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Module 42 the foreign exchange market

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    Module 42 the foreign exchange market Module 42 the foreign exchange market Presentation Transcript

    • THE FOREIGN EXCHANGE MARKET MODULE 42
    • WHAT IS THE FOREIGN EXCHANGE MARKET?The foreign exchange market (currency, Forex, or FX) trades currencies. It lets banks and other institutions easily buy and sell currencies.The purpose of the foreign exchange market is to help international trade and investment. A foreign exchange market helps businesses convert one currency to another. For example, it permits a U.S. business to import European goods and pay Euros, even though the businesss income is in U.S. dollars.
    • THE FOREIGN EXCHANGE MARKET IS UNIQUE BECAUSE OF:Trading volumesThe extreme liquidity of the marketIts geographical dispersionIts long trading hours: 24 hours a day except on weekendsThe variety of factors that affect exchange ratesThe low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
    • THE FOREIGN EXCHANGE MARKET IS UNIQUE BECAUSE OF:Trading volumesThe extreme liquidity of the marketIts geographical dispersionIts long trading hours: 24 hours a day except on weekendsThe variety of factors that affect exchange ratesThe low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)
    • THE ROLE OF THE EXCHANGE RATEThe exchange rate, which is determined in the foreign exchange market ensures that the balance of payments really does balance.Exchange rates are the equilibrium prices for national currencies.An exchange rate shows how much of a nation’s currency is needed to purchase a unit of another’s currency.
    • UNDERSTANDING EXCHANGE RATESInternational transactions require a market in which currencies can be exchanged for each other.This market is the foreign exchange market, and it establishes the exchange rates.The exchange rates are the prices at which currencies trade.
    • UNDERSTANDING EXCHANGE RATESExchange rates can be written in two ways:(exchanges as of May 9, 2012) U.S. dollars Yen Euros One U.S. dollar 1 79.6299 0.772900 exchanged for One yen 0.0125583 1 0.00970430 exchanged for One euro 1.29389 103.047 1 exchanged for
    • UNDERSTANDING EXCHANGE RATESWhen a currency becomes more valuable in terms of other currencies, economists say the currency appreciates.When a currency becomes less valuable in terms of other currencies, it depreciates.Movements in exchange rates, ceteris paribus, affect the relative prices of goods, services, and assets in different countries.
    • THE EQUILIBRIUM EXCHANGE RATEThe equilibrium exchange rate is the exchange rate at which the quantity of currency demanded in the foreign exchange market is equal to the quantity of currency supplied.Movements in the exchange rate ensure that changes in the financial account and the current account offset each other.
    • DOLLAR-YEN MARKETIn the dollar-yen market, the dollar price of a yen would be on the vertical axis and the quantity of yen would be on the horizontal axis. The intersection of the up-sloping supply of yen curve and down-sloping demand for yen would determine the dollar price of a yen.
    • DOLLAR-YEN MARKETIf US demand for Japanese goods increased, more yen would be needed to pay for the goods, and so the demand for yen would increase. This change increases the dollar price of yen, which means there has been a depreciation of the US dollar relative to the yen.
    • DOLLAR-YEN MARKETConversely, if Japanese demand for US goods increased, more dollars would be needed to pay for the goods, and the supply of yen would increase. This change will decrease the dollar price of yen, which means there has been an appreciation of the US dollar relative to the yen.
    • CURRENCY APPRECIATION AND DEPRECIATIONThe dollar price of foreign International value of the dollar falls currency rises (dollar depreciates) International value of foreignForeign currency price of currency rises dollar falls (foreign currency appreciates)
    • INFLATION AND REAL EXCHANGE RATESTo take into account the effects of differences in inflation rates, economists calculate the real exchange rates, which are the exchange rates adjusted for international differences in aggregate price levels.
    • INFLATION AND REAL EXCHANGE RATES: AN EXAMPLE
    • INFLATION AND REAL EXCHANGE RATES: AN EXAMPLESuppose the Mexican peso depreciates against the U.S. dollar, with the exchange rate going from 10 pesos to 15 pesos per U.S. dollar, which is a 50% change.At the same time the prices in Mexico increase by 50%, so that the price index rises from 100 to 150.
    • INFLATION AND REAL EXCHANGE RATES: AN EXAMPLE
    • INFLATION AND REAL EXCHANGE RATES: AN EXAMPLEIn this example, the peso has depreciated significantly in terms of the U.S. dollar, but the real exchange rate between the peso and the U.S. dollar has not changed at all.And because the real peso-U.S. dollar exchange rate has not changed, the nominal depreciation of the peso against the U.S. dollar will have no effect on the quantity of goods traded between the countries.
    • INFLATION AND REAL EXCHANGE RATES: AN EXAMPLEThe current account responds only to a change in the real exchange rate, not the nominal exchange rate.A country’s products become cheaper to foreigners only when that country’s currency depreciates in real terms.
    • PURCHASING POWER PARITYThe purchasing power parity between two countries’ is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.
    • PURCHASING POWER PARITYFor example, if the same basket of goods and services costs 800 pesos in Mexico and $100 in the U.S. the PPP would be: 800 pesos = $100 8 pesos per $1
    • PURCHASING POWER PARITYNominal exchange rates almost always differ from purchasing power parities.Some of the differences are systematic: in general, aggregate price levels are lower in poor countries than in rich countries because services tend to be cheaper in poor countries.
    • PURCHASING POWER PARITYBut even among countries with roughly the same amount of economic development, nominal exchange rates vary quite a lot from the purchasing power parity.Over the long run, however, purchasing power parities are quite good at predicting actual changes in nominal exchange rates.
    • PURCHASING POWER PARITYIn particular, nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket.