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FOREIGN EXCHANGE. 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 / $0.65). Exchange Rate (US$ per CDN$). Exchange Rates. appreciates

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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)

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

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)

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

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 $

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 $

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)

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)

demand for dollars

70

Decrease

in the

demand for

dollars

D1

D2

200

400

Changes in the Demand for Dollars90

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)

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)

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 $

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

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 $

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)

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)

S1

S2

Decrease in the

supply of dollars

70

Increase in the

supply of dollars

400

Changes in the Supply of DollarsS0

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)

at 65¢

S

Equilibrium

at 63¢

Shortage

at 61¢

D

Equilibrium Exchange RateUS¢ / C$

65

63

61

45

50

55

0

Q (C$)

.

- Textbook p. 422

S3

0.85

D3

Exchange Rate ChangesPrice

of CDN $

(in US$)

S2

0.80

D2

60

0

70

Q CDN $

.

- Textbook p. 424

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)

Cross Exchange Rates

How many USD can you purchase directly with $500CAD,

or indirectly by buying Euros?

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

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

Canada’s Exchange Rate System

- Managed Float (1971 -)
- flexible exchange rate system that allows exchange rate to vary, with the govt. sometimes intervening

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