Foreign Exchange and Foreign Exchange Market

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FOREIGN EXCHANGE AND FOREIGN EXCHANGE MARKET

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Exchange rate:
The price of one currency in terms of another currency
The demand for country’s currency relative to the supply of its currency determines the exchange
rate
Exchange Rate Determination

Foreign exchange rate can be measured in two ways
 The price of foreign currency (say, US$) in terms of domestic currency (say TZ shilling)
(commonly used)
 The price of domestic currency (TZ shilling) in terms of foreign currency (say US $)
Exchange rates fluctuate considerably over time;

Appreciation, is an increase in the value of a currency
Depreciation, Is a decline in the value of the currency
Foreign Exchange Market

This is where Foreign exchange transactions take place
It is a market within which individuals, business firms, governments and banks purchase and sell
foreign currency and other debt instruments
Market does not refer to specific meeting place, rather mean all locations and situations that
enable one country’s currency to be purchased and/or sold for other country’s currencies.
Functions of foreign exchange market

 Enables one country’s currency to be transferred to other countries in their own currencies
 It brings together parties who want to exchange their currencies and enable them to clear
their balances on the basis of the market exchange rates.
Participants in the Foreign Exchange Market (NISCCC) Nisisii

Non-Bank Financial Institutions
Individuals
Speculators
Central Bank
Commercial Banks
Corporations
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Central Bank is responsible for macroeconomic policies that affect exchange rates. In a
managed float exchange rate system.
It may buy or sell foreign currency in order to set the price (which is the exchange rate) at a
desired level.
Commercial Banks are at the center of the foreign exchange market since they bring together
those who demand and those who supply foreign currencies thus allow foreign exchange
transactions to take place.
When a commercial bank does not have its desire amount of foreign currency, it can turn to a
foreign exchange broker to purchase additional foreign currency or sell its unwanted surplus. The
foreign exchange brokers act as wholesalers of foreign currencies, operating in an interbank
market.
Non-Bank Financial Institutions, large pension funds and other institutional investors offer
Foreign exchange transactions
Corporations their operations in various countries frequently make or receive payments in

foreign currencies. That is, the international exchange of intermediate goods or final goods and
services always involve foreign exchange trading to pay for the activities.
Speculators are the individual foreign exchange traders, financial institutions, or nonfinancial
institution that buy and sell foreign exchange in order to make short-run profits.
Speculators are usually individual, or firms that undertake risks in anticipation of making profit.
Individuals, these include tourist, travelers, may also participate in the foreign exchange
markets.
Foreign Exchange Instruments (CCBLCO) sisi-biliko

Cable Transfer
Commercial Bill of Exchange
 Time bill
 Sight bill
Bank Drafts
Letter Of Credit
Other Means of Payment
 On a cash basis
 On an open account basis
Cable Transfer: Is an order transmitted by the bank in one country to its foreign correspondent
in another country, instructing the correspondent bank to pay out a specific amount to a
designated person or account.

Commercial Bill of Exchange: Is a written order by an exporter (the drawer) to an importer

(the drawee) instructing the importer to pay on demand, or on certain date, a specific amount to a
designated party (payee). The payee could be either the exporter or a local bank where the
exporter has an account.
There two types
Time bill, is a bill of exchange that is payable at some future date to the drawee
Sight bill, is a bill of exchange that is payable on presentation to the drawee
Bank Drafts, It is a written order by a drawer to a drawee instructing him or her to pay, on
demand or at certain date, a specified amount of money to a payee. In this case the drawee is a
bank rather than an importer.
A bank draft directs the exporter to receive payment directly from a bank designated by the
importer. Usually, it involves a bank in the importer’s country instructing its corresponding bank
in the exporter’s country to pay the specified amount to the exporter.
Letter Of Credit, it is a document issued by an importer’s bank declaring that payment will be
made to an exporter regarding a specific shipment of commodities.
Cash payment is especially done when the exporter is not trusting an importer hence considers
the transaction risky.
An open account is used when exporter trusts an importer; therefore, the exporter simply ships
the merchandise (product / a commodity offered for sale) to the importer along with the
necessary documents, without any prior payment or obligation on the part of the importer.
Foreign Exchange Transactions

It is very risk to participate in exchange rate business as the price of currency fluctuation every
second. Due to this, one may choose to do business in either the spot market or forward
market. Other may engage either in hedging or speculation as the means to deal with risks
The spot market: the transaction is made immediately
The forward market: sign a contract payment to be done on today’s price in the future
Factors that cause the shift in demand and supply of foreign currencies
(ITIPI) hi-tipi
Differences in inflation rate.
Changes in tastes for foreign products
Change in domestic income
Changes in relative prices
Changes in country’s relative interest rates

