202-T&C-12 - 1 Econ 202 Terms and Concepts 12 TRADE...

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Econ 202: Terms and Concepts 12: TRADE, CURRENCY and the BALANCE OF PAYMENTS In trade, a country is paid for its exports in its domestic currency. This means that an importer must first buy the currency of a country and then use the currency to buy the goods of that country. Domestic Price of Foreign Good = Foreign Price of Foreign Good x Domestic Price of Foreign Currency This necessitates a system for determining how much of a foreign currency a unit of domestic currency will buy. That is called an exchange rate system exchange rate - the unit price of a currency quoted in some other currency. The direction of the exchange rate must be stated, for example, the exchange rate between US dollars and Canadian dollars (USD/CAD) was 0.89 on November 16, 2014. This means that one Canadian Dollar costs 0.89 US dollars. The currency stated in the denominator is the currency whose unit equals 1, and the currency stated in the denominators is the currency being used to buy one unit of the currency in the denominator. The numerator shows the cost of one unit of 'foreign' currency. Because currency can be exchanged in either direction, USD/CAD and CAD/USD are reciprocals of each other. If one Canadian dollar costs US$0.89, the one US dollar costs 1÷ 0.89, or CA$1.123. The bank that performs the currency exchange keeps a 'wedge' as its fee, so the two exchange rates as quoted will not be perfect reciprocals. But we will ignore that transaction fee in our calculations to keep things simple. When we think of this in terms of real goods and services, the meaning of the exchange rate quote above is that something which cost CA$1.00 in Canada would only cost US$0.89 in the United States. ARBITRAGE arbitrage - is the practice of buying and selling currencies. A person who does this is called an arbitrageur. Most large banks will have an arbitrage department, not only for providing foreign currency to their customers but also for managing any foreign currency assets on their own balance sheet. We saw in the last unit that small changes in a bank balance sheet can have large consequences for a bank because their Equity positions are so small relative to their Liabilities. For banks that do business in multiple countries, managing currency reserves is an important function so that the bank does not lose asset value on fluctuating exchange rates. TYPES OF EXCHANGE RATE SYSTEM There are two basic types of exchange rate systems: fixed exchange - under a fixed exchange, the quantity of each currency issued is set as a multiple of some reserve standard , typically gold or silver, which has a highly inelastic supply. The reserve multiple of various trading partners then automatically determines the exchange rates between their currencies. Example, if the US and Germany were both on a gold standard , and the US issued $30 per troy ounce of gold and Germany issued 40 DM per troy ounce of gold, the the exchange rate between the dollar and the Deutschemark would be 3/4 (0.75) dollars per Deutschemark, and 4/3 (1.33) 1 1
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Deutschemarks per dollar. In order to change the exchange rate between these two currencies, one or the
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