forex sfls part 2

Introduction to Exchange Rates

(part 2)

Introduction to Exchange Rates:

3.) Change in Equilibrium – Appreciate vs Depreciate

1.) Classical Dichotomy - Nominal vs. Real

2.) Equilibrium - LoOP vs. PPP

4.) Change in Equilibrium – Reasons

5) Foreign Exchange regimes 制度

A fall in the value of a currency compared to other currencies.

It now buys less then before.

ex. - £1 = € 1.50 £1 = € 1.45

the balance of payments should ‘improve’

Depreciation Appreciation

A rise in the value of a currency compared to other currencies. It now buys more then before.ex. - £1 = $1.85 £1 = $1.91the balance of payments should get ‘worse’

This will depend on elasticity of imports and exports

(Weak) (Strong)

3.) Change in Equilibrium – Appreciate vs Depreciate

All the people in this land only use this money

All the people in this land only use this money

Marvel Land

DC Land

FOREX graph example

(Country B)(Country A)

Tony Stark has a motorcycle for sale in his country

Batman wants to buy it

But first he has to exchange his money

So he is going to go to the FOREX market to exchange the money

Marvel Land

DC Land

FOREX graph example

(Country B)(Country A)

Marvel Land

DC LandThe FOREX market is an

imaginary market that shows the supply and demand for both currencies

Amount

of B to

get an

A

Marvel Land

MoneyDC land

Money

Amount

of A to

get an

B

(Country B)(Country A)

FOREX graph example

Marvel Land

DC Land

Amount

of B to

get an

A

Marvel Land

MoneyDC land

Money

Amount

of A to

get an

B

(Country B)(Country A)

FOREX graph example

For B to get A stuffB has to get A money

D from B D from A

For A to get B stuffA has to get B money

Marvel Land

DC Land

Amount

of B to

get an

A

Marvel Land

MoneyDC land

Money

Amount

of A to

get an

B

(Country B)(Country A)

FOREX graph example

D from B D from A

For B to get A moneyB has to supply B money

S from BS from A

For A to get B moneyA has to supply A money

Marvel Land

DC Land

Amount

of B to

get an

A

Marvel Land

MoneyDC land

Money

Amount

of A to

get an

B

(Country B)(Country A)

FOREX graph example

D from B D from A

S from BS from A

If B wants to buy the motorcycle, will demand more A money

Marvel Land

DC Land

Amount

of B to

get an

A

Marvel Land

MoneyDC land

Money

Amount

of A to

get an

B

(Country B)(Country A)

FOREX graph example

D from B D from A

S from BS from A

This also means that he will supply more money in the open FOREX market

Marvel Land

DC Land

Marvel Land

MoneyDC land

Money

(Country B)(Country A)

FOREX graph example

D from B D from A

S from BS from A

So A money = more valuable

B/A A/B

And B money = less valuable

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

So …..

Country B buys a motorcycle from country A means…

Exchange rate valueExchange rate value

Trade surplus Trade deficit

Appreciation Depreciation

Current Account Current Account

This is true from the point I started at

However

This process is like a circle so if I started at a different point then the opposite would happen

FOREX graph example

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

so …..

This is step one in a circular process

This exchange rate system will “automatically” fix itself and his depreciatedcurrency will then fix the trade deficit

They have a trade deficit

They also have a depreciated currency

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

Since B’s currency is depreciatedIt is now possible for A’s money to buy more of B’s money

They have a trade deficit

They also have a depreciated currency

So for example…

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

B/A

Country A Money

A/B

Country B Money

D from AD from B

S from BS from A

Start here now…

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

B/A

Country A Money

A/B

Country B Money

D from AD from B

S from BS from A

Things in country B now look much cheaper for the people in country A

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

B/A

Country A Money

A/B

Country B Money

D from AD from B

S from BS from A

So A will buy more things from B which means he will first demand more of B’s money

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

B/A

Country A Money

A/B

Country B Money

D from AD from B

S from BS from A

But to do that, country A will supply more of it’s own money in the FOREX

so we should go back to the same (PPP) because of LoOP

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

So …..