If the inflation rate is lower in home country than in other countries, Ceteris Paribas, home
country’s products are cheaper than other countries products. This leads to the increase in
demand for home country’s products, causing demand for home currency to increase. The higher
demand for the currency, in turn, leads to its appreciation.
If a country’s taste for other country’s products increases Ceteris Paribas, the demand for
foreign currency will increase. This leads to an increase in the exchange rate or depreciation of
domestic currency.
If home country’s income increases, the demand for both foreign and domestic goods will
increase. The increase in demand for imported goods will cause an increase in demand for
foreign currency in the foreign exchange market. This leads to an increase in the price of foreign
currency, or depreciation of domestic currency.
If domestic prices rise relative to foreign prices, then the demand for foreign goods will
increase, this increases the demand for foreign currency leading to domestic currency
depreciation.
A high interest rate in one country compared with those in other countries, may encourage the
movement of short-term funds to that country. This causes an increase in demand for that
country’s currency, leading to its appreciation.
Two exchange rate system

Fixed / clean / free floating ERS
Flexible ERS
Flexible (freely fluctuating) Exchange Rate System

In a free market, Exchange rate for a currency is set/determined by the free market forces of
demand and supply for that currency. (There is the freely floating) clean-floating / floating
exchange rate system.
The exchange rate for a currency to fall or rise depending on the nature of the shift
 If supply shifts to the right, the equilibrium exchange rate declines, that is, domestic
currency appreciates (Point E’). Let R  2000TZS /1$ and R  1500TZS / 2$
Appreciation is an increase in the value of a currency relative to another currency.
An appreciated currency is more valuable (more expensive) and therefore can be
exchanged for (can buy) a larger amount of foreign currency.
An appreciated currency means that imports are less expensive and domestically
produced goods and exports are more expensive. An appreciated currency raises
the price of exports relative to the price of imports.

 If demand shifts to the right, the equilibrium exchange rate rises, that is, domestic
currency depreciates. Let R  1500TZS /1$ and R  2000TZS / 1$
Depreciation is a decrease in the value of a currency relative to another currency.
A depreciated currency is less valuable(less expensive) and therefore can be
exchanged for (can buy) a smaller amount of foreign currency.
A depreciated currency means that imports are more expensive and domestically
produced goods and exports are less expensive.
A depreciated currency lowers the price of exports relative to the price of imports.
NB: R=the price of US dollar in term of Tanzania shillings.

Demand curve for US dollars corresponds to the debit items in the home country’s BoP
arising from Tanzanians desire to import foreign goods and services or to invest in
foreign country.
E = equilibrium exchange rate
Advantages of FLEXIBLE ERS (Arguments in Favour of the System): EEETI It

Eliminates the need for central banks to hold large international reserves,
Enhances efficiency in the economy,
Enhances the effectiveness of monetary policies
Takes care of the BoP problems.
Insulates an economy from external shocks
 It eliminates the need for central banks to hold large international reserves, and thus allows
resources to be used more productively elsewhere in the economy.
 It enhances efficiency in the economy, with freely fluctuating price for foreign exchange;
resources will be guided in a competitive framework towards their most efficient use.

 It takes care of the BoP problems. A deficit (surplus) situation will set depreciation
(appreciation) of home currency into operation, hence removes the deficit (surplus).
 It insulates an economy from external shocks. E.g. if there is sudden increase in demand for
home country’s exports the demand stimulus will be at least partially offset by the effect of
appreciation of domestic currency. The appreciation will reduce country’s exports and
increase the country’s imports, thus the aggregate demand moves back towards original
levels. Therefore country’s GNP has been insulated from external shock.
 It enhances the effectiveness of monetary policies. An expansionary monetary policy
(increase in money supply) so as to increase national income generates depreciation of
home currency and this will act to reinforce increasing impact of the monetary expansion,
since trade balance improves.
Disadvantages of LERS(Arguments against Flexible Exchange Rate) WIRDTI

It generates wasteful resource movements.
It reduce trade and investment
Inflation becomes self-perpetuating
It is characterized by destabilizing speculation.
 It generates wasteful resource movements. Since it involves frequent change in the

exchange rate, which in turn will cause factors of production to move frequently into and
out of tradable goods sector. If resources are unwilling to undergo continuous movement,
there will be a more permanent misallocation and inefficiency.
NB: Tradable goods/sector – exportable goods (potential of being traded)
Non-tradable goods/sector – un-exportable (non-potential) goods
If domestic currency appreciates – Export decreases∴tradable goods shift to non-
tradable good viz
 It reduce trade and investment due to increase in risk and uncertainty involved in foreign
trade and FDI
 Inflation becomes self-perpetuating. If the economy is undergoing rapid inflation
country’s currency will depreciate adding to the aggregate demand in the economy,
thereby generate further inflationary pressure.
 It is characterized by destabilizing speculation. If a currency depreciates, speculators
assume that depreciation will last longer, ∴they will sell the currency. This will worsen
depreciation.
But, an appreciation of currency will cause speculators to anticipate further appreciation,
thus buy the currency, causing more appreciation. ∴The appreciation will be > normal
because of the destabilizing speculation
Fixed Exchange Rate System

The exchange rate is stable and can only fluctuate within the very limited band.

