FOREIGN EXCHANGE

1. FOREIGN EXCHANGE

2. Exchange Rates • exchange rate is the value of one country’s currency in terms of another country’s currency • can be expressed 2 ways • US$0.65 buys CDN$1, or • CDN$1.54 buys US$1 (1 / $0.65)

3. Exchange Rate (US$ per CDN$)

4. Exchange Rates • appreciates • the price of our currency rises in comparison to price of another currency • depreciates • the price of our currency decreases in comparison to price of another currency

5. Exchange Rates • depends on supply of and demand for Canadian currency Demand • Canadian dollars are demanded by foreigners to buy our goods/services, invest in our financial assets, or to speculate • demand influenced by price (exchange rate)

6. Demand for CDN $ and the Exports Effect • exchange rate is US$0.63 buys CDN$1 • a phone made in Canada with a price of CDN$100, will cost an American US$63 • exchange rate increases to US$0.70 buys CDN$1 • phone now costs the American US$70 • fewer phones sold • increase in price of CDN dollar (exchange rate) decreases demand for CDN dollar

7. Demand for CDN $ and the Exports Effect • An increase in the exchange rate • Exports become more costly for foreigners, which • Decreases demand for our exports, which • Decreases the demand for CDN $

8. Demand for CDN $ and the Expected Profit Effect • The greater the expected profit from speculating in CDN $, the greater the demand for CDN $, • The lower the exchange rate • The greater the expected profit • The greater the demand for CDN $

9. Demand for CDN $ and the Expected Profits Effect

10. D The Demand for Dollars 90 80 70 Exchange rate (US cents per Canadian dollar) 60 50 0 100 200 300 400 500 Quantity (billions of Canadian dollars per day)

11. Changes in Demand for CDN$ • Inflation • The more prices of our goods increase, the less demand for Cdn.$ (at any price) • Interest rate differential • If a positive differential increases, or a negative differential decreases, then there will be an increase in demand for CDN$ (at any price) • Expected future exchange rate • The higher the expected exchange rate, the greater the demand (at any price)

12. Interest Rate Differential – 3 Month T-Bills

13. Expected Future Exchange Rate

14. Increase in the demand for dollars 70 Decrease in the demand for dollars D1 D2 200 400 Changes in the Demand for Dollars 90 80 70 Exchange rate (US cents per Canadian dollar) 60 50 D0 0 100 200 300 400 500 Quantity (billions of Canadian dollars per day)

15. Exchange Rates Supply • CDN dollars are supplied by Canadians to convert to foreign currency to buy foreign goods/services, foreign investments, and to speculate in foreign currency • supply influenced by price (exchange rate)

16. Supply of CDN $ and the Imports Effect • An increase in the exchange rate • Imports become less costly for Canadians, which • Increases demand for imports, which • Increases the supply of CDN $

17. Exchange Rates • exchange rate is US$0.63 buys CDN$1 • a phone made in USA with a price of US$100, will cost a Canadian CDN$1.59 • exchange rate increases to US$0.70 buys CDN$1 • phone now costs the Canadian CDN$143 • more phones sold • increase in price of CDN dollar (exchange rate) increases supply of CDN dollar

18. Supply of CDN $ and the Expected Profit Effect • The greater the expected profit from speculating in foreign currency, the greater the supply of CDN $ • The higher the exchange rate • The greater the expected profit • The greater the supply of CDN $

19. Supply of CDN $ and the Expected Profits Effect

20. The Supply of Dollars S 90 80 Exchange rate (US cents per Canadian dollar) 70 60 50 0 100 200 300 400 500 Quantity (billions of Canadian dollars per day)

21. Changes in Supply of CDN$ • Inflation • The more prices of our goods increase, the more we import and the greater the supply of Cdn.$ (at any price) • Interest rate differential • If a positive differential increases, or a negative differential decreases, then there will be a decrease in supply of CDN$ (at any price) • Expected future exchange rate • The lower the expected future exchange rate, the greater the supply now (at any price)

22. Expected Future Exchange Rate

23. S1 S2 Decrease in the supply of dollars 70 Increase in the supply of dollars 400 Changes in the Supply of Dollars S0 90 80 70 Exchange rate (US cents per Canadian dollar) 60 50 0 100 200 200 300 400 500 Quantity (billions of Canadian dollars per day)

24. Surplus at 65¢ S Equilibrium at 63¢ Shortage at 61¢ D Equilibrium Exchange Rate US¢ / C$ 65 63 61 45 50 55 0 Q (C$) . • Textbook p. 422

25. S3 0.85 D3 Exchange Rate Changes Price of CDN $ (in US$) S2 0.80 D2 60 0 70 Q CDN $ . • Textbook p. 424

26. Cross Exchange Rates • Exchange markets insure that our currency buys the same amount of another country’s currency if we buy the other country’s currency directly, or through an intermediary country’s currency (assuming no transaction costs)

27. Cross Exchange Rates How many USD can you purchase directly with $500CAD, or indirectly by buying Euros?

28. Exchange Rate Systems • Flexible (Floating) Exchange Rates • currency allowed to move freely to equilibrium • Fixed Exchange Rates • currency exchange set at predetermined level • maintained by the govt buying or selling the currency to maintain price • Currency Union (European Union) • Merge the currencies of 2 or more countries

29. Exchange Rate Policy • Low Exchange Rates • increases exports, decreases imports • risk of inflation (demand-pull and cost push) • High Exchange Rates • decreases exports, increases imports • contractionary policy • Monetary Policy and Exchange Rates • higher interest rates encourage foreigners to invest in Canada, increasing our exchange rate

30. Canada’s Exchange Rate System • Managed Float (1971 -) • flexible exchange rate system that allows exchange rate to vary, with the govt. sometimes intervening