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Lecture 5
a. derived from the local buyers who are willing and able to purchase foreign goods but who must convert their local currencies.
b.
A direct relationship exists between the cost of foreign currency and amount demanded.
b. A direct relationship exists between cost of the foreign currency and the amount supplied.
Equilibrium
Inflation: Question?
Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) demand for Canadian dollars (b) supply for Canadian dollars for sale (c) equilibrium value of the Canadian dollars?
$0.92
This relates to Purchase power parity (PPP) theory in the next chapter.
$1.50
This relates to Interest rate parity (IRP) theory in the next chapter.
$0.90
Government control
Imposing foreign exchange barriers Imposing foreign trade barriers (e.g. tariff, quota, subsidy) Intervening (buying and selling currencies) in the foreign exchange markets Macro economic policies to affect inflation, interest rates and income levels.
$0.0105
Market expectations
Market efficiency in the foreign exchange market In an efficient foreign exchange market, the current exchange rate should reflect the aggregated market expectations of all factors that may impact the future exchange rate. Investors rely on signals to form their expectation. As signals contain noise information, investors may under-react or overreact in the foreign exchange market. Expectations can also quickly spread to other regions and currencies contagion effect.
Interaction of Factors
Impact of income increase
Import increases, depreciation pressure Interest rate increases, appreciation pressure But high national income is mostly related to good economic fundamentals.
Example: Weight of international trade and capital flows for the exchange rate determinants
Factor United States Venezuela Japan
-1%
+2%
-2%
-3%
-4%
-6%
Assume the U.S. and Venezuela have large amount of international trade, but not much financial capital flows. On the contrary, the U.S. and Japan have heavy capital investment, but not as much international trade. What do you expect about the exchange rate for Venezuela currency and Japanese currency in the next year?