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International Finance and the Foreign Exchange Market Foreign Exchange Market • Market where different currencies are traded, one for another. • The exchange rate enables people in one country to translate the prices of foreign goods into units of their own currency. • An appreciation of a nation’s currency will make foreign goods cheaper. • A depreciation of a nation’s currency will make foreign goods more expensive. Foreign Exchange Market $5.3 trillion per day. Currency % of Daily Share US dollar Euro Japanese yen 87.0% 33.4% 23.0% British pound Australian dollar Swiss franc 11.8% 8.6% 5.2% Canadian dollar Mexican peso Chinese yuan 4.6% 2.5% 2.2% Number of 1 country’s currency that is equal to 1 unit of another country’s $1 = 0.6292 € $1 = 0.755 € 1€ = 1.5892 $ 1€ = 1.3245 $ $1 = 0.5051 £ $1 = 0.6787 £ 1£ = 1.9797 $ 1£ = 1.4734 $ Currency Last Trade U.S. $ ¥en Euro U.S. $ ¥en 12/04 Euro 12/04 1 0.009328 Can $ 12/04 U.K. £ 12/04 Aust $ 12/04 SFranc 12/04 1.222 0.7705 1.733 0.7403 0.7894 1 131 82.59 185.8 79.36 84.62 0.8181 0.007632 1 0.6303 1.418 0.6057 0.6458 107.2 Can $ 1.298 0.01211 1.586 1 2.249 0.9608 1.025 U.K. £ 0.577 0.005382 0.7053 0.4446 1 0.4272 0.4555 Aust $ 1.351 0.0126 1.651 1.041 2.341 1 1.066 SFranc 1.267 0.01182 1.548 0.976 2.195 0.9378 1 Currency $ Appreciate / Depreciate Yahoo April 2008 Yahoo April 2005 U.S. $ 1 1 ¥en Euro Can $ U.K. £ 103.21 0. 6292 1.0197 0.5051 107.293 0. 7689 1.244 0.5232 Aust $ SFranc 1.0561 1.0125 1.2943 1.1879 Yahoo Mar 2004 Yahoo Dec 2003 1 1 105.6 107.2 0.8237 0.8181 1.31 1.298 0.5506 0.577 1.337 1.287 1.351 1.267 Text Oct 2002 1 123.3 1.01 1.5987 0.6391 1.84 1.49 Currency U.S. $ 1 ¥en Last Trade 1:09pm 1 Euro 1 Can $ 1 U.K. £ 1 Aust $ 1 SFranc 1:09pm 1:09pm 1:09pm 1:09pm 1:09pm U.S. $ 4/08 1 0.009689 1.5892 0.9708 1.9797 0.9468 U.S. $ 5/3 1 0.009077 1.195 U.S. $ 12/04 1 0.009328 U.S. $ 10/02 1 0.7262 1.774 1.222 0.7705 0.72 1.733 0.7403 0.00811 0.9901 0.6255 1.5648 0.545 0.9877 0.7696 0.7894 0.74 Currencies 1. Everyone has their own. dollar, peso, pound, … 2. Use someone else’s – Dollarize Ecuador, El Salvador, and Panama 3. Use a common currency - European Union euro Exchange Rate Regimes 1. Three major types of exchange rate regimes: a. flexible (floating) rates (US and 40% of all), b. Merged currency (unified currency), and, c. pegged exchange rates 1) hard peg – government sets a fixed rate 2) soft peg – market determines rate, but government may intervene. 2. Examples of a merged currency (unified): The • Nations of the European Union have recent adopted a unified currency system. Standard •Gold A country can also use a currency board to unify its currency with another. • The currencies of Hong Kong, El Salvador, and Panama are unified with the U.S. dollar. The Gold Standard a. $1 = 1/35 oz of Gold b. 4 German marks = 1/35 oz of Gold c. $1 = 4 German marks d. Devaluation – change rate flexible to fixed pegged strange? Determinants of the Exchange Rate • flexible rate system - the exchange rate is determined by supply and demand. • The dollar demand for foreign exchange originates from American demand for foreign goods, services, & assets (real or financial). • The supply of foreign exchange originates from sales of goods, services, & assets from Americans to foreigners. Foreign Exchange Market Equilibrium • If incomes increase in the foreign exchange United States, U.S. imports of (for pounds) foreign goods and services will grow. • The increase in imports will increase the demand for pounds in the foreign exchange $1.80 market causing the dollar price of the pound to rise from $1.50 $1.50 to $1.80. Dollar price of S(sales to foreigners) b a D2 D1 Q1 Q2 Quantity of foreign exchange (pounds) Demand for Foreign Currencies 1. Foreign Direct Investment. buying a foreign firm (InBev) 2. Portfolio Investment a. purely financial by individual investors b. taking advantage of changing exchange rates c. Taking advantage of higher interest rates. Demand for Foreign Currencies Demand for the US dollar Supply of the US dollar comes from… comes from… A U.S. exporting firm that earned foreign currency and is trying to pay U.S.