This is possible if, the central bank holds international resources, such as foreign currencies,
SDRs, and other assets that act as international media of exchange.
If the value of currency is pegged below the equilibrium exchange rate, an excess demand for
foreign currency occurs; central bank will thus sell foreign currency in question in order to re-
establish the equilibrium. Or, it will impose restrictions on the demand for foreign currency in
question.
If central bank decides to fill the gap out of its international reserves, the supply curve will shift
to the right thus, eliminates excess demand, and if the second option is implemented, demand
curve will shift to the left, the equilibrium will be re-established at lower quantities of foreign
currency.
NB: Price above E – Central bank buys foreign currency
Price below E - Central bank sells foreign currency
Advantages(Arguments for) Fixed Exchange Rate

Less Uncertainty
Stabilizing Speculation
Avoids wasteful resources movements
Price discipline
Less Uncertainty: The system avoid fluctuations that are likely to occur
Stabilizing Speculation: since the rates are always kept fixed, hence speculations are almost
certain to be stabilizing.
Avoids wasteful resources movements: the system avoids the wasteful resource movements
associated with flexible system
Price discipline: under this system, a country with higher rate of inflation than the rest of the
world (other countries) is likely to face persistent deficit in its balance of payment and thus loss
of international reserves. Thus fixed exchange system provides more stability to an open
economy to large internal shocks.

Disadvantage (Arguments against) Fixed Exchange Rate System

It does not insulate the economy from external shocks.
Inefficiency in resources allocation in the economy.
Structural and Policies Differences among Countries.
Ties up resources in the form of international reserves.
Foreign Exchange Market

This is the market in which individuals, firms, and banks buy and sell foreign currencies or
foreign exchange.
The Spot Market
 The spot exchange rate
Forward Market
 Forward exchange rate
Hedging
Speculation
 stabilizing or
 detailing
Swaps
Arbitrage
The Spot Market: This is a foreign exchange market in which foreign currencies are
purchased and sold for immediate delivery, that is, within two business days after the
transaction agreement. Y 2 days?
This is to allow the traders to instruct their respective commercial banks to make the necessary
transfers in their account.
The spot exchange rate is the exchange rate at which the transaction takes place, e.g.
R  TZS / US$  2200 is a post rate
Its advantage: One can avoid the risk of fluctuations in the exchange rate that may result
when the foreign currency is delivered at a future date.
Forward Market: transactions take place at a specified future date.

This is the foreign exchange market in which foreign currencies are purchased and sold for
future delivery. It involves an agreement between two parties to purchase or sell a given
amount of foreign exchange at a specified future date at a pre-arranged rate.
This rate is known as forward exchange rate. E.g. quoted for one month, three months, or six
months
NB: At any point in time, the forward rate can be equal to, above, or below the
corresponding spot rate.
If the forward rate is higher than the current spot rate the foreign currency is said to
at a forward premium compared to the local currency.
If the forward rate is lower than the current spot rate, the foreign currency is said to
be at a forward discount compared to the local currency.

Formula for percentage discount or premium for the forward rate to the spot rate is
 FR  SR  360 
FP or FD    100
 SR  N 
Where: 𝑆𝑅 − 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑵 − number of days. (E. g. 3 months = 30days)
𝐹 /𝐷 /𝑃 /𝑅 − 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 →/𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 / 𝒑𝒓𝒆𝒎𝒊𝒖𝒎/𝒓𝒂𝒕𝒆
Hedging usually takes place in the forward market in order to avoid the foreign exchange risk
The importer can hedge against the exchange risk by either buying or borrowing foreign
currency at the present spot rate and deposit the proceeds in the interest earning bank account for
say 90 days until the payment is due.
If importer chooses to borrow the funds, the cost involved will be the difference between the
higher interest rate that must be paid on the loan and the lowest interest that would be earned
from depositing the funds in the bank for 90 days.
If the importer uses his/her own funds to buy the foreign currency, transaction cost is the
difference between opportunity cost of the money used and the interest that would be earned
from depositing the funds in a bank account for 90 days.
Speculation is the opposite of hedging, whereas a hedger tries to avoid the foreign exchange
risk, the speculation purposely undertakes risk with expectation of a profit.
Speculation can occur in either the spot market or the forward market.
 If a speculator expects the spot rate of a particular foreign currency to fall, he/she will
borrow that currency for, say 30 days, and immediately exchange it for domestic
currency at the currency spot rate. The speculator may then deposit the domestic currency
in an interest earning bank account.
After 30 days, the speculator may pay off the loan by using the bank deposit of domestic
currency at the prevailing spot rate. At the time of payment, if the new spot rate is lower
as expected, speculator earns profit. Note that, the speculator earns profit only when the
revenue earned > the cost of borrowing.
 If a speculator believes that the spot rate of a particular foreign currency will rise, he or
she may borrow domestic currency, purchase the foreign currency at the current spot
rate, and hold it in an interest earning bank account for future resale.
If speculator’s predictions are correct, he/she earns a profit. If instead the spot rate falls,
the speculator incurs loss because he/she will have to re-sell the foreign currency at a
price lower than the purchase price
Speculation can be either stabilizing or detailing

