Unit 5: International Trade and Foreign Exchange
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The foreign exchange market involves firms, households, and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers. The vertical axis shows the exchange rate for U. The horizontal axis shows the quantity of U.
The demand curve D for U. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The demand curve D for Mexican pesos intersects with the supply curve S of Mexican pesos at the equilibrium point Ewhich is an exchange rate of 10 cents in U.
Note that the two exchange rates are inverses: In the actual foreign exchange market, almost all of the trading for Mexican pesos is done for U. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? The answer to this question is discussed in the following section. One reason to demand a currency on the foreign exchange market is the belief that the value of the currency is about to increase.
One reason to supply a currency—that is, sell it on the foreign exchange market—is the expectation that the value of the currency is about to decline. For example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Timesruns an article predicting that the Mexican peso will appreciate in value.
The likely effects of such an article are illustrated in [link]. Demand for the Mexican peso shifts to the right, from D 0 to D 1as investors become eager to purchase pesos. Conversely, the international trade and foreign exchange ppt of pesos shifts to the international trade and foreign exchange ppt, from S 0 to S 1because investors will be less willing to give them up. In contrast to all the other cases international trade and foreign exchange ppt supply and demand you have considered, in the foreign exchange marketsupply and demand typically both move at the same time.
Groups of participants in the foreign exchange market like firms and investors include some who are buyers and some who are sellers. An expectation of a future shift in the exchange rate affects both buyers and sellers—that is, it affects both demand and supply for a currency.
The shifts in demand and supply curves both cause the exchange rate to shift in the same direction; in this example, they both make the peso exchange rate stronger.
However, the shifts in demand and supply work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall.
In this specific example, the result is a higher quantity. But in other cases, the result could be that quantity remains unchanged or declines. This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months. The appreciation of the currency can lead other investors to believe that future appreciation is likely—and thus lead to even further appreciation.
Similarly, a fear that a currency might weaken quickly leads to an actual weakening international trade and foreign exchange ppt the currency, which often reinforces the belief that the currency is going to weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.
The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than they previously did.
As a result, more investors will demand U. Demand for the U. If a country experiences a relatively high inflation rate compared with other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency. Not surprisingly, as inflation dramatically decreased the purchasing power of the peso in Mexico, the exchange rate value of the peso declined as well. As shown in [link]demand for the peso on foreign exchange markets decreased from D 0 to D 1while supply of the peso increased from S 0 to S 1.
In this example, the quantity of pesos traded on foreign exchange markets remained the same, even as the exchange rate shifted. Visit this website to learn about the Big Mac index. Over the long term, exchange rates must bear some relationship to the buying power of the currency in terms of goods that are internationally traded.
If international trade and foreign exchange ppt a certain exchange rate it was much cheaper to buy internationally traded goods—such as oil, steel, computers, and cars—in one country than in another country, businesses would start buying in the cheap country, selling in other countries, and pocketing the profits.
For example, if a U. This is known as arbitragethe process of buying and selling goods or currencies across international borders at a profit.
It may occur slowly, but over time, it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries. The exchange rate that equalizes the prices of internationally traded international trade and foreign exchange ppt across countries is called the purchasing power parity PPP exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.
The purchasing power parity exchange rate has two functions. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years, and for ease of comparison, you are converting all the values into U.
But should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. The misleading appearance of a booming Japanese economy occurs only because we used the market exchange rate, which often has short-run rises and falls.
However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year. The second function of PPP is that exchanges rates will often get closer and closer to it as time passes. It is true that in the short run and medium run, as exchange rates adjust to relative inflation rates, rates of return, and to expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time.
But, knowing the PPP will allow you to track and predict exchange rate relationships. In the extreme short run, ranging from a few minutes to a few weeks, exchange rates are influenced by speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker. Such speculation can create a self-fulfilling prophecy, at least for a time, where an international trade and foreign exchange ppt appreciation leads to a stronger currency and vice versa.
In the relatively short run, exchange rate markets are influenced by differences in rates of return. Countries with relatively high real rates of return for example, high interest rates will tend international trade and foreign exchange ppt experience stronger currencies as they attract money from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies.
In the medium run of a few months or a few years, exchange rate markets are influenced by inflation rates. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity PPP rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar international trade and foreign exchange ppt all economies.
Suppose that political unrest in Egypt leads financial markets to anticipate a depreciation in the Egyptian pound. How will that affect international trade and foreign exchange ppt demand for pounds, supply of pounds, and exchange rate for pounds compared to, say, U. Expected depreciation in a currency will lead people to divest themselves of the currency.
We should expect to see an increase in the supply of pounds and a decrease in demand for pounds. What would be the likely impact on the demand for dollars, supply of dollars, and exchange rate for dollars compared to, say, euros? We should expect to see a decrease in international trade and foreign exchange ppt for dollars and an increase in supply of dollars in foreign currency markets. As a result, we should expect to see the dollar depreciate compared to the euro. Suppose Argentina gets inflation under control and the Argentine inflation rate decreases substantially.
A decrease in Argentine inflation international trade and foreign exchange ppt to other countries should cause an increase in demand for pesos, a decrease in supply of pesos, and an appreciation of the peso in foreign currency markets.
Does an expectation of a stronger exchange rate in the future affect the international trade and foreign exchange ppt rate in the present?
Does a higher inflation rate in an economy, other things being equal, affect the exchange rate of its currency? Think about how expected exchange rate changes and interest rates affect demand and supply for a currency. Do you think that a country experiencing hyperinflation is more or less likely to have an exchange rate equal to its purchasing power parity value when compared to a country with a low inflation rate?
You can also download for free at http: By the end of this section, you will be able to: Explain supply and demand for exchange rates Define arbitrage Explain purchasing power parity's importance when comparing countries.
What is the purchasing power parity exchange rate? Glossary arbitrage the process of buying a good and selling goods across borders to take advantage of international price differences purchasing power parity PPP the exchange rate that equalizes the prices of internationally traded goods across countries.