ECO 201 Ch 23 International Finance 1 The Foreign Exchange Market 2 Flexible Exchange Rates trade balance aka Net Exports or Balance of Trade the value of a country s exports minus the value of its imports sometimes referred to as net exports trade surplus the condition that exists when the value of a country s exports is greater than the values of its imports trade deficit the condition that exists when the value of a country s imports is greater than the value of its exports foreign exchange market the market in which currencies of different countries are exchanged exchange rate the price of one currency in terms of another currency a The Demand for Goods b The Demand for and Supply of Currencies If an American wants to buy a Mexican good then the American is causing a demand for pesos and a supply of dollars If a Mexican wants to buy an American good then the Mexican is causing a demand for dollars and a supply of pesos The demand curve for pesos is downward sloping indicating that as the dollar price per peso declines the quantity demanded of pesos by Americans rises The supply curve for pesos is upward sloping indicating that as the dollar price per peso rises the quantity supplied of pesos rises flexible exchange rate the system whereby exchange rates are determined by the forces of supply and demand for a currency a The Equilibrium Exchange Rate In a completely flexible exchange rate system the forces of supply and demand determine the exchange rate The quantity demanded equals the quantity supplied there are no shortages or surpluses b Changes in the Equilibrium Exchange Rate A change in demand or supply or both will change the equilibrium price appreciation an increase in the value of one currency relative to other currencies A currency has appreciated in value if it takes more of a foreign currency to buy it depreciation a decrease in the value of one currency relative to other currencies A currency has depreciated in value if it takes more of it to buy a foreign currency c Factors that Affect the Equilibrium Exchange Rate If the equilibrium exchange rate can change owing to a change in the demand for and supply of a currency then understanding what factors can change demand and supply is important A Difference in Income Growth Rates An increase in a country s income will usually cause the residents to buy more of both domestic and foreign goods The increased demand for imports will result in an increased demand for foreign currency 1 ECO 201 Ch 23 International Finance Differences in Relative Inflation Rates purchasing power parity theory theory stating that exchange rates between any two currencies will adjust to reflect changes in the relative price levels of the two countries A 10 depreciation in the dollar restores the original relative prices of American goods to Mexican goods The PPP theory predicts that changes in the relative price levels of two countries will affect the exchange rate in such a way that 1 unit of a country s currency will continues to buy the same amount of foreign goods as it did before the change in the relative price levels Since income growth also affects exchange rates the PPP theory is not always accurate In the long run however and particularly when the difference in inflation rates across countries is large the PPP theory does predict exchange rates accurately The flow of financial capital depends on different countries real interest rates interest rates adjusted for inflation If the real interest rate in the US increases Mexicans will want to purchase financial assets in the US that pay a higher real interest rate The Mexican demand for dollars will increase and therefore Mexicans will supply more pesos As the supply of pesos increases on the foreign exchange market the exchange rate will change and fewer dollars will be needed to buy them The dollar will appreciate and the peso will depreciate Changes in Real Interest Rates 3 Fixed Exchange Rates fixed exchange rate system the system whereby a nation s currency is set at a fixed rate relative to all other currencies and central banks intervene in the foreign exchange market to maintain the fixed rate a Fixed Exchange Rates and Overvalued Undervalued Currency Fixed exchange rate aka official price overvalued a currency is overvalued if its price in terms of other currencies is above the equilibrium price undervalued a currency is undervalued if its price in terms of other currencies is below the equilibrium price Overvalued peso Undervalued dollar Undervalued peso Overvalued dollar 2 ECO 201 Ch 23 International Finance b What is so Bad About an Overvalued Dollar The exchange rate and hence the value of the dollar in terms of other currencies affects the amount of US exports and imports What is so bad about overvalued dollar is that it makes US goods more expensive for foreigners to buy possibly affecting US exports c Government Involvement in a Fixed Exchange Rate System If the governments of Mexico and US agree to fix the exchange rate and a surplus of pesos exists the Federal Reserve System could buy the surplus of pesos with dollars or the Banco de Mexico could buy the surplus with dollars This would cause the demand for pesos to increase the demand curve to shift to the right and raise the equilibrium rate to the current fixed exchange rate d Options Under a Fixed Exchange Rate System Devaluation and Revaluation devaluation a government action that changes the exchange rate by lowering the official price of a currency revaluation a government act that changes the exchange rate by raising the official price of a currency Protectionist Trade Policy Quotas and Tariffs Quotas and Tariffs can be used to restrict trade to allow an overvalued dollar to Sometimes a country can use monetary policy to support the exchange rate or the decrease Changes in Monetary Policy 4 Fixed Exchange Rates Versus Flexible Exchange Rates official price of its currency a Promoting International Trade A major advantage of fixed exchange rates is certainty because exchange rate is constant With flexible exchange rates individuals are less likely to engage in international trade because of the added risk of not knowing from one day to the next what the exchange rate will be Fixed exchange rates is compared to having the same currency in all states Flexible exchange rates break up the world market Advocates for flexible exchange rates argue that it is better to adopt policies to meet domestic economic goals