Foreign Exchange Rates Overview

Foreign Exchange Rates

• Exchange rates are determined by supply and demand just like other markets.
• When looking at the dollar/pound market, the demand for pounds is driven by:
  • Americans buying goods and services from British firms.
  • Americans buying British assets like stocks, bonds, and real estate.
• The demand curve slopes downwards meaning a lower exchange rate leads to higher demand for pounds.
• Shifts in the demand curve are impacted by:
  • U.S. real GDP: Growth leads to increased demand for British goods, shifting the demand curve right.
  • Relative price levels: If U.S. prices rise faster than British prices, demand for British goods increases, shifting the demand curve right.
  • Increased interest in British goods: Demand for British goods increases, shifting the demand curve right.
  • Relative interest rates: Higher interest rates in Britain make British assets more attractive, leading to increased demand for pounds, shifting the demand curve right.
• The supply of pounds is affected by:
  • British investors buying U.S. assets: This increases the supply of pounds, shifting the supply curve right.
  • Expected changes in the exchange rate: If the British expect the pound to depreciate, they'll buy more U.S. assets, increasing the supply of pounds, shifting the supply curve right.
• A floating exchange rate is determined by supply and demand without government intervention.
• Appreciation of a currency occurs when its price increases due to a shift in supply, demand, or both.
• Depreciation of a currency occurs when its price decreases in a floating exchange rate system.
• Very Short-Run: Exchange rate fluctuations occur over weeks and days, driven by traders moving large volumes of funds and expectations about future exchange rates.
• Short-Run: Exchange rate fluctuations happen over months or years, influenced by economic fluctuations. A rising GDP leads to depreciation, and a falling GDP leads to appreciation.
• Long-Run: Exchange rates are determined by relative price levels between two countries.
• Purchasing Power Parity (PPP): The exchange rate between two countries adjusts in the long run to equalize the average price of goods in both countries.
• PPP Theory Implication: The currency of a country with higher inflation will depreciate against the currency of a country with lower inflation.
• Exceptions to PPP:
  • Goods difficult to trade (haircuts, non-tradable goods).
  • High transportation costs.
  • Artificial barriers to trade (taxes, quotas on imports).
• Managed Float: A country's central bank actively manages its exchange rate by buying its own currency to prevent depreciation and selling its own currency to prevent appreciation.
• Fixed Exchange Rate: A government declares a specific value for its exchange rate with another currency and intervenes in the market to maintain it.
• Foreign Currency Crisis: Occurs when people lose confidence in a country's ability to maintain a fixed exchange rate above the equilibrium rate, leading to increased supply, decreased demand, and rapid depletion of reserves.
• Devaluation: When a government lowers the fixed value of its currency.

Money, Banking & The Federal Reserve

• Money Supply: Refers to the total amount of money in circulation.
• M1: Includes cash in the public, checking account deposits, and traveler’s checks.
• M2: Includes M1 plus savings deposits, money market deposits, and other liquid assets.
• Functions of the Federal Reserve (Fed):
  • Bank for banks: Holds reserves, pays interest on these funds, and lends to banks at the discount rate.
  • Issues paper currency: Prints money and puts it into circulation.
  • Clears checks: Transfers funds between banks.
  • Guides the macroeconomy: Uses macroeconomic tools to influence economic activity.
  • Deals with financial crisis: Acts as a "lender of last resort" to ensure banks have enough reserves.
• Ways the Fed Changes the Money Supply:
  • Open Market Operations: The Fed buys or sells government bonds in the bond market.
    • Open Market Purchase: Buying bonds increases reserves and the money supply.
    • Open Market Sale: Selling bonds reduces reserves and the money supply.
• Money Multiplier: The ratio of the change in the money supply to the initial change in reserves. It depends on the required reserve ratio (RRR), calculated as 1/RRR.
• Treasury vs. Fed: The Treasury borrows money by issuing new government bonds, while the Fed does not borrow. Fed open market operations affect the money supply independent of the government budget.