Stabilizing Speculation refers to be purchase of foreign currency when its domestic price (the
exchange) is declining, in anticipation that it will soon increase and thus generate profit. It also

refers to the sale of foreign currency, when its domestic prices are rising/increasing in
anticipation that it will soon decline.
The stabilizing speculation moderates fluctuations in exchange rates over time, thus perform a
useful function due to the law of demand and supply.
Destabilizing Speculation refers to the sale of a foreign currency when exchange rate is falling
in anticipation that it will fall even lower in the future. It also refers to the purchase of a foreign
currency when exchange rate is rising or is high, in anticipation that it will increase even further
in the future.
Destabilizing speculation thus magnifies exchange rate fluctuation over time and can disrupt the
flow of international trade and investment.
A swap is an arrangement by which two parties exchange one currency for another and agree
that at certain future date, each party receives from the other the amount of the original currency
that was exchanged, when the swap took place.
Currency, swaps are very popular in large part because they have lower transaction costs than
other forms of currency transaction.
Arbitrage refers to the simultaneous purchase of a currency in one market where it is cheaper,
and sale in another market where it is more expensive, in order to make profit.
This riskless process results in equalization of exchange rate quotations in different monetary
centers. This happens because arbitrages raise demand for the foreign currency in the centers
where the currency is cheaper, causing the price of that currency to increase. At the same time
they increase supply of foreign currency in the financial center where the currency is expensive,
causing the price of that currency to fall.
E.g. if dollars are cheaper in New York than in London, Sir. Kubalyenda (people) will
buy dollars in New York and stop buying them in London. The price of dollars in New
York rises and the price of dollars in London falls, until the prices in the two markets are
equal.
BALANCE OF PAYMENTS
Balance of payments is a summary statement in which, in principle, all the transactions of the
residents of a nation with the residents of all other nations are recorded during a particular period
of time, usually a calendar year.
Credits and Debits in BoP

International transactions are classified as credits or debits.
Credit transactions are those that involve the receipt of payments from foreigners
Debit transactions are those that involve the making of payments to foreigners.

Credit transactions are entered with a positive sign, and debit transactions are entered with a
negative sign in the nation’s balance of payments.
NB: Payment received – recorded under Cr
The export of goods and services, unilateral transfers (gifts)
received from foreigners and capital inflows
Payment made – recorded under Dr
The import of goods and services, unilateral transfers or gifts made
to foreigners, and capital outflows
NB: When you export or import, payment should be done
Unilateral and gifts transfers / received no payment done
Four (4) key items of BoP

Current A/c
Capita A/c
Financial A/c
Compensating / Reserve A/c
Errors & Omissions/Official Reserves Accounts
Current A/c includes all international economic transactions with income or payment
flows occurring within one year, the current period. It consists of
 Goods trade and import of goods
 Services trade
 Income
 Current transfers
Capita A/c balance of payments measures all international economic transactions of

financial assets. It consists of
 Capita transfer
 Financial assets
Financial A/c consists of
 Direct Investment - investor exerts some explicit degree of control over the assets
 Security and portfolio investment - investor has no control over the assets
 Claims and liabilities
Compensating / Reserve A/c consists of

 Claims and liabilities
Errors & Omissions/Official Reserves Accounts

• When BoP fail to balance, a figure is put so as to bring balance
• Net Errors and Omissions account ensures that the BOP actually balances.

