Economics of the FOREX Market

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Economics of the FOREX Market
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Exchange Rate Systems

• Exchange rate systems can be classified according
  to the degree to which the rates are controlled
  by the government.
• Exchange rate systems normally fall into one of
  the following categories
• fixed
• freely floating
• managed float

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Free Float System

• In a freely floating exchange rate system,
  exchange rates are determined solely by market
  forces.
• Supply and Demand for a currency will determine
  its equilibrium price.
• Governments do not intervene in currency markets.

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UK good becomes more affordable to US consumers
as the appreciates We will demand more in
order to purchase more of the UK good
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US good becomes more affordable to UK consumers
as the depreciates They will supply more in
order to purchase more of the US good
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FOREX Demand Supply

• Price -cost of a unit of foreign currency
• Demand (D)
• Quantity demanded f price (-)
• Foreign goods become more expensive in -terms as
  the exchange rate (price) rises
• Holders of demand a smaller quantity of foreign
  currency to purchase these goods
• Supply (S)
• Quantity supplied f price ()
• Our goods become less expensive to foreign
  consumers as the exchange rate rises
• Holders of foreign currency will supply a greater
  quantity of their currency (for our ) to
  purchase our goods

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Quantity Supplied increases as the exchange rate
increases. gt Move upward along the supply
curve Quantity Demanded increases as the
exchange rate decreases. gt Move downward along
the demand curve
2/
1/
.5/
10
15
20
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Equilibrium Exchange Rate
Excess Supply
2/
Equilibrium exchange rate
1/
.5/
Excess Demand
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15
20
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Adjustment under Floating FX Rates

• Original equilibrium at 1/
• D S shift from 0 to 1
• Excess Demand Occurs
• XM Imports
• XE Exports
• EM Net Imports
• (trade deficit)
• We want more than supplied at 1/
• Bids up the exchange rate
• Decreases the quantity demanded (move along D1)
• Increases the quantity supplied (move along S1)
• New equilibrium when QdQs at 2/

S1
2/
1/
M
X
E
D1
10
15
20
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Change in Demand for Foreign Currency
An Increase in our demand for foreign currency
will push the demand curve to the right A
decrease in demand will move the demand curve to
the left
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Change in Supply for Foreign Currency
An Increase in their supply of foreign currency
will push the supply curve to the right A
decrease in supply will move the supply curve to
the left
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FX Determinants(shift supply and demand)

• Market Factors
• Relative Prices (inflation)
• Relative Interest Rates
• Income (domestic and foreign)
• Consumer Tastes
• Market Disruptions
• Expectations
• Administrative Factors
• Central bank intervention
• Economic Policy
• Government Controls

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Determinants of Exchange Rates

• Relative Inflation (?/ ?)

• U.S. inflation ? gt (?/ ?) ?
• ? U.S. demand for British goods, and hence .
• ? British desire for U.S. goods, and hence the
  supply of .

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Determinants of Exchange Rates

• Relative Interest Rates (I/ I)

• U.S. rates ? gt (I/ I) ?
• ? U.S. demand for British bank deposits, and
  hence .
• ? British desire for U.S. bank deposits, and
  hence the supply of .

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Determinants of Exchange Rates

• Relative Interest Rates
• High interest rates may actually reflect
  expectations of relatively high inflation, which
  discourages foreign investment.
• It is thus useful to consider real interest
  rates
• real nominal
• interest ? interest inflation
  rate
• rate rate
• This relationship is sometimes called the Fisher
  effect.

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Determinants of Exchange Rates

• Relative Income (GDP/ GDP)

• U.S. income ? gt (GDP/ GDP) ?
• ? U.S. demand for British goods, and hence .
• No expected change in British income means no
  change in the desire for U.S. goods, and hence
  the supply of .

,S1
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Consumer Tastes

• Consumer tastes for domestic and import goods can
  affect the exchange rate.
• If consumers tastes for Japanese cars increases
  (perhaps we see the quality of Japanese cars
  having improved over domestic cars),
• Then the demand for Yen will increase.
• The sell of and purchase of Yen will cause the
  value of the to fall (depreciate).

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Determinants of Exchange Rates

• Expectations
• Foreign exchange markets react to any news that
  may have a future effect.
• Institutional investors often take currency
  positions based on anticipated interest rate
  movements in various countries.
• Because of speculative transactions, foreign
  exchange rates can be very volatile.

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Determinants of Exchange Rates

• Expectations

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Maintaining a Fixed Exchange Rate

• Relatively higher US inflation depreciates the .
• To re-establish the fixed FX rate (r0)
• US and/or UK could Decrease D, Increase S, or
  both, until the new equilibrium is back at r0.

