ECN220 Global Economy and Exchange Rates

ECN220 Evolution of the Global Economy

• This course examines the evolution of the global economy.

Foreign Exchange Rates

• Different countries use their own currencies.
• Exchange rates convert one currency's value into another.
• Foreign exchange is the trading of currencies between nations. This mirrors how money is used within a country.
• October 2024 exchange rates are detailed in a table.

Types of Exchange Rates

• Spot Exchange Rate: Used for immediate currency exchanges.
  • For large trades, delivery usually occurs two business days after the agreement.
  • Some currency pairs (e.g., USD and CAD) result in delivery within one business day.
• Forward Exchange Rate: Agreed upon today for a future currency exchange (e.g., 30, 90, or 180 days).
  • Used to lock in exchange prices for future transactions.

Foreign Exchange Market

• A decentralized system, not a single physical location.
• Banks are key dealers.
• Most transactions involve banks in London and New York.
• Most transactions pair the US dollar with other currencies.
• The US dollar often acts as an intermediary in non-US dollar currency exchanges.
• This widespread use of the US dollar makes it a "vehicle currency."

Spot Foreign Exchange Market

• Facilitates smooth payment flows between individuals, businesses, and organizations with different currencies.
• Enables transactions for a wide range of activities including trade in goods and services and foreign financial assets as captured in the balance of payments.

Interbank Market

• Plays a crucial role in providing banks real-time foreign exchange rates and conditions.
• Observing quoted exchange rates allows banks to interact with other traders.
• Enables quick and cost-effective adjustments to financial positions after large trades.
  • A Canadian bank, buying yen from a Japanese firm, may quickly sell the yen to another bank.

Appreciation and Depreciation

• Exchange rates influence the cost of products in different countries.
• For example, a product priced at 1,000USDintheUS,wouldbeequivalentto1,000 USD in the US, would be equivalent to 1,000USDintheUS,wouldbeequivalentto1,375 Canadian dollars at an exchange rate of 1.375 USD/CAD. If the USD/CAD rate were to rise to 1.60, then the same product would cost $1,600 Canadian dollars.

Demand and Supply for Foreign Exchange

• Supply of one currency is the demand for another currency.
• In a floating exchange rate system, the foreign exchange rate is determined by market forces (demand and supply).

Demand in Foreign Exchange

• The law of demand for Canadian dollars means a rise in exchange rates results in decreased demand for CAD$.
• Non-Canadians' demand for CAD$ depends on Canadian goods, exports, assets, and speculation on future value.

Supply in Foreign Exchange

• The law of supply for Canadian dollars dictates a rise in exchange rates results in increased supply of CADS.
• Reasons for supply of CADs include paying for imports and speculative activity on future CADS values.

Equilibrium in Foreign Exchange Market

• The supply and demand for CADs cross at a specific price, resulting in an equilibrium rate.
• This determines the price of CADs in relation to other currencies.

Reciprocal Exchange Rate

• Divide 1 by the other exchange rate.
• When CADappreciatesagainstanycurrency,thatcurrencydepreciatesagainstCAD appreciates against any currency, that currency depreciates against CADappreciatesagainstanycurrency,thatcurrencydepreciatesagainstCAD.

Floating Exchange Rates

• Exchange rate fluctuations result from shifts in interest rates, inflation rates, Canadian real GDP, global demand for exports, and speculator expectations.
• These factors impact both demand and supply curves in the foreign exchange market.

Increase in Canadian Interest Rate Differential

• When Canadian interest rates rise, Canadian assets become more attractive to investors.
• This leads to increased demand for CAD,thusincreasingCAD, thus increasing CAD,thusincreasingCAD value. Increased demand and a limited supply causes the Canadian dollar to appreciate.

Decrease in Canadian Interest Rate Differential

• Conversely, falling Canadian interest rates make Canadian assets less attractive.
• This leads to lower demand for CAD$, causing Canadian dollar depreciation.

Inflation Rate Differential

• A rise in Canadian inflation rate compared to another country influences the supply and demand for CAD$.
• As goods/services become more expensive in Canada, the supply of CAD rises (so it must be sold for greater value in other currencies) and demand of CAD falls.

Canadian Real GDP

• Rising GDP increases the demand for CADs as Canadian assets become attractive.
• Higher demand drives an appreciation of CADs against other currencies. Alternatively, a decline in GDP would drive depreciation.

Globalization Transmission Mechanisms

• Exchange rates affect a country's real GDP and inflation rate through the globalization transmission mechanism, especially impacting net exports, aggregate demand, and the price level.
• A depreciating Canadian dollar boosts net exports and drives the economy into expansion, while a rising dollar yields the opposite effect.

Purchasing Power Parity (PPP)

• The law of one price, purchasing power parity, and rate of return parity are standards used to estimate future exchange rates.
• PPP allows money to have the same purchasing power in different countries.
• For example, if a book costs 8intheU.S.andCAD8 in the U.S. and CAD8intheU.S.andCAD10 in Canada, then CAD$ per USD is 0.80.

Fixed Exchange Rates

• Currency value is pegged to another major currency (e.g., US dollar, or a basket of currencies).
• This value is maintained by government or central bank intervention, even if it varies from a market equilibrium.
• Pegged rates can fluctuate within a prescribed trading band.

Gold Standard

• Each country pegged its currency to a specific quantity of gold.
• This led to stable exchange rates.
• This system was widely regarded as successful and stabilized systems worldwide.

Bretton Woods System

• The system reflected the U.S.'s strong economic position.
• It featured a fixed exchange rate system.
• Automatic adjustments for surpluses and deficits were part of policies.

Dollar Crisis

• Issues involving the U.S. dollar's role as a reserve currency led to the collapse of the Bretton Woods System.
• Large U.S. payment deficits worsened the issue.
• A significant drop in U.S. gold reserves made the system less sustainable.

Current International Monetary System

• A managed floating exchange rate system.
• Most countries peg their currencies to one another.
• Governments may intervene in the market.

This quiz explores the evolution of the global economy, focusing on foreign exchange rates and types of exchanges such as spot and forward rates. It helps students understand the role of currencies in international trade and the foreign exchange market.