Download International Finance and the Foreign Exchange Market

International Finance and the
Foreign Exchange Market
introduction
International trade involves two currencies. Because currency must
be exchanged and the traditional goods and services market is
utilized - two markets are in play:
1. market for currency
2. market for the product itself.
It is very helpful to simplify international transactions into these two
markets when analyzing the effect of our global economy on any
given national economy.
For example a transaction involving citizens of the United Sta tes and
citizens of Japan involves two currencies. In the U. S. sellers want to
receive dollars while purchasers in Japan have yen. Yen must be
exchanged for dollars and given to the seller in the United States. In
the Japan sellers want to receive yen while purchasers in the United
in the United States have dollars. Dollars must be exchanged for
yen and given to the seller in Japan.
This exchange of one currency for another in order to facilitate
international trade is organized in the foreign exchange market.
foreign exchange market -- market in which the currencies of
different countries are bought and sold
Commercial banks and currency brokers organize this market.
exchange rate -- the domestic price of one unit of foreign currency,
the price of one national currency in terms of another national
currency
The exchange rate translates the price of foreign goods into term of
the domestic currency.
Notes:
three exchange rate mechanisms
1. fixed exchange rates -- exchange rates are held steady by the
central bank
2. managed exchange rates --exchange rates are influenced by
the central bank
3. flexible (floating) exchange rates -- exchange rates that are
determined by the market forces of supply and demand
currency fluctuations and policy
appreciation -- an increase in the value of a domestic currency
relative to foreign currencies
An appreciation means foreign goods are less expensive in the
domestic country and domestic goods are more expensive in the
foreign country, therefore the domestic nation will import more and
export less -- move toward a trade deficit.
So a strong dollar may actually hurt the home economy because it
will cut into domestic aggregate demand as we sell less at home and
buy more from abroad,
depreciation -- a reduction in the value of a domestic currency
relative to foreign countries
A depreciation means foreign goods are more expensive in the
domestic country and domestic goods are less expensive in the
foreign country, therefore the domestic nation will import less and
export more -- move toward a trade surplus.
This is why we may at times follow a policy designed to cause the
dollar to fall relative to other countries currencies. A "weak" dollar is
consistent with a strong economy. A policy designed to cause the
depreciation of the domestic currency (devalue the currency) may
cause unemployment to increase in the foreign nation. This is
known as an "export of unemployment" and "beggar-thy-neighbor"
policy.
market mechanics
Assume a two country world:
1. United States -- domestic currency is the dollar
2. England -- domestic currency is the pound.
Notes:
If we assume a two country world the supply and demand for foreign
currency (pounds) is the supply and demand for foreign exchange.
demand
The demand for pounds (which is the supply of dollars in the foreign
exchange market in England) originates from the demand of United
States citizens for British goods. We must exchange dollars for
pounds, therefore for we demand pounds. We do not demand
pounds for the sake of demanding pounds -- the demand for pounds
is a derived demand. [This is not to say people who speculate in
currencies do not demand particular currencies simply to earn a
profit.] The basis for the demand for pounds comes from the
demand to use the pounds, not from intrinsic value in the pound
itself.
demand for pounds -- lower dollar price of the pound (an
appreciation of the dollar -- the dollar will buy more pounds) means
that British goods are relatively cheap; therefore citizens of the
United States desire a larger quantity of pounds and the demand
curve hence evidences the standard negative slope.
supply
The supply of pounds (which is the demand for dolla rs in the foreign
exchange market in England) comes from the demand of the British
for items supplied by United States producers. As the British
purchase United States' products they must exchange their pounds
to obtain the dollars the producers in the United States want to
receive.
Notes:
Notes:
supply of pounds -- higher dollar price of pounds (a depreciation of
the dollar -- the pound will buy more dollars) means goods produced
in the United States are less expensive and the British will purchase
more goods from the United States and will hence supply more
pounds, the supply curve evidences the standard positive slope.
equilibrium exchange rate determination
The market clearing price equates the value of U.S. purchases on
items produced by the British (U.S. imports) with the value of items
sold by the United States to the British (U.S. exports).
exchange rate fluctuation
differential growth rates of income
If domestic income increases faster than foreign income we will
spend some fraction of the increase on goods purchased from
foreign nations (imports). Because we are purchasing more goods
from the British we will demand more pounds to use to buy the
increased imports.
