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Foreign Exchange and Currencies

Foreign Exchange and Currencies. Economics 71a Spring 2007 Mayo, Chapter 6 (skim) Lecture notes 2.6. International Money Flows. Funds flow between countries Two basic reasons Trade flows Investment (capital) flows Central banks also intervene in these markets.

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Foreign Exchange and Currencies

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  1. Foreign Exchange and Currencies Economics 71a Spring 2007 Mayo, Chapter 6 (skim) Lecture notes 2.6

  2. International Money Flows • Funds flow between countries • Two basic reasons • Trade flows • Investment (capital) flows • Central banks also intervene in these markets

  3. The Demand and Supply of Foreign Currency • Example: U.S. ($) and France (euros) • U.S. consumer buys French wine • + demand for euros • U.S. firm sells ipod to French consumer • +supply for euros • U.S. investor buys French stock • +demand for euros • U.S. firm sells stock to French investor • +supply for euros

  4. Supply and Demand for Euros S P = $/euro D Q = euros

  5. The Demand and Supply of Foreign Currency • Example: U.S. ($) and France (euros) • U.S. consumer buys French wine • + demand for euros ($/euro rises) • U.S. firm sells ipod to French consumer • +supply for euros ($/euro falls) • U.S. investor buys French stock • +demand for euros ($/euro rises) • U.S. firm sells stock to French investor • +supply for euros ($/euro falls)

  6. $/euro = exchange rate • Amount of $’s required to purchase 1 euro • When this rises • $ price of euro goods rises (imports more expensive) • US consumers of imports worse off • Euro price of $ goods falls (U.S. exports cheaper) • US firms exporting better off • And investors feel • $ price of euro investments (stocks) rises • US investors holding foreign assets better off • Euro price of $ investments (stocks) falls • Foreign investors holding US assets worse off

  7. More Supply/Demand • In the end it is the aggregate of all of these that matters • One other key player: Central bank • Some central banks actively intervene to move (or fix) the exchange rate

  8. Foreign Exchange Markets • Huge markets • Open 24 hours • Moving both trade and investment flows • Important to international investors • As exchange rates move, values of investments change

  9. Balance of Payments(Measured over fixed period) • Exports - Imports = Trade account • >0 Trade surplus • <0 Trade deficit • Net new foreign investments = Capital account • <0 net investment flows out of country • >0 net investment flows into country • Trade account + net investment income + Capital account = 0 • Investment income relatively small

  10. U.S. Balance of Payments • Large trade deficit • Relatively small income flows • Large capital inflows • Borrowing from rest of world • Trading IOU’s for goods

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