Download ECN 104 sec003 Notes Foreign Exchange Market –A market in

ECN 104 sec003 Notes
Foreign Exchange Market –A market in which the money (currency) of one nation can
be used to purchase (can be exchanged for) the money of another nation.
Why do we need a foreign exchange market? As we discussed before, Polish currency
will not buy goods or services in downtown Toronto. If you want to buy goods/services
in another country, you must first purchase the currency in which it is sold.
In any country, prices are stated in the domestic currency. To find out the price of a good
in a different currency, one must look at the exchange rates of these currencies.
Exchange rate: the rate at which the currency of one nation is exchanged for the
currency of another.
Exchange rates are the equilibrium prices in the Foreign Exchange market as we shall
see.
Foreign exchange markets are competitive, and contain large numbers of buyers and
sellers dealing in standardized products (currencies of the world)
Ex/
Dollar-Yen Market
Scenario:
Canadian firms export wheat to Japan. Japanese firms export automobiles to Canada.
Canadians must purchase Yens to buy Japanese automobiles, and Japanese must purchase
Canadian Dollars to buy Canadian wheat.
$ price
of Yen
Sy
0.1
Dy
Qe
Quantity of Yen
As the price of Yen increases, the amount of Canadian dollars it takes to buy a Yen (and
therefore to buy a Japanese product) increases. Therefore, as the price of Yen increases,
the demand decreases.
As the price of Yen increases, the amount of Canadian dollars received on the sale of a
Yen increases (and therefore the amount of Canadian products Japanese firms can
purchase increases), so the supply of Yen increases with the price.
Suppose there is a change in taste in Canada. Japanese automobiles become more
popular in Canada. Then demand for automobiles increases (shifts out). Since these cars
must be paid for in Yen, this increased demand for Japanese automobiles means an
increase in demand for Yen as well. In order to buy Yen, Canadians supply dollars.
Therefore as the demand for Japanese automobiles increases the supply of Canadian
dollars increases as well. This will cause the equilibrium price of Yen to rise.
Pr of Yen
Sy
0.2
0.1
D’y
Dy
Qe Q’e
Quantity of Yen
This increase in the price of the Yen is called appreciation of the Yen.
Depreciation- a decrease in the value of one currency relative to another currency. (ex/
depreciation of the dollar=> the dollar buys a smaller amount of the foreign currency)
Appreciation-an increase in the value of one currency relative to another currency.