Economics Dr.

Sauer

Lecture Chapter 11: Foreign Exchange I. Currency Currency is a _____________________________. It is exchanged for: - goods - services - other currency Most countries have control over the supply and production of their own currency. Usually Central Banks or Ministries of Finance control the currency. There are about _______ currencies in current circulation. There are about 195 countries in the world. - several countries use the_________________________________ ex: the euro is used by Portugal, Spain, France, Italy, Ireland, Belgium, Luxembourg, Germany, Netherlands, Austria, Slovenia, Slovakia, Finland, Malta, Greece and Cyprus - some countries declare use _____________________ currency ex: Panama and El Salvador use the US dollar as legal tender Several countries use the ______________ for their currency: dollar peso United States Philippines Belize Uruguay Canada Mexico Hong Kong To avoid confusion, the __________________ classification system is used. (three letter currency code) II. Foreign Exchange When making international _______________________ (like paying for imports or buying foreign assets), currencies are exchanged as well. A. Exchange Rate Basics The ____________________________________ (exchange rate, forex rate, FX rate) specifies how much one currency is worth in terms of another currency. (abbreviated e) 1. The current exchange rate is also called the ___________________. Example Spot Rates: USD USD GBP EUR 1.0000 0.6485 0.7759 GBP 1.5421 1.0000 1.1966 EUR 1.2889 0.8357 1.0000

With 1 US dollar you could get how many British pounds?

With 1 British pound you could get how many US dollars?

2. Using exchange rates to convert prices into another currency: On June 18, 2007, our meal in Vienna, Austria cost 19.70 and the exchange rate was 1 USD = 0.73169EUR. How many US dollars did it cost?

On August 3, 2005 in Nice, France a kilo of peppers cost 2.20. The exchange rate was 1 EUR = 1.19501 USD. How much did a kilo of peppers cost in US dollars?

The concept of a McDonalds dollar menu exists in other nations/currencies as well. The eurozone has the euro menu. In Salzburg, Austria in June 2007 the exchange rate was 1$ = 0.74270euro. does an item on the euro menu cost? How many US dollars

B. Exchange Rate Fluctuations: When one unit of currency A can ________________ of currency B, then currency A has ________________ versus currency B. When one unit of currency A can ________________ of currency B, then currency A has _________________versus currency B. For example: 7/25/2009 7/25/2010

1 USD = 0.718692 EUR 1 USD = 0.790398 EUR

Has the US dollar appreciated or depreciated versus the euro during this time? dollar has ______________________ versus the euro the euro has ____________________versus the dollar

Some implications of an ____________________ currency: - import more (currency is strong, buying power is strong) - export less - trade balance changes: more of a deficit or less of a surplus) - travel abroad is cheaper

Some implications of a _______________________ currency: - import less - export more - trade balance changes: less of a deficit or more of a surplus) - travel abroad is more expensive Economists dont believe that appreciating/depreciating currencies are _____________________good or bad it depends on the circumstances. III. Types of exchange rates _________________________ (aka flexible): the currencys value is determined by market forces _________________________ (aka pegged): the currencys value is set at a fixed value of another currency _________________________: the currencys value is kept within a certain range of predetermined values with another currency

The Foreign Exchange Market for British pounds (exchange rate between $ and ) _________________ for for foreign exchange - investors who have $ and wish to buy -denominated assets - investors who are selling $-denominated assets and wish to convert back to - US importers of British goods (have $ but need to pay for the order in ) __________________ of for foreign exchange - Investors who have and wish to buy $-denominated assets - Investors who are selling denominated assets and wish to convert back to $ - British importers of US goods (have but need to pay in $) - government policy (Central Banks or Ministries of Finance), and bank practices

the Foreign Exchange Market for British pounds: The notation e$/ indicates the exchange rate in terms of ____________________________________. As the value of e$/ increases, the is _____________ against the $. As the value of e$/ decreases, the is _____________ against the $. D slopes _____________________ because as the depreciates, it is cheaper to buy using $ (as the price of a falls, the quantity demanded of it rises). S is ________________ because there is a certain quantity of available for foreign exchange at any given time.

1. Floating Exchange Rates (flexible) The intersection of the ___________________ for determines the exchange rate. When supply or demand ______________, so does a floating exchange rate. Suppose that $-denominated assets are paying a higher return than -denominated assets. - D will _________________ as people sell assets in favor of $ assets - the exchange rate ___________( depreciates vs the $)

2. Fixed (Pegged) Exchange Rates Flexible (floating) exchange rates _______________________and may be quite volatile. To reduce the _____________________ associated with a floating forex rate, a country might choose to peg its currency to a certain value. The main benefit of a pegged exchange rate is ___________________________. - investors are more certain of a return - import/export transactions have less risk The drawback of a pegged exchange rate is it causes a ________________________ for other policies. - the Central Bank / Ministry of Finance has to take steps to maintain the peg - need to have reserves of the currency you are pegging to A pegged rate ____________ than the market rate: Suppose Estonia pegs the kroon to the euro at a rate of e1. - at e1, _________________ which means there is a surplus of kroon in the market - normally, the kroon would ________________ - the Estonian Central Bank must ____________ to keep the kroon from depreciating The Estonia Central Bank must use its reserve of euros to buy up the surplus of kroon. - needs to be willing to do so at the fixed exchange rate - The Central Bank ends up with more kroon - Depletes reserves of euros

Implications: An overvalued currency can lead to a _________________________________: - decreases exports (they are more expensive) - increases imports (they are cheaper) - It benefits imports at the expense of exports The Central Bank __________________ its foreign exchange reserves. If a currency is overvalued for a long period of time, then a ________________________ crisis could be on the horizon. - run out of reserves - cant pay for imports ___________________________ if running out of foreign reserve currency: - __________________foreign exchange from another central bank or the IMF to maintain the peg - __________________ to a lower level, more consistent with the market rate - allow the exchange rate to ________________________ down to the market level

If __________________ think that a currency will be devalued, they may sell all of their assets in that currency. - the demand for currency falls - This would put more pressure on the peg. - the market equilibrium is even further below the peg - the surplus is larger - A government may be forced to devalue the currency. - _________________________ prophecy The investors could then move back into the currency, but since it has depreciated, they can buy much more of it. _________________________________________________________________________________ A pegged rate ________ than the market rate: Suppose China pegs the yuan to the US dollar at a rate of e1. - at e1, ____________ which means there is a shortage of yuan in the market - normally, the yuan would ______________ - to keep the currency from appreciating, the central bank must _____________ The Central Bank must put yuan into the market. - will be spending yuan to buy up dollars - needs to be willing to do so at the fixed exchange rate - China ends up with more reserves of dollars

Implications: An undervalued currency can lead to a __________________: - increases exports - decreases imports - It benefits exports at the expense of imports The government will _______________ its foreign currency reserves. If a currency is undervalued for a __________________, then the government may be forced to expand the domestic money supply to get more domestic currency. - domestic ________________ If currency ____________________ think that the government may re-value the currency, then hot money may flow into the country. - increases demand for the currency - the peg is now even further below market equilibrium - more of a shortage - need more domestic currency - inflation increases - the government re-sets the peg higher, or lets the currency float - speculators make a profit