chapter 9 - the exchange rate Flashcards
foreign exchange market
market in which one country’s currency is exchanged for another’s currency
foreign exchange rate
price at which one currency exchanges for another
currency depreciation
a fall in the value of one currency in terms of another currency
currency appreciation
a rise in the value of one currency in terms of another currency
the law of demand for foreign exchange
as the exchange rate rises, the quantity of Canadian dollars demanded in the foreign exchange market decreases
the exchange rate influences the quantity of Canadian dollars demanded for which two reasons?
- exports effect
- expected profit effect
exports effect
as the value of canadian exports increases, the quantity of canadian dollars demanded by buyers of canadian exports on the foreign exchange market increases
lower exchange rate = more canadian exports = demand for cad dollars increases
expected profit effect
the larger the expected profit from holding Canadian dollars, the greater the demand for cad dollars
lower exchange rate = greater expected profit from buying cad dollars = greater quantity of cad dollars demanded
quantity of Canadian dollars supplied in the foreign exchange market
the amount that traders plan to sell during a given time period at a given exchange rate
the law of supply of foreign exchange
the higher the exchange rate, the greater the number of Canadian dollars supplied in the foreign exchange market
if the exchange rate is too high…
a surplus of Canadian dollars drives it down
if the exchange rate is too low…
a shortage of Canadian dollars drives it up
influences beside exchange rate that influence the demand for canadian dollars (3)
- world demand for canadian exports
- the canadian interest rate relative to the foreign interest rate
- expected future exchange rate
how world demand for canadian exports affects demand
at a given exchange rate, if world demand for canadian exports increases, the demand for canadian dollars increases
how the canadian interest rate relative to the foreign interest rate affects demand
canadian interest rate differential = the canadian interest rate - the foreign interest rate
if the canadian interest differential rises, the demand for canadian dollars increases
how expected future exchange rate affects demand
at a given current exchange rate, if the expected future
exchange rate for Canadian dollars rises, the demand
for Canadian dollars today increases, and the demand
curve for Canadian dollars shifts rightward.
influences beside exchange rate that influence the supply for canadian dollars (3)
- canadian demand for imports
- canadian interest rates relative to the foreign interest rate
- expected future exchange rate
how canadian demand for imports affects supply
if the Canadian demand for imports increases, the supply of Canadian dollars on the foreign exchange market increases, and the supply curve of Canadian dollars shifts rightward.
how canadian interest rates relative to the foreign interest rate affect supply
if the Canadian interest differential rises, the supply of
Canadian dollars decreases, and the supply curve of
Canadian dollars shifts leftward
how the expected future exchange rate affects supply
at a given current exchange rate, if the expected future
exchange rate for Canadian dollars rises, the supply of
Canadian dollars today decreases, and the supply curve
for dollars shifts leftward.
arbitrage
the practice of seeking to profit by buying in one market and selling for a higher price in another related market
arbitrage in the foreign exchange market and international loans and goods markets achieves what 4 outcomes?
- the law of one price
- no round-trip profit
- interest rate parity
- purchasing power parity
the law of one price
states that if an item can be traded in more than one place, the price will be the same in all locations.
no round-trip profit
A round trip is using the currency A to buy currency B,
and then using B to buy A.
Arbitrage removes profit from all transactions of this
type.
interest rate parity
Interest rate parity means equal interest rates when exchange rate changes are taken into account.
Market forces achieve interest rate parity very quickly.
purchasing power parity
when two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity (or PPP), which means equal value of money
flexible exchange rate
exchange rate determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.
fixed exchange rate
pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of
demand and supply.
requires active intervention in the foreign exchange market
crawling peg
exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market a crawling peg works like a fixed exchange rate except
that the target value changes.
the idea behind a crawling peg is to avoid wild swings in
the exchange rate that might happen if expectations
became volatile and to avoid the problem of running out of
reserves, which can happen with a fixed exchange rate.
speculation
trading on the expectation of making a profit. contrasts with arbitrage, which is trading on the certainty of making a profit
real exchange rate
the relative price of canadian-produced goods and services to foreign-produced goods and services
measure of the quantity of the real GDP of other countries that a unit of Canadian real GDP buys
real exchange rate equation (RER)
RER = (E x P) / P*
e = exchange rate
p = canadian price level
p* foreign price level
exchange rate equation
E = (RER x P*) / P