This causes an appreciation of the pound and a depreciation of the
dollar.
Notes:
If domestic income lags behind international growth rates the
demand for pounds will fall as we import less.
This causes a depreciation of the pound and an appreciation of the
dollar.
Notes:
differential rates of inflation
If domestic inflation increases faster than the foreign inflation rate
citizens of the United States will purchase more from Britain
(imports) because British goods cost less compared with
commodities produced in the United States. Hence we will demand
more pounds to finance our increased purchases of imports.
Consumers in Great Britain will purchase less from the United States
because of the relatively high cost of our products (U.S. exports).
Hence the supply of pounds will fall.
This causes an appreciation of the pound and a depreciation of the
dollar.
Notes:
If domestic inflation increases slower than the foreign inflation rate
citizens of the United States will purchase less from Britain (imports)
because their goods cost more compared with commodities
produced in the United States. Hence we will demand fewer pounds.
Consumers in Great Britain will purchase more from the United
States because of the relatively low cost of our products (U.S.
exports). Hence the supply of pounds will rise.
This causes a depreciation of the pound and an appreciation of the
dollar.
Notes:
changes in the interest rate
If domestic interest rates are high compared with global financial
investment opportunities foreign investors will demand more dollars
and hence supply more pounds.
This causes a depreciation of the pound and an appreciation of the
dollar.
Notes:
If domestic interest rates are low compared with global financial
investment opportunities foreign investors will demand fewer dollars
and hence supply fewer pounds.
This causes an appreciation of the pound and a depreciation of the
dollar.
balance of payments
balance of payments a summary of all economic transactions
between a country and all other countries for a specified time period
•
•
imports -- debit because monies flow out of the country
exports -- credit because monies flow into the country
current account
current account -- the record of all transactions with foreign nations
that involve the exchange of merchandise goods and services
(imports and exports) and services or unilateral gifts
balance on merchandise trade -- the difference between the value of
exports and the value of imports
Notes:
Notes:
When one hears the phrase "trade deficit" it is the balance on
merchandise trade that is being referred to.
balance on current account -- the import - export balance of goods
and services plus net private and government transfers
•
•
if: exports > imports + transfers the balance on current
account is in surplus
if: exports < imports + transfers the balance on current
account is in deficit
capital account
capital account -- the record of all transactions with foreign nations
that involve direct investment and foreign loans
official settlements account
official settlements account -- an account with the International
Monetary Fund (IMF)
also known as the official reserve account
the account balance
the aggregate balance of payments must balance (analogue of
double entry bookkeeping), therefore:
current
account
balance
+
capital
account
balance
+
official reserve
account
balance
=
0
a deficit in one area implies a surplus in another area
Changes in the official settlements account are effectively zero
(because of flexible exchange rates). Hence,
current
account
balance
+
capital
account
balance
=
0
A deficit (surplus) an current account means a surplus (deficit) on
capital account.
Notes:
If the United States is running a trade deficit, we are running a
surplus on capital account. Foreigners find investment in the United
States attractive. If the United States is viewed as a good place to
invest globally, we will run a current account deficit.
If investment opportunities in the United States were no longer
attractive to foreigners, a current account deficit would be a
problem. We would have difficulty financing the deficit.
origin of current account deficit
1. favorable investment opportunities in the United States -good investment means a higher demand for dollars which will
cause the dollar the appreciate which in turn will move us
toward a current account deficit
2. high United States interest rates -- means a higher demand
for dollars which will cause the dollar the appreciate which in
turn will move us toward a current account deficit
3. federal government budgetary deficits -- high return on
government securities means a higher demand for dollars
which will cause the dollar the appreciate which in turn will
move us toward a current account deficit