Unit 16.1 Flashcards
What are exchange rates
the price of one currency in terms of another set on the foreign exchange markets.
Exchange rates also have a powerful influence over the macro and micro-economy. For example, a rise in the value of the US Dollar(US$) can:
Increase the price of US exports and may cause an increase in the US trade deficit
Cause the cost of imported goods to fall which might reduce inflation
Make visiting the US more expensive for foreign tourists and negatively affect the US hotel industry.
What is free floating excahnge rates?
A floating exchange rate is when a currency’s value changes based on supply and demand in the foreign exchange market, without government control.
What creates the demand of a currency
Foreign Trade: Overseas companies and individuals need US dollars to pay for American exports, like a French company buying Microsoft Office 365 from the US.
Foreign Direct Investment (FDI): When international investors buy businesses in the US, like a Chinese investor purchasing a US renewable energy company, they need to convert their money to US dollars.
Portfolio Investment: If foreign investors, such as a Saudi bank, want to invest in US financial assets like stocks or bonds, they need to acquire US dollars to do so.
Speculation: Investors who speculate on the forex market buy currencies like the US dollar if they expect its value to increase. Their buying contributes to the demand for the US dollar.
What creates supply of a currency
Imports: When American buyers purchase goods from abroad, like a BMW from Germany, they exchange US dollars for the foreign currency, increasing the supply of US dollars on the foreign exchange market.
Foreign Direct Investment (FDI) Outward: If a US company invests in a business outside the US, such as a car production plant in Mexico, it converts US dollars to the local currency, contributing to the supply of US dollars.
Portfolio Investment Abroad: American investment in foreign financial assets, like a US bank purchasing UK government bonds, leads to the conversion of US dollars into the foreign currency, adding to the supply of US dollars.
Speculation: Speculators who anticipate a rise in the value of another currency will sell their US dollars to buy that currency, thus supplying US dollars to the foreign exchange market. For instance, an investor might exchange US dollars for euros expecting the euro to rise in value.
What does appreciation in currency mean?
means its value rises against the value of another currency. An appreciation in the value of a currency will occur if either demand for the currency increases or the supply of it decreases.
What causes Increase in currency demand leads to appreciation (D curve shift right)
Increase in foreign demand for exports of goods and services: More demand for a country’s exports means more foreign buyers need that country’s currency, driving up its value.
Lower inflation leading to increase in foreign demand for exports: When inflation is low, a country’s goods and services are cheaper for foreigners, so they buy more, increasing demand for that country’s currency.
High growth rates of trading partners leading to increase in foreign demand for exports: If a country’s trading partners are doing well economically, they tend to buy more goods from that country, which increases demand for that country’s currency.
Increase in inward investment: If more investors want to put their money into a country’s businesses or real estate, they need that country’s currency, pushing its value up.
Higher interest rates leading to more inward financial investment: High interest rates are attractive to foreign investors because they can get a better return on their investments, so they buy more of that country’s currency to invest there, increasing its value.
Increase in inflow of remittances: When people working abroad send money back home, they convert it into their home country’s currency, raising its demand and value.
Speculators expect currency X will rise so they buy currency X: If traders believe a currency will increase in value, they buy more of it now to sell later at a profit, which increases demand and the value of the currency.
Central bank buys the domestic currency: When a country’s central bank buys its own currency, it reduces the amount available in the market, making it rarer and more valuable.
What causes decrease in currency demand leads to depreciation (D curve shift left)
Decrease in foreign demand for exports of goods and services: If fewer foreign customers are buying a country’s exports, they need less of that country’s currency, causing its value to fall.
Higher inflation leading to decrease in foreign demand for exports: High inflation makes a country’s goods more expensive for foreigners, reducing their purchases and decreasing demand for the country’s currency.
Low growth rates of trading partners leading to decrease in foreign demand for exports: When a country’s trading partners’ economies are slowing down, they buy less from that country, lowering the demand for that country’s currency.
Decrease in inward investment: If fewer investors are interested in a country’s markets, they buy less of its currency, which can cause the currency’s value to drop.
Lower interest rates leading to less inward financial investment: When interest rates are low, investors look elsewhere for better returns, so they buy less of the country’s currency, decreasing its value.
Decrease in inflow of remittances: When less money is sent home by nationals working abroad, there’s less demand for the currency, leading to its depreciation.
Factors Leading to Currency Appreciation Due to Decreased Supply (S curve shift left)
Decrease in domestic demand for imports of goods and services: When a country buys fewer goods from abroad, there’s less of its currency being offered for foreign currencies, which can push its value up.
Lower inflation leading to decrease in domestic demand for imports: With lower inflation, domestic goods are relatively cheaper, so residents buy more locally and less from abroad, reducing the amount of domestic currency available on the foreign market.
Low domestic growth rate leading to decrease in domestic demand for imports: A slower economy often means people and businesses are buying less in general, including foreign products, so they use less of their currency to buy other currencies.
Decrease in outward investment: If residents are investing less in other countries, they are converting less of their own currency into foreign currency, tightening the supply of their currency on the foreign exchange market.
Higher interest rates leading to less financial investment by domestic residents in foreign countries: When domestic interest rates are high, people prefer to invest at home rather than abroad, reducing the flow of domestic currency to foreign markets.
Decrease in outflow of remittances: When residents send less money abroad, they are exchanging less of their currency into foreign currencies, which decreases the supply of their currency on the foreign exchange market.
Factors Leading to Currency Depreciation Due to Increased Supply (S curve right)
Increase in domestic demand for imports of goods and services: More purchases of foreign goods means more domestic currency is exchanged for foreign currency, increasing supply and potentially lowering its value.
Higher inflation leading to increase in domestic demand for imports: Higher prices domestically can push consumers to seek cheaper foreign goods, upping the currency supply on the market as they exchange more.
High domestic growth rate leading to increase in domestic demand for imports: A booming economy often increases the appetite for imports, swelling the amount of domestic currency available for exchange.
Increase in outward investment: More domestic investments abroad lead to greater conversion of domestic currency into foreign currencies, adding to the supply in the market.
Lower interest rates leading to more financial investment by domestic residents in foreign countries: Attractive foreign investment opportunities cause residents to exchange more of their domestic currency, boosting its supply in the global market.
Increase in outflow of remittances: When more money is sent overseas by residents, this translates into a higher supply of the domestic currency on the foreign exchange market.
Speculators expect currency X will fall so they sell currency X: If traders believe a currency will drop in value, they sell it, which can increase supply and decrease the currency’s value.
Central bank sells the domestic currency: When the central bank puts more of its own currency into the market, the increased supply can lead to depreciation.
how to calculate exchange rate
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