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Week_11_-_Open_Economy_Part_1 - 1 ECMA06 Open Economy(Part...

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1 ECMA06 – Open Economy (Part 1) Open Economy (Part 1) Outline What is the foreign exchange market? Discuss factors that affect demand for and supply of a country’s currency. Use of the demand and supply curves of C$ in the foreign exchange market to determine the value of C$. Discuss different exchange rate regimes. Go through a numerical example to show how changes in exchange rate affect the economy.
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2 The Foreign Exchange Market The foreign exchange market is the market where we exchange one currency for another, and the price in the market is the exchange rate, E. There are two ways to quote exchange rate: 1) The value of foreign currency, say US$, in C$ (i.e., # of C$ needed to exchange 1 US$), E C$ per US$ . 2) The value of C$ in US$ (i.e., # of US$ needed to exchange 1 C$), E US$ per C$ . In our class, exchange rate is quoted as the # of US$ needed to exchange 1 C$, E US$ per C$ . The relationship between these two quotations is: The exchange rate is determined by the forces of demand for and supply of C$ internationally . There is a big difference between the exchange rate and interest rate, do don’t get yourself confused!
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3 ECMA06 – Open Economy (Part 1) Foreign Exchange Market vs. (Domestic) Money Market (International) Demand for C$ vs. (Domestic) Demand for Money Demand for C$ in the foreign exchange market comes from people who want to use foreign currency to buy C$ (i.e., mostly people who are outside Canada). They need C$ because they want to buy Canadian goods and/or Canadian assets . (Domestic) Demand for money , L(r, Y), is the demand for liquidity by people reside in Canada (i.e., Canadians who live in Canada). Demand for money comes from: 1) Canadians want to hold a portion of their wealth in the form of liquid assets such as cash. 2) We need to have cash in our pockets to facilitate our daily transactions .
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4 (International) Supply of C$ vs. (Domestic) Supply of Money Supply of C$ in the foreign exchange market comes from people who want to use C$ to buy foreigners (i.e., usually Canadians). They need to sell C$ because they want to buy foreign goods and/or foreign assets . ( Domestic) Supply of money , MS, is determined by the Bank of Canada and the commercial/chartered banks (from the loan creation process). MS = Currency in circulation + Demand deposits.
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5 ECMA06 – Open Economy (Part 1) Sources of (International) Demand for C$ & Supply of C$ A country’s BOP accounts summarize its international transactions with the rest of the world: By looking at these accounts, we will have an idea where the sources of the demand for and supply of a country’s currency come from. We know that whenever foreigners buy stuffs from us, there will be a demand for C$; and whenever we buy stuffs from them, there will be supply of C$.
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