-based expenses Foreign tourists visiting the United States Foreign investors who wish to make direct investments in the U.S. economy Foreign investors who wish to make portfolio investments in the U.S. economy A foreign firm that has sold imported goods in the United States, earned U.S. dollars, and is trying to pay expenses incurred in its home country U.S. tourists leaving to visit other countries U.S. investors who want to make foreign direct investments in other countries U.S. investors who want to make portfolio investments in other countries A Strong Dollar Favors, or A Weak Dollar Favors: 1. 2. 3. 4. 5. 6. A US exporting firm? A foreign firm exporting to the US? A US tourist abroad? A foreign tourist in the US? A US investor abroad? A foreign investor in the US? • Changes in the Exchange Rate Determinants: 1. A change in interest rates, or an expected change in interest rates (relative to rates abroad). a. High rates attract money b. Currency appreciates 2. A change in the inflation rate in one country. a. Higher rate decreases demand b. Lower demand - depreciation 3. Purchasing Power Parity. a. Exchange rates make it cheaper to buy the same product in a particular country at lower cost. b. Causes a demand for that currency 4. Changes in incomes and tastes Inflation With Flexible Exchange Rates S • If the price level in the U.S. increased by 50 % … the U.S. demand for British goods (and pounds) would increase (relatively cheap). Since U.S. exports to Britain would decline and thereby cause the supply of pounds to fall. • These forces would cause the dollar to depreciate relative to the pound. 2 Dollar price of foreign exchange (for pounds) S1 $2.25 b $1.50 a D2 D1 Q1 Quantity of foreign exchange (pounds) Labatt’s beer is produced in Canada. In 1990, in Ontario, a six-pack of Labatt’s beer sold for $6.60 Canadian. Across the border in Michigan, a six pack of the same beer was on sale for $2.75 U.S. At the time, the exchange rate was $0.75 U.S. = $1.00 Canadian. In Ontario, $6.60 Canadian. In Michigan, $2.75 U.S. $0.75 U.S. = $1.00 Canadian. 1. How much would it cost in U.S. currency to buy the beer in Ontario? 2. How much would it cost in Canadian currency to buy the beer in Michigan? 3. Is there an arbitrage opportunity? 4. Where would you buy and where would you sell? 5. How much profit could you expect on a six-pack? $6.60 x ($2.93 .75 = $4.95 US $4.95 $2.75 = $2.20 Canadian) $2.75 .75 = $3.67 Can Buy in/-Michigan, sell inUS Ontario Peso – Appreciation or Depreciation? 1. The US reduces tariffs on Mexican products. 2. Mexico encounters severe inflation. 3. Deteriorating political relations reduce American tourism in Mexico. 4. The US economy moves into a severe recession 5. A bartender puts a lime in a Corona and beer sales jump 6. The Mexican government encourages American firms to invest in Mexican oil fields 7. A large federal government budget deficit raises interest rates in the US Euro – Appreciation or Depreciation? 1. An American importer purchases a shipload of Bordeaux wine. 2. BMW decides to build an assembly plant in LA 3. A CVCC student decides to spend a year studying at the Sorbonne. 4. A Spanish manufacturer exports machinery to Morocco on an American freighter. 5. The US incurs a balance of payments deficit in its transactions with Belgium. 6. A US government bond held by an Italian citizen matures. 7. It is widely believed that the international value of the Euro will fall in the near future. Balance of Payments • Balance of payments: accounts that summarize the transactions of a country’s citizens, businesses, and governments with foreigners • Imports create a demand for foreign currency (and a supply of the domestic currency) and are recorded as a debit item. • Exports create a supply of foreign currency (and demand for the domestic currency) and are recorded as a credit item. Balance of Payments • Under a pure flexible rate system, the foreign exchange market will bring the quantity demanded and the quantity supplied into balance, and as a result, it will also bring the total debits into balance with the total credits. Balance