Learning Objectives. Chapter 17. Trading Currencies in Foreign Exchange Markets. Trading Currencies in Foreign Exchange Markets (cont.

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1 Chapter 17 Financing World Trade Learning Objectives Explain how foreign exchange rates are determined. Differentiate between floating and fixed exchange rate systems. Contrast the balance of trade and the balance of payments. Argue why a trade deficit is not necessarily detrimental to the U.S. economy. Copyright 2005 Pearson Addison-Wesley. All rights reserved Trading Currencies in Foreign Exchange Markets The U. S. dollar is the legal currency accepted in virtually all transactions in this country. Currently there are over 100 different national currencies in existence. When U.S. residents want to purchase goods or services in other countries, they typically have to exchange their U.S. dollars for the other countries currencies. Trading Currencies in Foreign Exchange Markets (cont.) When foreigners wish to buy goods or invest in the United States, they have to do the reverse exchange their local currency for U.S. dollars. A worldwide market exists for such exchanges. It is called the foreign exchange market. Like all markets, the worldwide foreign exchange market responds to the demand for, and the supply of, different currencies. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

2 The Demand for Foreign Exchange Japanese Yen Every time a U.S. resident wants to buy a Japanese laptop, a Japanese car, or a Japanese-made MP3 player, such decisions create a demand for Japanese yen. In this sense, the demand for any foreign currency is a derived demand, derived from the demand for the imported good or service desired. The Demand for Foreign Exchange Japanese Yen (cont.) The more goods and services U.S. residents desire to purchase from Japanese companies, the greater the demand for Japanese yen. (This concept applies equally well to all countries and currencies.) Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Appreciation and Depreciation The Supply of Foreign Currency Let s say that it costs you 1 cent to purchase 1 yen; that is the exchange rate between dollars and yen. If tomorrow you had to pay 1 1/4 cents ($0.0125) for the same yen, the exchange rate would have changed. Looking at such a change, we would say that there has been an appreciation in the value of the yen, or that there has been a depreciation in the value of the dollar. The more U.S.-made goods and services Japanese residents desire, the greater the supply of Japanese yen. Japanese residents will be willing to supply more yen when the dollar price of yen goes up, because they can then buy more U.S. goods with the same quantity of yen. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

3 Equilibrium for Each Foreign Currency Equilibrium is a condition in which there is no further tendency for the price of something to change, at least in the short run. Equilibrium in the market for a foreign currency is the result of the worldwide demand and worldwide supply of that currency. Equilibrium for Each Foreign Currency (cont.) Figure 17-1, next, shows the equilibrium price of Japanese yen the foreign exchange rate at a point in time. The graph shows the demand for Japanese yen by U.S. residents and the supply of Japanese yen offered by Japanese residents. The result is a price of 1 cent per yen. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Figure 17-1: Finding the Equilibrium Price of a Foreign Currency Shifts in the Demand for Foreign Currencies Assume, for example, that the New York Times published an article demonstrating that Japanese laptop computers were more reliable than those made in the U.S. This would probably cause an increase in the demand for Japanese laptops. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

4 Shifts in the Demand for Foreign Currencies (cont.) Because the demand for Japanese yen is derived from the demand for Japanese goods and services, the result would be a rise in the demand for yen. The price per yen in dollars would then likely rise. Strong versus Weak Currencies Whenever a currency appreciates in value in the foreign exchange market, commentators will talk about the currency strengthening or that it is a strong currency. Whenever a currency depreciates in value in the foreign exchange market, commentators refer to it as weakening or a that it is a weak currency. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Shifts in the Demand for Foreign Currencies Figure 17-2: The Results of a Shift in the Demand for Japanese Yen In Figure 17-2, next, you can see that if U.S. residents demand more Japanese products, the derived demand curve for yenwill shift outward to the right from D 1 to D 2. The equilibrium price will rise from 1 cent per yen to 1.2 cents per yen and the equilibrium quantity will increase from 3 trillion to 4 trillion yen per year. Equilibrium changes from E 1 to E 2. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

5 Shifts in the Supply of Foreign Currencies The supply of Japanese yen can also change. When that happens, the equilibrium price of yen is affected. For instance, Microsoft Corporation has just announced a revolutionary operating system that will make all existing computers run five times faster. It has announced that this new operating system will be sold in Japan this week. Shifts in the Supply of Foreign Currencies (cont.) Consequently, Japanese computer users will demand more software products from Microsoft and in the process supply more yen to the foreign exchange market. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Graphing a Shift in the Supply of Japanese Yen Figure 17-3: An Increase in the Supply of Japanese Yen In Figure 17-3, next, you can see that the supply of Japanese yen has increased from S to S 1. The equilibrium has changed from point E to E 1. The equilibrium price of Japanese yen has dropped in this case from 1 cent per yen to 0.5 cent per yen, representing a weakening of the yen in the foreign exchange market. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

6 What Determines Exchange Rates? There are numerous reasons why the demand and supply curves for foreign currencies change. Some of the variables that may cause a change in exchange rates are: real interest rates, productivity, consumer preferences, and perceptions of economic stability Floating Exchange Rates In a floating (flexible) exchange rate system, the value of a country s currency in terms of other currencies can change depending on world market conditions. Under a floating exchange rate system, there is no government intervention to attempt to keep the exchange rate at a specific value. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Government Intervention in Foreign Exchange Markets Today, most of the world uses a floating exchange rate system. Occasionally, however, governments do intervene to try to either alter the value of their own currency in international exchange markets, or to help some other country do so. The result is called a managed exchange rate system. Fixing the Exchange Rate In much of the world before the 1970s and in certain countries today, such as China, exchange rates have been or are fixed by various governments through intervention in the foreign exchange market. Because of this intervention, there are virtually no variations in the foreign exchange value of a domestic currency in a fixed exchange rate system. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved

7 Foreign Exchange Risk The Balance of Trade The possibility that variations in the market value of assets can take place because of changes in the value of a nation s currency is called the foreign exchange risk which residents of a country face because the value of their nation s currency can fluctuate. A currency s exchange rate can have an important effect on a nation s balance of trade exports minus imports. If a nation s currency depreciates, the nation will likely export more goods because its products will become cheaper for other nations residents to buy. At the same time, its residents will tend to import less because other nations goods will become relatively more expensive. Copyright 2005 Pearson Addison-Wesley. All rights reserved Copyright 2005 Pearson Addison-Wesley. All rights reserved Trade in Goods versus Trade in Services The Balance of Payments When international trade started, literally thousands of years ago, virtually all of it was in the form of trade in goods. Today we trade in not only goods, but also services. The United States in a recent year sold $400 billion of services to other countries and purchased about $300 billion of services from other countries. Copyright 2005 Pearson Addison-Wesley. All rights reserved The balance of payments is a record of all the transactions between households, firms, and the government of one country with the rest of the world. It includes: The Current Account Balance, and The Capital Account Balance Copyright 2005 Pearson Addison-Wesley. All rights reserved

8 Current Account versus Capital Account Transactions Key Terms and Concepts Current account transactions involve trading goods, trading services, and unilateral transfers. Capital account transactions involve foreign investments, either those made by foreigners in America, or those made by U.S. residents in foreign countries. Whenever the current account is in deficit, the capital account is in surplus and vice versa. Copyright 2005 Pearson Addison-Wesley. All rights reserved appreciation balance of payments balance of trade capital account transactions depreciation derived demand fixed exchange rate system floating (flexible) exchange rate system foreign exchange market foreign exchange risk trade deficit unilateral transfers Copyright 2005 Pearson Addison-Wesley. All rights reserved