Foreign Exchange Markets

1. Foreign Exchange Markets ECO 473 - Money & Banking - Dr. D. Foster

2. Perspective! The U.S. • We want to buy foreign exchange. • We don’t really want the “money.” • We want the goods/services/financial assets • We pay $ to get foreign exchange. • When the $ appreciates, we can buy more . . . i.e. the price is lower. • When the $ appreciates, the £ depreciates. • When $ depreciates … price is higher.

3. Perspective! The U.S. We demand foreign exchange - £, Ұ, € $ (per £) Demand shows: our demand for British goods and services (our imports) The market for pounds (£) E = $2 E = $1 D £ At higher prices… it takes more dollars to buy a pound, British goods are more expensive, the dollar is depreciating (and the £ is appreciating). At lower prices … Q£

4. A change in our tastes and preferences for their goods. A change in our income. A change in trade restrictions. A change in monetary policy... The Fed may buy pounds! Perspective! The U.S. $ (per £) What would shift the demand for British pounds? The market for pounds (£) D’£ D £ D”£ Q£

5. $ (per £) S £ E = $2 E = $1 Q£ Perspective! The U.S. Foreigners supply foreign exchange - £, Ұ, € Supply shows: British demand for dollars to buy our goods (our exports). To acquire $ they must supply £. The market for pounds (£) At higher prices… pounds buy more dollars, American goods are cheaper, the dollar is depreciating (and the £ is appreciating). At lower prices …

6. $ (per £) S £ A change in theirtastes and preferences for our goods. A change intheirincome. A change in trade restrictions. A change in monetary policy... Q£ The Fed may sell pounds! Perspective! The U.S. S’£ What would shift the supply of British pounds? S’£ The market for pounds (£)

7. $ depreciates; the price rises; we buy less $ (per £) S £ E $ appreciates; the price falls; we buy more D £ Q£ Perspective! The U.S. • Exchange rate changes as S & D change . . . Equilibrium in the market for pounds (£)

8. $ (per £) $ (per £) $ (per £) S £ S £ S £ E’ S’ E E E A - Decrease Demand; E falls; $ appreciates D’ E’ D £ D £ D £ Q£ Q£ Q£ A - Increase Demand; E rises; $ depreciates E’ A - Increase Supply; E falls; $ appreciates D’ Perspective! The U.S. Q - What if we want less British goods? Q - What if our incomes rise? Q - What if Brits want more US goods?

9. Perspective! Britain • They want to buy foreign exchange ($). • They don’t really want the “money.” • They want our goods/services/financial assets • They pay £ to get $ (foreign exchange). • When the £ appreciates, they can buy more . . . i.e. the price is lower. • When the £ appreciates, the $ depreciates. • When £ depreciates … price is higher.

10. £ (per $) S $ D $ Q$ Perspective! Britain £ depreciates; the price rises; we buy less • Exchange rate changes as S & D change . . . $ appreciates £ appreciates; the price falls; we buy more $ depreciates

11. £ (per $) £ (per $) £ (per $) S $ S $ S $ 1/E’ S’ 1/E 1/E 1/E D’ A - Decrease Supply; 1/E rises; $ appreciates 1/E’ D $ D $ D $ Q$ Q$ Q$ S’ 1/E’ A - Increase Supply; 1/E falls; $ depreciates A - Increase Demand; 1/E rises; $ appreciates Perspective! Britain Q - What if we want less British goods? Q - What if U.S. incomes rise? Q - What if Brits want more US goods?

12. Current Exchange Rates

13. Current Exchange Rates $ (per £) S £ £ (per $) S $ .7221 1.385 D £ D $ Q£ Q$

14. Real Exchange Rates • Nominal: What we see reported. • SFr/US $: 2013 – 1.229 2014 – 1.171 • Nominal %Δ: – 4.72%

15. Nominal: What we see reported. Real: Adjusted for price level changes. Real Exchange Rates Real = Nominal*(CPIUS/CPISFr) • SFr/US $: 2013 – 1.229 2014 – 1.171 • CPI (Swiss): 2013 - 100 2014 - 102 • CPI (US): 2013 - 100 2014 - 103 1.1825 • Nominal %Δ: – 4.72% Real %Δ: – 3.785%

16. Who’s perspective? Draw it out . . . SFr/$ S$ So, the SFr is . . . And, the $ is . . . D$ Real Exchange Rates . . . appreciating in value. 1.229 1.171 . . . depreciating in value.

17. Foreign Exchange Markets ECO 473 - Money & Banking - Dr. D. Foster