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FX DETERMINATION

FX DETERMINATION. Supply and Demand determine S t. S t Supply of FC. Q: What moves Supply & Demand? - International Investing: Foreign Investors investing in the US US Investors investing abroad - International Trade: Exports/Imports - International Tourism

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FX DETERMINATION

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  1. FX DETERMINATION

  2. Supply and Demand determine St St Supply of FC • Q: What moves Supply & Demand? - International Investing: Foreign Investors investing in the US US Investors investing abroad - International Trade: Exports/Imports - International Tourism - Central Banks. (DC/FC) StE Demand of FC Quantity of FC

  3. Economic Variables (“Fundamentals”) behind Supply & Demand: - interest rates (iUSD - iFC) - inflation rates (IUSD - IFC) - income growth rates (yUSD - yFC) - others: tariffs, quotas, other trade barriers, expectations, taxes, etc. Changes in the fundamentals will affect St. Example 1: Changes in the interest rate differential The U.S. Fed increases interest rates (iUSD ↑) => (iUSD-iEUR)↑ Two effects: - European residents buy more U.S. T-bills (Supply of EUR ↑) - U.S. residents buy less European T-bills (Demand for EUR ↓) => both Supply and Demand curves shift.

  4. Example 1 (continuation): Effect on St: (iUSD-iEUR)↑ => St ? St (USD/EUR) S0 S1 - European residents buy more U.S. T-bills (Supply ↑) A S0= 1.50 B D0 S1= 1.47 D1 Quantity of EUR - U.S. residents buy less European T-bills (Demand ↓) • St moves from A to B => The EUR becomes less expensive in terms of USD. => We say: “the EUR depreciates against the USD”. ¶

  5. Intuition check: The U.S. Fed decreases interest rates (iUSD↓) => (iUSD-iEUR)↓ - European residents buy less U.S. T-bills (Supply of EUR ↓) - U.S. residents buy more European T-bills (Demand for EUR ↑) • St moves from A to B => The EUR becomes more expensive in terms of USD. => We say: “the EUR appreciates against the USD”.¶ St S1 (USD/EUR) B S0 S0= 1.50 S1= 1.45 D1 A D0 Quantity of EUR

  6. Example 2: Changes in the inflation rate differential U.S. inflation increases (IUSD) => (IUSD- IEUR)↑ Foreigners want to buy less U.S. goods (Supply ↓) Americans want to buy more European goods (Demand ↑) • St moves from A to B => The EUR becomes more expensive in terms of USD. ¶ S1 St (USD/EUR) B S0 S0= 1.50 A S1= 1.45 D1 D0 Quantity of EUR

  7. Intuition check: U.S. inflation decreases relative to European inflation (IUSD-IEUR) ↓ => St ? St S0 (USD/EUR) S1 - European residents buy more U.S. goods (Supply of EUR ↑) - U.S. residents buy less European goods (Demand for EUR ↓) A S0= 1.50 B D0 S1= 1.47 D1 Quantity of EUR • St moves from A to B • => The EUR becomes cheaper in terms of USD.

  8. Example 3: Changes in other factors: Tariffs U.S. government imposes tariffs on Korean steel. Assume no trade wars. St S0 (USD/EUR) - U.S. residents buy less Korean goods (Demand for WRN ↓) - No movement on U.S. exports to Korea (Supply unchanged) A S0= 1.50 B D0 S1= 1.48 D1 Quantity of WRN • St moves from A to B • => The WRN becomes cheaper in terms of USD.

  9. Example 4: Changes in other factors: Uncertainty Uncertainty (political, social, war, terrorism threats, etc) increase. Suppose Switzerland is considered a safe haven. - Foreign residents bring less CHF to the U.S. (Supply of CHF ↓) - U.S. residents buy more CHF (Demand for CHF ↑) • St moves from A to B => The CHF becomes more expensive in terms of USD. ¶ S1 St (USD/CHD) B S0 S1= 1.04 A S0= 1.00 D1 D0 Quantity of CHF

  10. Example 5: Changes in export prices The price of oil decreases significantly. - Canadian oil exports are worth less USD. (Supply of USD ↓) - There may be a secondary effect –Canadian may be able to buy less imports. (Demand for USD may go down) • St moves from A to B => The USD becomes more expensive in terms of CAD. ¶ S1 St (CAD/USD) S0 B S1= 1.01 A S0= 1.00 D0 Quantity of USD

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