BoP can be at equilibrium when

BoP  CA  KA  0 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴/𝑐 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐴/𝑐 = 0
If CA>KA; current a/c register surplus: If KA>CA, Capital a/c register surplus
If capital a/c register surplus, current a/c must register deficit
• A surplus in the BOP implies that the demand for the country’s currency exceeded the
supply and that the government should allow the currency value to increase – in value –
or intervene and accumulate additional foreign currency reserves in the Official Reserves
Account.
• A deficit in the BOP implies an excess supply of the country’s currency on world
markets, and the government should then either devalue the currency or expend its
official reserves to support its value.
NB: A balance isn't always reflected in reported figures for the current and capital accounts,
which might, for example, report a surplus for both accounts, but when this happens it always
means something has been missed—most commonly, the operations of the country's
central bank—and what has been missed is recorded in the statistical discrepancy term
(the balancing item).
A nation’s BoP interacts with nearly all of its key macroeconomic variables
GDP = GDP = C + I + G + X – M
The exchange rate
Interest rates
Inflation rates
NB: Under a fixed exchange rate system, the government bears the responsibility to
ensure that the BOP is near zero
Under a floating exchange rate system, the government has no responsibility to peg
its foreign exchange rate
CA  X  M  f (Y .Y .e) >> Y  = foreign income, Y = domestic income, e =exchange rate

CA  X (Y .e)  M (Y .e)
KA  i  i >>>i and i are domestic and foreign interest rate respectively
NB: Physical capital has (-ve) relation with i
Portfolio capital has (+ve) relation with i
If i increase, investment will come in
 .Y .e 
Y  i  i 
BoP  CA   KA 
     
When our currency appreciate we expect CA 
Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may not
remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an

imbalance in the balance of payment account. Such an imbalance is called the disequilibrium.
Disequilibrium may take place either in the form of deficit or in the form of surplus
Causes of Disequilibrium in Balance of Payment
Population Growth
Development Programmes
Demonstration Effect
Natural Factors
Inflation
Globalization
Population Growth: Most countries experience an increase in the population and in some like
India and China the population is not only large but increases at a faster rate. To meet their
needs, imports become essential and the quantity of imports may increase as population
increases.
Development Programmes: Developing countries which have embarked upon planned
development programmes require to import capital goods, some raw materials which are not
available at home and highly skilled and specialized manpower. Since development is a
continuous process, imports of these items continue for the long time landing these countries in a
balance of payment deficit.
Demonstration Effect: When the people in the less developed countries imitate the consumption
pattern of the people in the developed countries, their import will increase. Their export may
remain constant or decline causing disequilibrium in the balance of payments.
Natural Factors: Natural calamities such as the failure of rains or the coming floods may easily
cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial
production in the country. The exports may decline while the imports may go up causing a
discrepancy in the country's balance of payments.
Inflation: An increase in income and price level owing to rapid economic development in
developing countries, will increase imports and reduce exports causing a deficit in balance of
payments
Globalization: Due to globalization there has been more liberal and open atmosphere for
international movement of goods, services and capital. Competition has beer increased due to the
globalization of international economic relations. The emerging new global economic order has
brought in certain problems for some countries which have resulted in the balance of payments
disequilibrium.
NB: Policies that Shift the BP Line
Lower exchange rate, BP line shifts outward
Fewer imports, BP line shifts outward
More exports, BP line shifts outward

Fewer capital outflows, BP line shifts outward

Fewer capital inflows, BP line shifts inward
BoP curves
Point above BoP line is associated with surplus (Credit> Debit)

Point below BoP line is associated with deficit
For surplus i is higher than that i required to keep BoP in equilibrium
Viz
BoP is positively sloped because increase in Y will cause more imports to come in
i Will cause short term capital to come in causing
portfolio to come in = surplus
This (-ve) effect of Y and (+ve) effect of i will offset each other (effects means surplus viz
deficit)
The slope of BoP curve

Depends on MPI - Marginal propensity to Import
Interest elasticity of internal capital flow
 If MPI is small and capital flow (short term capital) is interest elastic >> BoP curve will
be much flatter Viz>> Stepper
Capital Mobility

Perfect / Complete capital mobility>>>BoP curve is horizontal:BoP3

Perfect / Complete capital immobility >>> BoP curve is vertical:BoP0
Low capita mobility (High capital immobility) >>>BoP near Perfect capital immobility:BoP1
Low capita immobility (High capital mobility) >>>BoP near Perfect capital mobility:BoP2
Determinants of BoP
Export
Import
Interest rate
Exchange rate
If any of these factors change, BoP curve mush change
 ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡 → 𝐵𝑜𝑃 𝑐𝑢𝑟𝑣𝑒 𝑠ℎ𝑖𝑓𝑡 𝑡𝑜 𝑟𝑖𝑔ℎ or
 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡 → 𝐵𝑜𝑃 𝑐𝑢𝑟𝑣𝑒 𝑠ℎ𝑖𝑓𝑡 𝑡𝑜 𝑟𝑖𝑔ℎ
Equilibrium in small / large open economy

