Mechanics of Foreign Exchange (FOREX)

1. Mechanics of Foreign Exchange (FOREX)

2. Foreign Exchange (FOREX) • The buying and selling of currency • Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell their Dollars and buy Euros. • Any transaction that occurs in the Balance of Payments necessitates foreign exchange • The exchange rate (e) is determined in the foreign currency markets. • Ex. The current exchange rate is approximately 8 Yuan to 1 dollar • Simply put. The exchange rate is the price of a currency.

3. Changes in Exchange Rates • Exchange rates (e) are a function of the supply and demand for currency. • An  in the supply of a currency will  the exchange rate of a currency • A  in supply of a currency will  the exchange rate of a currency • An  in demand for a currency will  the exchange rate of a currency • A  in demand for a currency will  the exchange rate of a currency

4. Appreciation and Depreciation • Appreciation of a currency occurs when the exchange rate of that currency increases (e↑) • Depreciation of a currency occurs when the exchange rate of that currency decreases (e↓) • Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate.

5. Increase in the Supply of U.S. Dollars relative to the Euro € / $ S$ S$ 1 e e1 D$ Q$ q q1 S$ .: e (ex. rate) ↓ & Q$↑ .: $ depreciates relative to €

6. Decrease in the Supply of Yen relative to the Euro €/¥ S¥1 S¥ e1 e D¥ Q¥ q q1 S¥ .: e ↑ & Q¥↓ .: ¥ appreciates relative to €

7. Increase in the Demand for the British Pound relative to the U.S. Dollar $/£ S£ e1 e D£ 1 D£ Q£ q q1 D£ .: e ↑ & Q£↑ .: £ appreciates relative to the $

8. Decrease in the Demand for Yen relative to the British Pound £/¥ S¥ e e1 D¥ D¥ 1 Q¥ q1 q D¥ .: e ↓ & Q¥↓ .: ¥ depreciates relative to the £

9. Exchange Rate Determinants – G.R.I.T.S. • Growth Rate • Strong economy = weaker currency • Example: If Mexico’s economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate

10. Exchange Rate Determinants – G.R.I.T.S. • Real Interest Rates • Exchanges rates do what interest rates do – as the interest rates go up, people want to put their money here and get the interest, so as demand rises, exchange rate rises too • Inflation • Inflation turns your currency into a rancid, 3 week old, hairy burrito you found on the street. Nobody wants it! • Example: Zimbabwe during inflation • Increasing supply decreases demand = decrease value

11. Exchange Rate Determinants – G.R.I.T.S. • Tastes • Tastes for a country’s goods create a taste for a country’s currency. • Speculation • Gambling / Betting on currency • Ex. If U.S. investors expect that Swiss interest rates will climb in the future, then Americans will demand Swiss Francs in order to earn the higher rates of return in Switzerland. This will cause the Dollar to depreciate and the Swiss Franc to appreciate.

12. Exports and Imports • The exchange rate is a determinant of both exports and imports • Appreciation of $ = U.S. goods cost more $$$$ + foreign goods cost less $ .: exports  and imports  • Depreciation of $ = U.S. costs less $ + foreign goods cost more $$$$ .: exports  and imports 