1Topic 7-2 The Foreign Exchange MarketIn topic 7-1: WE saw that the market for loanable funds shows us how financial capital flows into or out of a nation’s capital account. We also saw how g/s also flow (but that is tracked as balance of payments into and out of the current account. Given that the financial account reflects the movement of capital and the current account reflects the movement of g/s, what ensures that the balance of payments really does balance? Foreign Exchange Market- the market in which currencies are traded Exchange rate- the price at which currencies trade The mindset of “buying dollars” or another currencySuppose you are traveling to Mexico and you wish to buy a T-shirt at a market and the price is 187.5 Mexican pesos. Youonly have US dollars in your pocket, but you must pay in the currency the shirt manufacturer is most useful to, the peso.In order to get your hands on some pesos, you must exchange your dollars for them in the foreign exchange market.How many pesos one US dollar will fetch at the foreign exchange counter depends on the exchange rate.Let’s say it is mid June, 2010. $1 could buy about 12.5 pesos.If you were going back to the US and you wanted to exchange your pesos back to dollars, it would take 12.4 pesos to buy$1. If you only had one peso, you could buy 1/12.5= $.80So how much does the shirt cost in June 2010? 187.5 pesos/12.5 pesos per dollar = $15The exchange rate is: just a price In this case, 12.5 pesos is the price of a US dollar. Prices change based upon the: force of supply and demand Suppose now that in April of 2012 it took 12.1 pesos to buy a dollar. This means that if you were in Mexico that month,your dollar would have been able to purchase fewer pesos. How much would the shirt cost in April 2010? $15.50In other words: the dollar was more expensive as measured in pesos/dollar in April 2010 than June Economists would say that the dollar has depreciated in value against the peso because it has became more expensive They would also say that in the span of two months, the same amount of pesos bought fewer dollars or that the peso had If the dollar can buy more of a foreign currency, it has appreciated. The other currency must have depreciated againstthe dollar because those consumers must supply more of their currency to buy the dollar.2____________________________________________________________________________________The Equilibrium Exchange RateThe price of a currency, or exchange rate, is determined in the market with forces of supply and demand.If I want pesos, I demand them. In order to acquire pesos, I must supply dollars to the exchange market. When demanding more of a foreign currency, you must apply more of your own. Graphing the market for US dollars X axis- Quantity of US dollars Y axis- Price of US Dollars measured in the other currency (exchange rate)(What goes below goes below! Dollars is in the denominator of Y as well as on the XEquilibrium Exchange rate is 12.4 Mexican Pesos per US dollar. Where is this point located on your graph?At the equilibrium exchange rate of 12.5 pesos/dollar, the quantity of dollars demanded is equal to thequantity of dollars supplied.3Why does the Demand for dollars slope downward?- As the price of a dollar falls (value depreciates), it takes fewer pesos to buy one dollar - Consumers in Mexico will find US goods to be less expensive - US exports in Mexico will rise and more dollars will be demanded to pay for those goods Why does the Supply of Dollars slope upward?- As the price of a dollar rises (value appreciates), one dollar can buy more pesos - Consumers in the US will find Mexican made goods to be less expensive - US imports from Mexico will rise and more dollars will be supplied to pay for those goods Changes in the Demand for US dollars:Suppose the demand for U.S. dollars increases. Maybe Mexican consumers have more money to spendand some of that additional income is being spent on financial investments in America. The paymentsfrom those Mexican citizens will flow into the U.S. financial account.- As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates o It will now cost more than 12.5 pesos to buy one US dollar - Because the US dollar has appreciated against the peso, American consumers will increase purchases of g/s from Mexico - More US dollars will be supplied and will flow out of the US accounts4This tells us that any increase in the U.S. balance of payments on the financial account is exactlyoffset by a decrease in the U.S. balance of payments on the current account.Summary:- An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a decrease in US net exports - A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an increase in US net exports ___________________________________________________________________________________Inflation and Real Exchange RatesThe price of imported goods depends on the exchange rate for foreign currencies, but also on the APL in those nations To take account of the effects of differences in inflation rates, economists calculate real exchange rates, or exchange rates adjusted for international differences in APLs Purchasing Power Parity between two countries’ currencies- exchange rate at which a given basket of g/s would cost the same amount in each country The purchasing power parity between two countries’ currencies is the nominal exchange rate at which aSuppose that the exchange rate we are looking at is the number of Mexican pesos per U.S. dollar.Let PUS and PMex be indexes of the aggregate price levels in the United States and Mexico, respectively. Then the real exchange rate between the Mexican peso and the U.S. dollar is defined as:Real exchange rate = Mexican pesos/US dollar x (Price US/Price Mexican) To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate.Example 1: There is no difference in aggregate price levels between the U.S. and Mexico in the base year. Real exchange rate = 12.5 x (100/100) = 12.5 pesos/dollar Nominal exchange rate because there is no inflation to account for Nominal = real Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and PMex=110. Real exchange rate = 12.5 x (100/110) = 11.4 pesos per dollarSo in real terms, even