foreign exchange and currencies

Foreign Exchange and Currencies

Economics 71aSpring 2007

Mayo, Chapter 6 (skim)Lecture notes 2.6

International Money Flows

Funds flow between countriesTwo basic reasons

Trade flows Investment (capital) flows

Central banks also intervene in these markets

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

Supply and Demand for Euros

P = $/euro

Q = euros

D

S

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)

$/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

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

Foreign Exchange Markets

Huge marketsOpen 24 hoursMoving both trade and investment flows

Important to international investors

As exchange rates move, values of investments change

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

U.S. Balance of Payments

Large trade deficitRelatively small income flowsLarge capital inflows

Borrowing from rest of world Trading IOU’s for goods