 Is attained when IS, LM, BoP intersect (when the 3 lines intersect)
BoP Adjustment (two options)

Do nothing (allow automatic correct mechanism) – Force of demand and supply
Take policy actions
 Fiscal policy
 Momentary policy
Both, their effectiveness depends on degree of K-mobility
Do nothing

From the figure above, Point E (home / domestic equilibrium) is formed above the BoP curve,
hence:
At point E is associated with surplus (Means we receive more than we pay out): Export >
Import
NB: Deficit means we pay more than we receive: Imports >>> Exports
Policy used: BoP adjustment (Fixed Exchange rate system)

 Fiscal policy under different capital mobility
Case A: Perfect capital immobility
E0 is the initial equilibrium

If the government decide for any reason to apply expansionary fiscal policy, the IS curve will
shift from IS0 to IS1 form an equilibrium at point E1 where there is high Y and low i.
Since E1 is at the right of BoP, it is associated with deficit (i is lower than that necessary i
required to keep BoP at equilibrium).
The presence of deficit, it will lead to the depreciation of exchange rate. But Central bank will
not agree / allow exchange rate to depreciate, it will collect (buy) domestic currency from people
and increase foreign currency (this will lead↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↑↑ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift upward from LM0 up to LM1
where both 3 curves intersect at E2.
At E2, Crowding out effect is equivalent to government spending. Therefore, Fiscal policy is
useless in this case of Perfect capital immobility

Case B: Low capital mobility

If the government decide for any reason to apply / deploys expansionary policy (increase
spending or reduce taxation), the IS curve will shift from IS0 to IS1 form an equilibrium at point
E1 where there is high Y and low i.
Since E1 is at the right of BoP, it is associated with deficit (i is lower than that necessary i
required to keep BoP at equilibrium).
The presence of deficit, it will lead to depreciation of exchange rate. But Central bank will not
agree / allow exchange rate to depreciate, it will collect (buy) domestic currency from people and
increase foreign currency (this will lead↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↑↑ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift upward from LM0 up to LM1
At E2, Y 2  Y 1 (there is low output than at E1): This is because of Crowding out effect
NB: Y falls from Y1 to Y2 due to fall in Investment and Investment falls due to high
interest rate (AD = C+I+G+X-M). Investment is the component of aggregate
demand (Y)
∴↑↑ 𝑖 →↓↓ 𝐼 →↓↓ 𝑌
Whenever there is Deficit, it will allow exchange rate to depreciate
Case C: Relative high capital mobility


If the government decide for any reason to apply / deploys expansionary policy (increase
E1 where there is high Y and i.
Since E1 is at the left of BoP, it is associated with surplus (people have plenty foreign
currency) (i is higher than that necessary i required to keep BoP at equilibrium).
The presence of surplus, it will lead to appreciation of exchange rate. But Central bank will not
agree / allow exchange rate to appreciate, it will collect (buy) foreign currency from people and
increase domestic currency (this will lead↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
∴ LM curve as a result of ↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift to the right from LM0 up to LM1
At E2, Y 2  Y 1 (there is high output than at E1):
NB: Y increases from Y1 to Y2 due to raise in Investment and Investment raises due to
fall in interest rate (AD = C+I+G+X-M). Investment is the component of
aggregate demand (Y)
∴↓↓ 𝑖 →↑↑ 𝐼 →↑↑ 𝑌
Whenever there is surplus, it will allow exchange rate to appreciate
Case D: Perfect capital mobility

If the government decide for any reason to apply / deploy expansionary policy (increase
E1 where there is high Y and i.
Since E1 is at the left of BoP, it is associated with surplus (people have plenty foreign
currency) (i is higher than that necessary i required to keep BoP at equilibrium).
The presence of surplus, it will lead to appreciation of exchange rate. But Central bank will not
agree / allow exchange rate to appreciate, it will collect (buy) foreign currency from people and
increase domestic currency (this will lead↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
∴ LM curve as a result of ↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift to the right from LM0 up to LM1
At E2, Y 2  Y 1 (there is high output than at E1): No crowding out effect