of Payments • Current account transactions: all payments (and gifts) related to the purchase or sale of goods and services and income flows during the current period • Four categories: • Merchandise trade (import and export of goods) • Service trade (import and export of services) • Income from investments • Unilateral transfers (gifts to and from foreigners) Balance of Payments • Capital account transactions: transactions that involve changes in the ownership of real and financial assets • The capital account includes both • direct investments by foreigners in the U.S. and by Americans abroad, and, • loans to and from foreigners. • Under a pure flexible-rate system, official reserve transactions are zero; therefore: • a current-account deficit implies a capital-account surplus. • a current-account surplus implies a capital-account deficit. Monetary Policy & the Exchange Rate • An unanticipated shift to a more restrictive monetary policy will: • raise the real interest rate, • reduce the rate of inflation, and, • at least temporarily, reduce aggregate demand and the growth of income; • causing an appreciation in domestic currency. • the currency appreciation (with shift the current account toward a deficit). • An unanticipated shift to more expansionary monetary policy will cause the opposite: • • • • lower interest rates, and, an outflow of capital; leading to a currency depreciation, and, a shift toward a current account surplus. 1. A depreciation in the value of the U.S. dollar would a. encourage foreigners to travel on American owned airlines. b. make U.S. goods more expensive to foreign consumers. c. decrease the number of dollars it takes to buy a Swiss franc. d. make it more expensive for U.S. citizens to travel abroad. 2. a. b. c. d. A nation’s trade deficit will tend to expand when its economy is expanding. its economy is shrinking. its investment environment is less attractive to foreigners. both b and c above are true. 3. Under a system of flexible exchange rates, an increase in demand for a nation’s currency in the foreign exchange market will a. cause the nation’s currency to appreciate. b. make it more expensive for the nation to import goods. c. cause the nation’s balance on current account to shift toward a surplus. d. make it less expensive for foreigners to buy the nation’s goods. 4. Under a system of flexible exchange rates, which of the following will most likely cause a nation’s currency to appreciate on the foreign exchange market? a. a decrease in domestic interest rates b. an increase in foreign interest rates c. domestic inflation of 10 percent while the nation’s trading partners are experiencing stable prices d. stable domestic prices while the nation’s trading partners are experiencing 10 percent inflation 5. Suppose a German-produced car becomes very popular in the United States. This would tend to a. affect the U.S. balance of payments but not the balance of trade. b. reduce any existing balance of trade deficit in the United States. c. increase a balance of trade surplus in the United States. d. increase a balance of trade deficit in the United States. 6. If the dollar price of the euro goes from $1 to 90 cents, the euro has a. appreciated, and Europeans will find U.S. goods cheaper. b. appreciated, and Europeans will find U.S. goods more expensive. c. depreciated, and Europeans will find U.S. goods cheaper. d. depreciated, and Europeans will find U.S. goods more expensive. Which of the following would cause the American demand for foreign exchange (pounds) to shift from D1 to D2? a. an increase in the U.S. real interest rate b. higher inflation in Britain than in the United States c. higher income growth in Britain than in the United States d. an increased level of vacation travel to Britain by Americans Which of the following would cause the demand for foreign exchange (pounds) to shift from D1 to D2? a. an increase in the real interest rate in Britain relative to the US b. higher inflation in Britain than in the United States c. higher income growth in Britain than in the United States d. an increase in the number of British citizens vacationing in the US