Exchange Rates Flashcards
What is the balance of payments? What are the two accounts?
Balance of Payments accounts measure all international transactions in a year. This includes the sale and purchase of goods/services and assets. There are two accounts within the balance of payments: (1) the current account, and (2) the capital account. Keep in mind, adding the current account balance and capital account balance should always equal to zero
What does the current account include? Explain.
Current Account includes:
Net Exports: Exports count as positive asset, Imports count as negative asset. If a country has more exports than imports, it has a trade surplus. If a country has more imports than exports its a trade deficit.
Net investments: Any interest or dividend paid to or from domestic investors.
Net transfers: Any aid or grants paid to and from the domestic economy. This includes international aid or the transfer of income. Paid to the domestic economy is positive, from is negative.
Current account as previously shows the imports and exports (and their payments) of goods and services.
It also shows investments made by foreigners and foreign assets, respectively.
If You Send more foreign currency than you receive, the balance of the current account would be negative. On the contrary, if we received more foreign currency, the current account would be positive.
What does the capital account include? Explain
Capital Account
Capital Account include:
Financial investments: purchase of foreign and domestic financial assets. Foreign purchase of domestic assets is positive, and domestic purchase of foreign assets is negative
Real Investments: The purchase of foreign and domestic land and businesses, including plant capacities and factories.
Capital account, looks at real estate or financial assets of another nation.
If there was more capital investment within the US than American investments abroad, that’s a surplus balance, making the capital account positive.
What is the Official Reserve Account? What do they do?
They hold some foreign currency which is called the official reserve
If there’s a balance of payments deficit when adding current and capital accounts, because the US sent more dollars out than receiving foreign currency, the Fed comes in and pays with their official reserve foreign currency to make the deficit disappear and make it 0
If we have a balance of payments surplus, in which we have more dollars going abroad than foreign currency coming in, the Fed will take the surplus currency and save it as official reserves until we need it.
What is Exchange Rates? What is Appreciation and Depreciation?
Exchange rates are the price at which one international currency can be exchanged for another. In other words, it’s the price at which one currency can be bought with another
When the exchange rate increases, it is more expensive to purchase currency. This makes goods and services from this country more expensive
When the exchange rate decreases, it is less expensive to purchase currency. This makes goods and services from this country less expensive
Appreciation occurs when the value of a country’s currency increases relative to a foreign currency. Depreciation occurs when the value of a country’s currency falls.
Exchange rates between countries are reciprocals of each other, meaning that when one currency appreciates, the other currency depreciates
What are the factors that change exchange Rates?
consumer taste, relative, income, relative inflation, speculation
Explain the consumer taste factor
When Americans, for example, prefer European products and services, demand for euros increase. This causes the demand for euros shift to the right, increasing the quantity of euros and the price of the euros. Now, instead of being able to buy a euro with $1, you need to bring $2 in order to trade in for (or buy) a euro. In this case, the value of the dollar depreciates, because supply of the dollar has increased, or shifted to the right (more Europeans are trading in their euros for dollars, more dollars are now available in the markets)
On the other hand, if Europeans have a strong preference of American products, demand for dollar (USD) will increase, since you can only buy American products with dollars. This causes the demand for dollars to shift to the right, increasing the quantity and price of dollars. Now you’ll need 2 euros to trade in for one dollar, a change from 1 euro for 1 dollar. In this case, the value of the dollar appreciates.
Explain Relative Income Factor
If one nation’s GDP is increasing and everyone’s income is increasing, they will demand more of all goods and products, including international ones. For example, the US was in a recession while Europe was enjoying an economic boom, Europeans would obviously want to buy more of American products with more money to spend. This will increase the demand for dollars and appreciate its value. if you have more money to spend then usual, you contribute to the change in exchange rates if you buy any foreign products
Explain Relative Inflation factor
A situation where one nation’s price level is increasing due to inflation at a way faster rate than another nation. Now, consumers from the inflation-high nation will demand more products from the other nation because it’s cheaper. This will increase demand for products from the nation, appreciating its currency value.
Explain Speculation Factor?
Because foreign currency acts kind of like assets, there will be investors trying to make some profit by buying currency at low rates and selling them at high rates. If many speculate interest rates will fall in the US relative to Europe, the euro will be a good investment, right? Most investors will start buy European assets, thus increasing the value of euro and depreciating the dollar.
Explain Demand in Foreign Exchange Market.
Foreign exchange demand is the quantity of an international currency that all domestic and foreign currencies are willing and able to purchase at various rates of exchange. Either fortunately or unfortunately, supply and demand still come back even with foreign exchange.
Demand for the exchange market is not the same as demand for money. It’s more about how much of a dollar is wanted in terms of euros. What does that mean? It means:
Europeans want more of American goods and services
Europeans want to invest in America
Because more Europeans want to buy American products, demand shifts right, and the exchange rate now increases from e to e1. Now, the American dollar is more expensive for Europeans to buy.
Relationship between exchange rates and the quantity of currency demanded is inverse:
As the exchange rate rises, domestic and foreign consumers will purchase less quantity of the currency.
As the exchange rate falls, domestic and foreign consumers will purchase more quantities of the currency.
Explain Supply in Foreign Exchange Markets.
Foreign exchange supply is the quantity of an international currency that all domestic and foreign sellers are willing and able to sell at various rates of exchange.
Supply in the foreign exchange market is upward sloping because if more dollars are supplied, then the price would be higher. It makes sense because if more people will be wanting to buy euros if they could buy more of them with a singular dollar. So when does supply change?
It changes when:
Americans want more European products
Americans want to invest more in Europe
If Americans buy a lot of French stuff, then they’ll change trade in their dollars for euros. As a result, the supply of dollars will increase. If, however, the French buy more American stuff, the supply of dollars would decrease, as shown in the graph. This will cause a price increase for buying dollars from e1 to e2.
The relationship between exchange rates and quantity of currency supplied is positive or direct:
As exchange rates rise, domestic and foreign consumers are willing to sell more.
As exchange rates fall, domestic and foreign consumers are willing to sell less
Explain FOREX Market Equilibrium
Equilibrium is achieved in the FOREX Market (the market in which foreign currency is bought and sold) when the quantity supplied of the currency equals the quantity demanded of the currency at a specific exchange rate.
Since in the FOREX market we are working with has flexible exchange rates, the exchange rates are constantly changing. When they rise above equilibrium or fall below equilibrium, the market will force them back up to equilibrium.
What are the four determinants that can change either supply or demand in the FOREX Market
There are four determinants that can change either the supply or demand in the FOREX Market. These include:
Foreign Tastes
Trade Prices
Income Levels
Real Interest Rates
For Each Following Scenario, explain if it appreciates or depreciates draw a graph.
Scenario # 1: Tourist Tourists from all over the world travel to Mexico for Vacation. (PESO currency)
The demand for the peso will increase and the peso will appreciate. Appropriately, demand will shift to the right