Compressive summary
Y0 to Y1 is an immediate effect of fiscal policy
Y1 to Y2 in an effect of monetary policy
For Relative high capital mobility and Perfect capital mobility, no crowding out
effect
Fiscal policy is 100% effective under Perfect capital mobility (Much I but less i)
The greater the K –mobility, the greater the effectiveness of fiscal policy
Since Investment (I) is the component of aggregate demand (Y)
∴↓↓ 𝑖 →↑↑ 𝐼 →↑↑ 𝑌viz
Whenever there is surplus, it will allow exchange rate to appreciate
Whenever there is deficit, it will allow exchange rate to depreciate
IS curve: The IS shifts right when there is (Increase in gvt spending) an
expansionary fiscal policy change or the exchange rate depreciates (i.e., e
increases). The IS curve shifts left when there is (decrease in gvt spending) a
contractionary fiscal policy change or when the exchange rate appreciates.
LM curve: The LM shifts right when there is (Increase in domestic money
supply) an expansionary monetary policy change. It shifts to the left when there
is (decrease in money supply) a contractionary monetary policy change.
BP curve: Fixed exchange rate system: The BoP does not shift, regardless of the
degree of capital mobility. The central bank must increase or decrease the money
supply to counter any surplus or deficit in the Balance of Payments.
Policy used: BoP adjustment (Fixed Exchange rate system)

 Monetary policy under different capital mobility

If the government for any reason decides to increase money supply the LM curve will shift
from LM0 to LM1 form equilibrium at point E1 where there is high Y.
Since E1 is at the right of BoP, it is associated with deficit (people lack foreign currency) (i is
lower than that necessary i required to keep BoP at equilibrium).

The presence of deficit will exert pressure on exchange rate to depreciate. But Central bank will
and increase foreign currency (this will lead↑↑ 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will again shift to the left from LM1 up to
LM0 (origin position) where both 3 curves intersect at E0.
Hence, Monetary policy is completely (100%) ineffective under Perfect K – Mobility
BoP and IS curves do not shift, just only LM curve do
Case B: Relatively low capital mobility
Since E1 is at the right of BoP, it is associated with deficit (people lack foreign currency) (i is
lower than that necessary i required to keep BoP at equilibrium).
Hence, Monetary policy is completely (100%) ineffective under Low K – Mobility

Case C: Relatively high capital mobility
Since E1 is at the right of BoP, it is associated with Balance of payment deficit (people lack
foreign currency) (i is lower than that necessary i required to keep BoP at equilibrium).
Since E1 is at the right of BoP, it is associated with Balance of payment deficit (people lack
foreign currency) (i is lower than that necessary i required to keep BoP at equilibrium).

Policy used: BoP adjustment (FLEXIBLE Exchange rate system)

 FISCAL policy under different capital mobility
If the economy starts at point E0 , and for any reason, if government deploy the expansionary
fiscal policy, the IS curve shifts to the right from IS0 to IS1 and form the new domestic
equilibrium at point E1 where new IS curve intersect with origin LM curve.
Since E1 is to the right of the BoP curve, therefore it is associated with deficit which will put
pressure for domestic currency to depreciate, Do to depreciation, export becomes less expensive
and imports much expensive (↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 thus causing further movement of
IS curve to the right, as it is flexible exchange market system (Central bank will does nothing).
Do to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 will cause movement of BoP curve to the right until E2
where both three lines intersect each other
Note: the fiscal policy is effective
LM curve does not shift

Since E1 is to the right of the BoP curve, therefore it is associated with BoP deficit which will
put pressure for domestic currency to depreciate, Do to depreciation, export becomes less
expensive and imports much expensive (↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 thus causing further
movement of IS curve to the right, as it is flexible exchange market system (Central bank will
does nothing).
Do to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 will cause movement of BoP curve to the right until E2
where both three lines intersect each other
Note: the fiscal policy is effective

Since E1 is above of the BoP curve, therefore it is associated with BoP surplus which will put
pressure for domestic currency to appreciate, Do to appreciation, imports becomes less expensive
and exports much expensive ( ↑↑ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 thus causing back movement of IS
curve and leftward shift of BoP curve until the meet LM curve, and thus intersection of three
Note: the fiscal policy is less effective
Since E1 is above the BoP curve, therefore it is associated with BoP surplus which will put
pressure for domestic currency to appreciate, Do to appreciation, Imports becomes less
expensive and export much expensive ( ↑↑ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 thus causing back
movement of IS curve to the origin position, as it is flexible exchange market system (Central
bank will does nothing).
Note: the fiscal policy is ineffective
LM curve and BoP do not shift
IS curve move temporarily from IS0 to IS1 and back to IS0
Policy used: BoP adjustment (FLEXIBLE Exchange rate system)

 Monetary policy under different capital mobility

monetary policy, the LM curve shifts to the right from LM 0 to LM1 and form the new domestic
equilibrium at point E1 where new LM curve intersect with origin IS curve.
Since E1 is below the BoP curve, therefore it is associated with BoP deficit which will put
pressure for domestic currency to depreciate, Do to depreciation, exports becomes less expensive
and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓
𝐼𝑚𝑝𝑜𝑟𝑡𝑠 IS curve and BoP curve to shift to the right until at point E1 , where both new LM,
BoP and IS curves intersect each other
Note: the monetary policy is effective
LM, IS and BoP shift

and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . Due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓
and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . Due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓

