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Exchange Rates

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Exchange Rates

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  1. Exchange Rates What is an exchange rate? What types of rates exist, and how are they different? How would you graph supply and demand for a currency? Why would exchange rates change?

  2. Current Exchange Rates • Appreciation of the dollar –an increase in the value of the dollar relative to the currency of another nation • dollar buys more foreign stuff • Depreciation of the dollar – a decrease in the value of the dollar relative to another currency • dollar buys a smaller amount of foreign currency and thus foreign goods

  3. Floating Exchange Rates • Market Exchange Rates determined by Supply and Demand • Items requiring foreign exchange: • Services • Tourism • Business trips • Currency speculators • Set-up a manufacturing company

  4. An Overview • Suppose: • Canadian Dollars • Mexican Pesos • IF Mexican importers demand Canadian goods they must pay for the goods in Canadian dollars, therefore, an increase in demand for Canadian dollars. Peso Price of C$ D2 for C$ D1 Q of C$

  5. The lower the price of the C$ the more will be demanded The cheaper the C$ is to Mexican traders the cheaper are Canadian goods, services and assets. Therefore the demand curve for the dollar will slope downward. Canadian Dollar Exchange Rate Downward Sloping Demand Peso Price of C$ D by Mexico Q of C$

  6. Supply of C$ into foreign exchange markets comes from Canadians wishing to buy Mexican goods, services and assets The higher the C$/peso exchange rate the more pesos will be bought and the more dollars will be supplied. This is because the price of Mexican goods, services and assets are cheaper in Canadian dollars the higher is the price of the C$. Exchange Rate for Canadian $ Upward Sloping Supply Peso Price of C$ S by Canada Q of C$

  7. A= Equilibrium exchange rate, DC$ = S C$ If exchange rate is below equilibrium, at C$1 =90 pesos then D>S, shown as B-C. Dealers wanting to earn commission by exchanging money will have to raise the offer price for the C$ to encourage greater supply and reduce the excess demand. This would continue until equilibrium was reached. In practice the process is very rapid, they adjust to small gaps in rates minute by minute. Exchange Rate for Canadian $ Equilibrium Exchange Rates Peso Price of C$ S of C$ by Canada A 100 B C 90 80 D of C$ by Mexico Q of C$

  8. Suppose there is an increase in demand for British goods. This means that foreigners need pounds and the need for pounds drives up the exchange rate. The reverse is true as well. Exchange rates for British Sterling (Pounds) Floating Exchange Rates

  9. Currency Terms • Appreciate = A rise in the exchange rate is called appreciation. • Depreciation = A fall in the exchange rate is called depreciation. A fall in demand of C$ is shown As a shift in the demand curve From D1 to D2. An increase in Supply is shown as a movement From S1 to S2. In both cases the exchange rate Of the C$ will fall, or depreciate (Conversely, the peso has Appreciated). S1 of C$ Peso price Of C$ A S2 of C$ B D1 of C$ C D2 of C$ Quantity of C$

  10. Suppose there is an increase in demand for British Sterling= D1 to D2, thus increasing exchange rate. British authorities will then tap into their currency reserves and sell more sterling, thus increasing supply from S1 to S2, and maintaining fixed exchange rate. Fixed Exchange Rates

  11. Determinants of Foreign Exchange Rates • Taste and Preferences • Increase taste for German cars = increase demand for Euro, therefore euro appreciates • Relative Interest Rates • Canada offers high interest rates = increased demand for C$ therefore C$ appreciates • Income, real Income • If GDP increases then increased M, increase supply of their currency, therefore their currency depreciates • Prices levels, relative Price Levels • If a country has high inflation, consumers in that country will increase M because M is relatively cheaper, increase supply currency to buy M- currency depreciates • Speculation – • If speculators think the currency will do well then buy low and sell high. If speculators think $ is overvalued and is due for a fall, people holding $ will rush to sell and the supply of $ will increase - $ depreciates

  12. China, A Currency Manipulator?