Current account

If you have a trade deficit…

Exchange rate value

Trade deficit

Depreciation

A depreciation currency will make you stuff look cheap for others…

So it should “automatically” fix the deficit

Trade deficit gets smaller

Marvel Land

DC Land

(Country B)(Country A)

FOREX graph example

Current account

The same thing will be true on the other side too just the opposite…

Exchange rate value

Trade surplus

Appreciation

An appreciated currency tends to reduce a trade surplus.

Trade surplus gets smaller

But with “floating” exchange rates everything should “smooth” out in the long run

Surplus

Time

Deficit Long Run

Short Run

So in the short run things go up and down and can be quite volatile

Of course we always live in the short run causing things to be volatile but we usually drift back and move towards the long run because of (LoOP)

FOREX graph example

Introduction to Exchange Rates:

3.) Change in Equilibrium – Appreciate vs Depreciate

1.) Classical Dichotomy - Nominal vs. Real

2.) Equilibrium - LoOP vs. PPP

4.) Change in Equilibrium – Reasons

5) Foreign Exchange regimes 制度

Mostly things that change in demand for imports and exports

Mostly things that change the demand for investments

1.) Consumer Tastes

2.) Relative incomes (booms and recessions)

3.) Relative prices (PPP) (Inflation)

5.) Speculation

4.) Interest rates

4.) Change in Equilibrium – Reasons

Reasons that change on the Current Account side

Reasons that change on the Financial Account side

6.) Government debt

7.) FDI or Portfolio investment

- Increased preferences for imports increases demand and visa versa.

Country B’s Demand for Country A’s goods

Appreciation in Country A

Example:

1.) Consumer Tastes

B/A

Country A

D from B

S from A

D from B1

Country B

A/BS from B

S from B1

4.) Change in Equilibrium – Reasons

- Recessions lowers demand for imports, booming economies raise demand for imports.

Example:

2.) Relative Incomes

Country AEcon good times

Appreciation in Country B

Country BEcon bad times

A Demands more B money

B Supplies less B money

4.) Change in Equilibrium – Reasons

- Recessions lowers demand for imports, booming economies raise demand for imports.

Example:

2.) Relative Incomes

Country AEcon good times

Appreciation in Country B

Country BEcon bad times

A Demands more B money

B Supplies less B money

A/B

Country B Money

D from A

Country B Money

A/B

*** for country A everything would be the exact opposite

** notice both these graphs are really the same graph for the same country

4.) Change in Equilibrium – Reasons

Example:

D from A

3.) Relative Prices(PPP) (Inflation)

- If a nation’s price level is rising faster then another nations, consumers seek cheaper goods.( Real vs. Nominal changes important to note)

Country A’s prices in their economy

Appreciation

in country B

Country B’sstay the same

A demands more B money

B demands less A money

B supplies less B money

A supplies more A money

Deprecation

in country A

4.) Change in Equilibrium – Reasons

Example:

D from A

4.) Interest Rates - Increased interest rates means larger investment income by investors.

Country A’s interest rates

Appreciation

in country A

Country B’sstay the same

A demands less B money

B demands more A money

B supplies more B money

A supplies less A money

Deprecation

in country B

4.) Change in Equilibrium – Reasons

Country A’s interest rates

B Demands less A money

A supplies more A money

Deprecation

in country A

Since currencies can be traded as assets, investors seek profit buying low and selling high.

Country B’sstay the same

4.) Speculation

Example:Less desire to have A money since the possible income from having it falls.

*3.) interest rates

4.) Change in Equilibrium – Reasons

Country A’s interest rates

B Demands less A money

A supplies more A money

Deprecation

in country A

Since currencies can be traded as assets, investors seek profit buying low and selling high.

Country B’sstay the same

4.) Speculation

Example:Less desire to have A money since the possible income from having it falls.

B/A

Country A Money Country A Money

B/A

** notice both these graphs are really the same graph for the same country

*3.) interest rates

4.) Change in Equilibrium – Reasons

Country A’s national debt is a problem

B Demands less A money

A supplies more A money

Deprecation

in country A

Since currencies can be traded as assets, investors seek profit buying low and selling high.

Country B’sstay the same

4.) Speculation

Example:Less desire to have A money since investors worry that the debt can be causing a problem for growth in the country.

*5.) government debt

4.) Change in Equilibrium – Reasons

Country A’s national debt is a problem

B Demands less A money

A supplies more A money

Deprecation

in country A

Since currencies can be traded as assets, investors seek profit buying low and selling high.

