Econ 102 - Chapter 25

Front 1

foreign currency

Back 1

Foreign bank notes, coins, and bank deposits

Front 2

foreign exchange market

Back 2

market in which the currency of one country isexchanged for the currency of another

Front 3

Foreign exchange rate

Back 3

price at which one currency exchanges for another

Front 4

currency depreciation

Back 4

A fall in the value of one currency in terms of another currency

Front 5

currency appreciation

Back 5

A rise in value of one currency in terms of another currency

Front 6

How is the exchange rate determined?

Back 6

demand and supply in the forex market.

Front 7

Reasons people buy Canadian $ in the forex market? (3)

Back 7

i. buy Canadian produced goods and services;

ii. they can buy Canadian assets such as bonds, stocks, and real estate;

iii. they can keep part of their money holding in a C$ bank account

Front 8

The quantity of Canadian dollars that traders plan to buy in the foreign exchange market during a given period depends on: (4)

Back 8

1. The exchange rate

2. World demand for Canadian exports

3. Interest rates in Canada and other countries

4. The expected future exchange rate

Front 9

the higher the exchange rate, the _______ is the quantity of Canadian dollars demanded in the foreign exchange market.

Back 9

smaller

Front 10

The exchange rate influences the quantity of Canadian dollars demanded for two reasons:

Back 10

• Exports effect

• Expected profit effect

Front 11

Exports Effect

The larger the value of Canadian exports, the _____ is the quantity of Canadian dollars demanded on the foreign exchange market.

The lower the exchange rate, the _______ is the volume and value of Canadian exports, so the _________ is the quantity of Canadian dollars demanded.

Back 11

1. greater

2. greater

3. greater

Front 12

Expected Profit Effect

The larger the expected profit from holding Canadian dollars, the ______ is the quantity of Canadian dollars demanded today.

But expected profit depends on the exchange rate.

The lower today’s exchange rate, other things remaining the same, the _____ is the expected profit from buying Canadian dollars and the ______ is the quantity of Canadian dollars demanded today

(a weak Canadian dollar is good for exports for Canada)

Back 12

1. greater

2. larger

3. greater

Front 13

Why do people sell C$ and buy other currencies? (3)

Back 13

i. buy foreign-produced goods and services (Canadian imports);

ii. buy foreign assets;

iii. hold part of their money in bank deposits denominated in foreign currency

Front 14

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 ones are: (4)

Back 14

1. The exchange rate

2. Canadian demand for imports

3. Interest rates in Canada and other countries

4. The expected future exchange rate

Front 15

Other things remaining the same, the higher the exchange rate, the ______ is the quantity of Canadian dollars supplied in the foreign exchange market.

Back 15

greater

Front 16

The exchange rate influences the quantity of Canadian dollars supplied for two reasons:

Back 16

• Imports effect

• Expected profit effect

Front 17

Imports Effect

The larger the value of Canadian imports, the _______ is the quantity of Canadian dollars supplied on the foreign exchange market.

The higher the exchange rate, the _______ are the prices of foreign-produced goods and services, the ______ is the volume of Canadian imports, and so the _______ is the quantity of Canadian dollars supplied in the foreign exchange market.

Back 17

1. larger

2. lower

3. greater

4. greater

Front 18

Expected Profit Effect

For a given expected future Canadian dollar exchange rate, the lower the current exchange rate, the ______ is the expected profit from holding Canadian dollars, and the _______ is the quantity of Canadian dollars supplied on the foreign exchange

Back 18

1. greater

2. smaller

Front 19

The demand for Canadian dollars in the foreign exchange market changes when thereis a change in: (3)

Back 19

• World demand for Canadian exports

• Canadian interest rate relative to the foreign interest rate

• The expected future exchange rate

Front 20

Factors that shift demand curve (3)

Back 20

World Demand for Canadian Exports

At a given exchange rate, if world demand for Canadian exports increases, the demand for Canadian dollars increases and the demand curve for Canadian dollars shifts rightward.

Canadian Interest Rate Relative to the Foreign Interest Rate

The Canadian interest rate minus the foreign interest rate is called the Canadian interest rate differential. If the Canadian interest differential rises, the demand for Canadian dollars increases and the demand curve for Canadian dollars shifts rightward.

The Expected Future Exchange Rate

if you are american you want to convert your US dollar to canadian BEFORE the appreciation occurs therefore demand for canadian increases, the demand curve for dollars shifts rightward.

EXPORTS only affects demand curve, not supply. the rest affect both

Front 21

Factors that shift supply curve (3)

Back 21

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.

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.

The Expected Future Exchange Rate

if CAD expected to go up, the supply will decrease because people want to keep their CAD so that they profit after appreciation. supply decreases, the supply curve of Canadian dollars shifts leftward.

IMPORTS only affects supply curve, not demand. the rest affect both

Front 22

Changes in the Exchange Rate

• If demand for Canadian dollars increases and supply does not change, the exchange rate ______.

Back 22

rises

Front 23

• If demand for Canadian dollars decreases and supply does not change, the exchange rate _______.

Back 23

falls

Front 24

• If supply of Canadian dollars increases and demand does not change, the exchange rate ______.

Back 24

falls

Front 25

• If supply of Canadian dollars decreases and demand does not change, the exchange rate ______.

Back 25

rises

Front 26

Arbitrage

Back 26

the practice of buying in one market and selling for a higher price in another market.

Front 27

Arbitrage activities can lead to:

Back 27

The Law of One Price

states that if an item is traded in more than one place, the price will be the same in all locations.

Interest Rate Parity

Suppose that bank deposit earns 1% a year in Tokyo and 3% a year in Toronto.Why are there differences in rates of return across countries?• .For Japanese investors to earn 3% in Toronto, they must first convert their Yen (¥) to C$.One year later, convert C$ back to Yen.Today’s exchange rate: ¥100=C$1.¥100 gives C$1, deposit this in Toronto and obtain C$1.03 one year later.But 1-year later exchange rate: ¥98=C$1. so C$1.03 gives ¥101 Thus, rate of return that you get in Toronto, after accounting for the depreciation of C$, is 1%. Interest rate parity means equal interest rates when exchange rate changes are taken into account

Purchasing Power Parity (PPP)

Suppose a camera costs ¥10,000 in Tokyo and $100 in Toronto.If the ex rate is ¥100=C$1, the two monies have the same value.You can buy the camera in either Tokyo or Toronto for the same price. You can express that price as either ¥10,000 or $100, but the price is the same in the two currencies.• This situation is called PPP which means equal value of money.• In this example, ¥100=C$1 is the PPP exchange rate. PPP: One dollar should be able to buy the SAME quantity of goods in all countries. If PPP does not prevail, powerful arbitrage forces go to work (buy in the market where it is low and sell in the market where it is high, and profit the difference).

Front 28

difference between nominal and real exchange rate

Back 28

nominal exchange rate is from currency to currency

real exchange rate is from goods to goods

Front 29

The Real Exchange Rate (RER)

Back 29

the relative price of Canadian-produced goods and services to foreign-produced goods and services.

Front 30

The equation that links the nominal exchange rate (E) and real exchange rate (RER) is (short run)

Back 30

RER = (E x P)/P*

where P is the Canadian price level and P* is the Mexican (or foreign) price level.

If both countries produce identical goods, then the price levels expressed in the same currency would be the same and RER would equal 1

Front 31

RER in the short run

Back 31

In the short run, the equation determines RER.

RER = (E x P)/P*

In the short run, if the nominal exchange rate changes, P and P* do not change and thechange in E brings an equivalent change in RER

Front 32

RER in the long run

Back 32

in the long run, the RER should go towards 1

In the long run, RER is determined by the real forces of demand and supply in themarkets for goods and services.

So in the long run, E is determined by RER and the price levels. That is,

E = RER x (P*/P)

A rise in the Japanese price level P* brings an appreciation of the Canadian dollar in the long run.

A rise in the Canadian price level P brings a depreciation of the Canadian dollar in the long run

Front 33

Three possible exchange rate policies are

Back 33

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.

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.

** review graphs in Ch25 Part 2

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