Lecture 16 - Lecture 16 1 International Monetary and...

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Lecture 16 1 International Monetary and Finance Structure The Role of Exchange Rates Introductory Macroeconomic theory behind the monetary system What factors determine the value of one country’s currency relative to another? When the state does not interfere in the market flexible or market based exchange rates are determined by the interaction of demand & supply in foreign exchange markets. As an example we can look at the Rupee -Dollar exchange rate In 1996 1$ = Rs.46 The demand for dollars reflects the desire of Pakistan’s domestic economy to buy US goods and services, to buy US assets (stocks and bonds and real estate etc.), and to travel to the US where they will spend dollars. So the quantity of dollars is inversely related to the price of dollars.
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Lecture 16 2 As the price of the dollar increases fewer dollars will be demanded i.e the dollar appreciates. So you need more Rs to buy one Dollar. As the dollar appreciates US goods and services become less attractive to domestic buyers so the quantity of dollars demanded will decrease. In summary when the Price of the Dollar will rise, its quantity demanded by Pakistan will fall--- this is a movement along the demand curve. The demand for dollars is effected also by interest rates in the US relative to those in Pakistan and the price level in the US relative to the price level in Pakistan If interest rates in the US rise relative to those in Pakistan, Pakistani investors will find US a good place to invest in and will buy interest earning assets. So more dollars will be demanded at every price level. Similarly if price levels in US rise less rapidly than price levels in Pakistan, the demand for dollars in Pakistan will increase. People want more dollars to buy more American goods. In the same way if business expectations in US are strong relative to Pakistan, Pakistani investors will find US assets desirable because of the anticipated capital gains.
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Lecture 16 3 This is reflected by a shift in the demand curve On the Supply Side The supply of dollars reflects the desire of US economy to buy Pakistan’s goods and services. Dollars are supplied in the international market to make these exchanges possible. The quantity supplied is related directly to the price. The supply curve will curve upwards. Why? If a football in Pakistan is Rs. 92, and the exchange rate of the dollar to the rupee is Rs. 46, then the football costs $2. If the dollar appreciates to Rs.69, the football becomes cheaper i.e. $1.50. And buying footballs is more desirable for the US. Thus US dollars supplied will increase as US wants to buy more. (this is a shift along the supply curve). Just as the demand for dollars in effected by interest rates so is the supply of dollars. As interest rates in Pakistan rise relative to US rates, the supply of dollars will
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This note was uploaded on 05/21/2010 for the course X 110 taught by Professor Xyz during the Spring '10 term at Louisiana College.

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Lecture 16 - Lecture 16 1 International Monetary and...

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