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Administrative Factors

• DIRECT INTERVENTION
• Use of Reserves
• INDIRECT INTERVENTION
• Government Controls
• Trade Barriers
• Tariffs Quotas
• Capital Flow Barriers (case capital controls)
• Taxes Restrictions on Financial Flows
• Foreign Exchange Conversion Barriers
• Ration FX
• Economic Policy
• Monetary Fiscal Policy (colander)

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Reserves

• Central Bank Reserve Assets
• Foreign Currency
• Gold
• SDRs
• Loans from IMF
• US Central Bank Sells Reserves (buy )
• DS gt0
• US Central Bank Buys Reserves (sell )
• DD gt0

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Reserves

• Problems
• Requires that trade deficits and surpluses are
  random, roughly same size, and dont persist too
  long
• Otherwise a central bank can exhaust its
  reserves trying to maintain the fixed exchange
  rate
• Or go into debt borrowing reserves
• Persistent deficits tend to require a
  De-valuation of a currency

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Sterilized Non-Sterilized Intervention

• Non-Sterilized
• No adjustment to money supply
• Sterilized
• Adjust money supply

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Example of Sterilized Intervention

• U.S. Federal Reserve wants to devalue the
• It will Sell and Buy FC
• This increases the supply of gt inflationary
• To counteract the inflationary force of a larger
  supply of , the fed could Sell US Treasury
  Securities (thereby acquiring ).
• Reduces the money supply.
• If the Fed acquires a number of equal to that
  put into the market via intervention in the
  foreign exchange market, then there is no change
  in the money supply. This is sterilization

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Trade Barriers

• Tariff
• Tax on Imports
• Raises US price of Foreign goods
• P e x P T
• Relatively higher price leads to DD lt 0
• Import Quota
• Restriction on quantity of imports
• Set quota such that trade deficit (EM) quantity
  is in excess of the quota and cannot be satisfied.

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Capital Controls

• Restrictions placed on Monetary Flows through the
  BOP Capital (Financial) Account
• Direct (administrative)
• Indirect (market-based)
• Taxes on capital flows
• Dual exchange rate system

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Economic Consequences of International Capital
Flows
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TRI-LEMMA
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Summary of FX History

• Pre WW I
• Countries used econ policy to maintain a fixed
  exchange rate
• War Period
• Countries used econ policy to extract taxes to
  fund war effort. Restricted capital flows to
  keep exchange rates fixed
• Bretton Woods
• Capital account solely used to finance trade
  flows and foreign direct investment. Cross
  border financial investment restricted.
• Modern Era
• New tools available to hedge currency risk.
  Exchange rates allowed to float, leaving capital
  free to move between countries and economic
  policy available for domestic policy goals

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Why Restrict Capital Flows?

• Financial markets prone to panics, herding, and
  crashes, while Trade markets more stable
• Economic policy free to use for domestic
  objectives

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Why Allow Free Flow of Capital?

• Allows capital to seek out its most efficient
  use w/o artificial barriers
• Firms and govt seek out low cost financing
• Investors seek out high returns
• Investors achieve greater diversification
  globally than domestically
• Capital controls
• May deter FDI
• Can be circumvented via transfer pricing
• Lead to rent seeking
• Involves wasteful red tape

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Economic Policy

• Economic Policy
• Monetary
• Changing money supply
• Fiscal
• Taxation and government spending

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Impact of Monetary Policy
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Impact of Fiscal Policy
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Problems with use of Economic Policy

• May be inconsistent with Domestic Goals
• Every country maintaining a fixed exchange rate
  is essentially agreeing to have the same fiscal
  and monetary policy

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Determinants of Exchange Rates

• Interaction of Determinants
• different determinants may place opposing
  pressures on the value of a foreign currency.
• The sensitivity of the exchange rate to these
  factors is dependent on the volume of
  international transactions between countries (see
  Balance of Payments lecture)

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How Determinants Can Affect Exchange Rates
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Factors AffectingInternational Trade Flows

• Inflation
• A relative increase in a countrys inflation rate
  will decrease its current account, as imports
  increase and exports decrease.
• National Income
• A relative increase in a countrys income level
  will decrease its current account, as imports
  increase.

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Factors AffectingInternational Trade Flows

• Government Restrictions
• A government may reduce its countrys imports by
  imposing tariffs on imported goods, or by
  enforcing a quota. Note that other countries may
  retaliate by imposing their own trade
  restrictions.
• Sometimes though, trade restrictions may be
  imposed on certain products for health and safety
  reasons.

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Factors AffectingInternational Trade Flows

• Exchange Rates
• If a countrys currency begins to rise in value,
  its current account balance will decrease as
  imports increase and exports decrease.
• Note that the factors are interactive, such that
  their simultaneous influence on the balance of
  trade is a complex one.

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Factors Affecting Capital Flows

• Economic Growth
• Investment flows to regions with forecast of
  strong economic growth
• Tax Rates
• Investors will normally prefer countries where
  the tax rates are relatively low.
• Interest Rates
• Money tends to flow to countries with high
  interest rates.
• Exchange Rates
• Foreign investors may be attracted if the local
  currency is expected to strengthen
• Explicit Barriers
• Privatization

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Determinants of Exchange Rates

• How Factors Have Influenced Exchange Rates
• Because the dollars value changes by different
  magnitudes relative to each foreign currency,
  analysts often measure the dollars strength with
  an index.
• The weight assigned to each currency is
  determined by its relative importance in
  international trade and/or finance.

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When a currency is loosing (gaining) value
against another currency, it is probably .
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.loosing (gaining) value against Most other
currencies! .
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.though it can move in the opposite direction
against Some currencies! (note FX / )
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Value of Foreign Currency Index Over Timewith
respect to the dollar
The Dollar Index is useful to discern movements
of a currency against the Rest of the World.
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Value of Foreign Currency Index Over Timewith
respect to the dollar
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• The Federal Reserve also has a dollar index. The
  FRB Dollar Index has several features
• Trade Weighted
• Upward (downward) movement gt Appreciation
  (depreciation)

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Summary

• Change in Quantity Demanded or Supplied
• Move along the demand or supply curve
• Result of a change in the exchange rate (price)
• Change in Demand or Supply
• Shift location of the demand or supply curve
• Result of change in FX determinant