Exchange RatesExchange RatesExchange RatesElias YannopoulosDecember 3, 2012Elias Yannopoulos Exchange RatesExchange RatesExchange RatesWhy do we buy foreign currency?The primary reason is so we can buy goods, services, andfinancial assets that originate in the foreign countryEx: German Chocolates, Ex: ToyotaMost of the demand for currency is derived demand - demandthat comes from your demand for that countries stuffSome of the demand is people holding foreign currency as anassetExchange Rate - The price of a unit of foreign currencyThere are two ways to express exchange rates - how manydollars to buy foreign currency, and how much foreigncurrency to buy a dollar Ex: websiteElias Yannopoulos Exchange RatesExchange RatesCurrency MarketIf we have exchange rates as how many dollars to buy foreigncurrency then we can use supply and demand to evaluate thecurrency marketIn the currency market the good is foreign currency (Euros)The price is the exchange rate (expressed in terms of dollarsfor a unit of foreign currency)Using supply and demand we can find the equilibrium quantityof foreign currency and the exchange rate Ex: graphThe supply of foreign currency is assumed fix (just like inmoney market)Dollar Appreciation - decrease in the number of dollars perunit of foreign currency, the exchange rate falls, each dollar isworth moreDollar Depreciation - increase in the number of dollars perunit of foreign currency, the exchange rate rises, each dollar ifworth lessElias Yannopoulos Exchange RatesExchange RatesDemand for Foreign CurrencyWhat factors affect the demand for foreign currency?Price (exchange rate) - affects the quantity demanded justlike with other assets, increase in the exchange rate thequantity demanded fallsDemand for foreign goods and services - Increase in thedemand for foreign goods and services leads to an outwardshift in the demand for that goods currencyDemand for US goods and services - this has the oppositeeffect of a change in the demand for foreign goods andservices, increase in demand for US goods leads to a shift in indemand for foreign currencyDemand for foreign assets - moves the same as demand forforeign goods and services (also demand for US assetsfunctions the same as the demand for US goods)The supply of foreign currency is determined by the foreigngovernmentElias Yannopoulos Exchange RatesExchange RatesApplicationsBasic application - increase in the demand for German carsSecond application - increase in the interest rate in UKThird application - Change in the supply of foreign currencyUS and ChinaElias Yannopoulos Exchange RatesExchange RatesAdditional Exchange Rate TermsReal Exchange Rate - exchange rate adjusted for differentialinflation%∆ real exchange rate = %∆ nominal exchange rate +(Domestic inflation - Foreign inflation)DONT BE CONFUSED! This formula works for foreigncurrency/dollar not the exchange rate I have been using so farin the lectureFloating Exchange Rate - when the government does notenter into foreign exchange markets, leaves the determinationof exchange rates up to currency marketsFixed/Pegged Exchange Rate - when the governmentchooses a particular exchange rate and offers to buy and sellits currency at that priceElias Yannopoulos Exchange
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