floating – exchange rate determined by
market forces
Managed or dirty float – government sets
upper and lower rate bands
Exchange Rate set below
Equilibrium Exchange Rate
Government sells its currency reserves and buys
other currencies.
Exchange Rate set above
Equilibrium Exchange Rate
Government buys its currency by selling its holdings of other currencies
Government buys its currency by
selling its other currency reserves
All major world currencies are floating
supply and demand will determine the equilibrium exchange rate
Example
Demand for a yen is influenced by
1. Japanese Exports (others buy yen to pay for these exports)
2. Inflows of funds into Japan (others buy yen to bring to Japan)
3. Speculation (others buy yen in the expectation that it will rise in
value)
Supply of a currency is influenced by
1. Imports into Japan (yen is sold to pay for these imports)
2. Outflows of funds from Japan (yen sold to obtain these funds to
send out of Japan)
3. Speculation (other sell yen in the expectation that if will fall in
value)
Appreciation - this describes an upward movement in a
freely floating exchange rate
Impact: it is more expensive in terms of another
currency to buy your currency
Revaluation - this also describes an upward movement in
an exchange rate, but in a fixed exchange rate system.
(Very infrequent)
Depreciation - this describes a downward movement in a
floating exchange rate
Impact: it is cheaper in terms of another currency to buy
your currency
Devaluation - this means that the government has
changed the fixed rate of a fixed exchange rate
downwards (Very infrequent)
Appreciation - this describes an upward
movement in a freely floating exchange
rate due to market forces
100 Yen = $1.00
100 Yen = $1.20
Yen has gained value
Depreciation - this describes a downward
movement in a floating exchange rate due
to market forces
100 Yen = $1.00
100 Yen = $0.80
The Yen has lost value
Revaluation - this also describes an upward
movement in an exchange rate, but in a
fixed exchange rate system the
government sets the rate
Devaluation - this means that the
government has changed the fixed rate of a
fixed exchange rate downwards
If one currency
is appreciating
the other is
depreciating
Demand for yen will increase if:
Americans will buy yen if Japanese inflation rates lower
they want to: than US making Japanese
goods and services relatively
buy Japanese products less expensive
travel to Japan Increasing US incomes so that
invest more in Japanese they can buy more Japanese
products
companies
Change in tastes for Japanese
deposit funds in Japanese products
banks
Japanese investment prospect
speculate about the value of improve as do interest rates
the yen US speculators expect the yen
will rise in value
Americans will buy yen if Demand for yen will decrease if:
they want to Japanese inflation rate higher
than US making Japanese
buy Japanese products goods and services relatively
more expensive
travel to Japan
US incomes fall so that they
invest more in Japanese can buy less Japanese products
companies Change in tastes away
deposit funds in Japanese Japanese products
banks Japanese investment prospect
worsen as do interest rates
speculate about the value US speculators expect the yen
of the yen will fall in value
1. Reduced need for currency reserves as
reserve banks do not have to intervene in the
currency markets to keep a fixed exchange
rate.
2. Useful instrument of macroeconomic
adjustment
3. Partial automatic correction for a trade
deficit
4. Reduced risk of currency speculation on a
currency that does not match fundamentals
5. Freedom (autonomy) for domestic monetary
policy
Changes exchange rates cause impact the prices
of imports and exports.
An increase in the exchange rate i.e appreciation
will cause export prices to rise and import prices to
fall. Your exports are now more expensive as less
competitive but your imports are cheaper.
A decrease in the exchange rate i.e. depreciation
will cause export prices to fall, your exports are
cheaper and more competitive but import prices to
are expensive.
Unemployment in
Export Industries
Reduce import led
price inflation
Increased
Employment in
Export Industries
results in AD rise
import price led
inflation
Interest rates can impact exchange rates but
they also impact the domestic economy
Goal is to 'balance' the rate to be both
internationally competitive but not add to
inflationary pressures
Exchange rates are best when they are:
Predictable
Consistent
Not open to 'outside' interference by speculators