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Review questions
Why Tanzania shilling has recently been depreciating? What are the possible effect on
investors, exporters, importers and public as a whole?
 High demand for foreign goods and services which leads to demand for highly
convertible currency (dollar), therefore this leads to excess demand for dollar. So
many people will be rushing for few available foreign currency, hence price of
dollar raise (appreciates)
The demand for foreign exchange arises from
 The desire to import or purchase goods and services from other nations and to
make investments abroad.
The supply of foreign exchange comes from
 Exporting or selling goods and services to other nations and from the inflow of
foreign investments.
If the domestic currency price of the foreign currency rises, we say that the domestic
currency has
 Depreciated.
In the opposite case, we say that the domestic currency has
 Appreciated (and the foreign currency depreciated).
What are foreign exchange markets? What is their most important function?
What are the four different levels of participants in foreign exchange markets?
What is meant by the exchange rate? How is the equilibrium exchange rate determined
under a flexible exchange rate system?
What is meant by a depreciation of the domestic currency? An appreciation?
What is arbitrage? What is its result?
Why is the measure of the balance-of-payments deficit or surplus not strictly appropriate
under a flexible exchange rate?
What is meant by a spot transaction and the spot rate? A forward transaction and the
forward rate? What is meant by a forward discount? Forward premium? What is a
currency swap? What is a foreign exchange futures? A foreign exchange option?
What is meant by foreign exchange risk? How can foreign exchange risks be covered in
the spot, forward, futures, or options markets? Why does hedging not usually take place
in the spot market?
What is meant by speculation? How can speculation take place in the spot, forward,
futures, or options markets? Why does speculation not usually take place in the spot
market? What is stabilizing speculation? Destabilizing speculation?
Assume that the three month FR = $2.00/￡1 and a speculator believes that the spot rate
in three months will be SR = $2.05/￡1. How can a person speculate in the forward
market? How much will the speculator earn if he or she is correct?
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Foreign Exchange and Foreign Exchange Market

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Droits d'auteur :

Foreign Exchange and Foreign Exchange Market

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International Economics: Visit http://kubalyendas.blogspot.com Prepared by: Sir.

FOREIGN EXCHANGE AND FOREIGN EXCHANGE MARKET

Exchange Rate Determination

Exchange rates fluctuate considerably over time;

Foreign Exchange Market

Functions of foreign exchange market

Participants in the Foreign Exchange Market (NISCCC) Nisisii

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Corporations their operations in various countries frequently make or receive payments in

Foreign Exchange Instruments (CCBLCO) sisi-biliko

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Commercial Bill of Exchange: Is a written order by an exporter (the drawer) to an importer

Foreign Exchange Transactions

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Two exchange rate system

Flexible (freely fluctuating) Exchange Rate System

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NB: R=the price of US dollar in term of Tanzania shillings.

Advantages of FLEXIBLE ERS (Arguments in Favour of the System): EEETI It

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Disadvantages of LERS(Arguments against Flexible Exchange Rate) WIRDTI

 It generates wasteful resource movements. Since it involves frequent change in the

Fixed Exchange Rate System

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Advantages(Arguments for) Fixed Exchange Rate

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Disadvantage (Arguments against) Fixed Exchange Rate System

Foreign Exchange Market

Forward Market: transactions take place at a specified future date.

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Speculation can be either stabilizing or detailing

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Credits and Debits in BoP

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Four (4) key items of BoP

Capita A/c balance of payments measures all international economic transactions of

Compensating / Reserve A/c consists of

Errors & Omissions/Official Reserves Accounts

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BoP can be at equilibrium when

CA  X  M  f (Y .Y .e) >> Y  = foreign income, Y = domestic income, e =exchange rate

Disequilibrium in Balance of Payment

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Fewer capital outflows, BP line shifts outward

Point above BoP line is associated with surplus (Credit> Debit)

The slope of BoP curve

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Perfect / Complete capital mobility>>>BoP curve is horizontal:BoP3

Equilibrium in small / large open economy

BoP Adjustment (two options)

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Policy used: BoP adjustment (Fixed Exchange rate system)

Case A: Perfect capital immobility

E0 is the initial equilibrium

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Case B: Low capital mobility

E0 is the initial equilibrium

Case C: Relative high capital mobility

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E0 is the initial equilibrium

Case D: Perfect capital mobility

E0 is the initial equilibrium

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Policy used: BoP adjustment (Fixed Exchange rate system)

Case A: Perfect capital immobility

E0 is the initial equilibrium