Country B’sstay the same

4.) Speculation

Example:Less desire to have A money since investors worry that the debt can be causing a problem for growth in the country.

B/A

Country A Money Country A Money

B/A

*5.) government debt

** notice both these graphs are really the same graph for the same country

4.) Change in Equilibrium – Reasons

Direct Investment:

Portfolio Investment:

- Investors putting their funds into stocks and shares, government bonds and property. Strong inflows from overseas cause increased demand in the country’s cuurency/

- An economy that attracts high net inflows of capital investment from overseas will have increased demand for the country’s currency.

7.) FDI or Portfolio investment

Appreciation

in the country

Appreciation

in the country

4.) Change in Equilibrium – Reasons

Mostly things that change in demand for imports and exports

Mostly things that change the demand for investments

1.) Consumer Tastes

2.) Relative incomes (booms and recessions)

3.) Relative prices (PPP) (Inflation)

5.) Speculation

4.) Interest rates

Reasons that change on the Current Account side

Reasons that change on the Financial Account side

6.) Government debt

7.) FDI or Portfolio investment

4.) Change in Equilibrium – Reasons

A few examples…

Demand for country A’s goods

How would a change in consumer tastes cause Appreciation in country A ?

Appreciation in country A

Supply of A’scurrency How would Appreciation in country A cause a

change in consumer spending?

Appreciation in country ADemand for country A’s goods

Supply of A’s currency

4.) Change in Equilibrium – Reasons

How would an increase in relative prices (inflation) cause Deprecation in country A ?

Country A’sprices

Demand for A’s goods

Supply of A’scurrency

Deprecation in country A

How would Deprecation in country A effect the foreign exchange market?

Deprecation in country A

Demand for A’s goods

Supply of A’scurrency

*** But only if the deprecation is larger than the price increase

4.) Change in Equilibrium – Reasons

If country A is experiencing bad economic times (recession) how could that lead to appreciation of it’s currency?

Appreciation in country's FOREX

Country hasEcon bad times

Country’s supply of currency

How could appreciation effect an economy?

Appreciation in country's' FOREX

Demand exports

Demand imports

*** It depends on which effect is higher and what caused the bad times

4.) Change in Equilibrium – Reasons

If country A is experiencing bad economic times (loss of comparative advantage) how could that lead to deprecation of it’s currency?

Deprecation in country's' FOREX

Country hasEcon bad times

Demand of country’s goods

How could Deprecation effect an economy?

Deprecation in country's' FOREX

Demand exports

Demand imports

*** It depends on which effect is higher and what caused the bad times

4.) Change in Equilibrium – Reasons

If a country’s government decides to increase the interest rate it pays on bonds what will happen to the exchange rate?

Country’s interest rates

Demand for country’s currency

Supply of country’s currency

Appreciation in country’s

currency

4.) Change in Equilibrium – Reasons

So to summarize…

Law of One Price

- A unit of any currency should be able to buy the same quantity of goods in all countries.(should end up with same.nominal values everywhere )

- based on the law of one price.

Purchasing Power Parity( PPP)

(Nominal = Real)

2.) Equilibrium - LoOP & PPP

Long run – Everything should balance be worth the same

A fall in the value of a currency compared to other currencies.

It now buys less then before.

ex. - £1 = € 1.50 £1 = € 1.45

the balance of payments should ‘improve’

Depreciation Appreciation

A rise in the value of a currency compared to other currencies. It now buys more then before.ex. - £1 = $1.85 £1 = $1.91the balance of payments should get ‘worse’

This will depend on elasticity of imports and exports

(Weak) (Strong)

3.) Change in Equilibrium – Appreciate vs Depreciate

Marvel Land

DC Land

Marvel Land

MoneyDC land

Money

(Country B)(Country A)

FOREX graph example

D from B D from A

S from BS from A

So A money = more valuable

B/A A/B

And B money = less valuable

Mostly things that change in demand for imports and exports

Mostly things that change the demand for investments

1.) Consumer Tastes

2.) Relative incomes (booms and recessions)

3.) Relative prices (PPP) (Inflation)

5.) Speculation

4.) Interest rates

Reasons that change on the Current Account side

Reasons that change on the Financial Account side

6.) Government debt

7.) FDI or Portfolio investment

4.) Change in Equilibrium – Reasons

End of part 2

Thanks!