week13 single session - Exchange Rates and Macroeconomic...

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Exchange Rates and Macroeconomic Policy EC1301 Week 13 Read: Chapter 29 (Skip “Concerns about the Trade Deficit”)
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Outline Exchange Rates and the Macroeconomy Government Intervention in Currency Markets Explaining Exchange Rate Movements Supply and Demand in Currency Markets Currency Markets 2
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Currency Markets Currencies are traded for one another in Currency Markets Local money-changer Big currency exchanges at major financial centers of London, NY, Tokyo, SG etc. Also called Foreign Exchange Markets You buy a currency by selling another currency 3
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Exchange Rates Exchange Rate = rate at which one currency is exchanged for another Let USA be domestic while Britain is foreign Exchange rates are stated in two ways 1) Number of units of domestic currency per unit of foreign currency E.g. USD1.60 = GBP1 Think of this as Price of Foreign Currency 2) Number of units of foreign currency per unit of domestic currency e.g. GBP0.63 = USD1 4
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Appreciation and Depreciation Appreciation = Currency becomes stronger That is, price of foreign currency falls If we use (1), exchange rate rises/falls Depreciation = Currency becomes weaker That is, price of foreign currency rises If we use (1), exchange rate rises/falls When one currency appreciates, it necessarily means the other currency depreciates 5
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Floating Exchange Rates In some currency markets, the exchange rate is determined purely by supply and demand Such exchange rates are called Floating Exchange Rates We first examine how floating exchange rates are determined Thereafter, we examine government intervention in currency markets 6 Back to Outline
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Supply and Demand in Currency Markets Standard Supply and Demand model Price of Foreign Currency on vertical axis Quantity of Foreign Currency on horizontal axis 7 Dollars Per Pound Millions of British Pounds 1.50 300 S GBP D GBP E US = Domestic Britain = Foreign
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Demand for GBP in USD-GBP₤ market Assume for simplicity that US residents are the only people who have USD and want to exchange for GBP Why do US residents want GBP? 1. To buy British goods 2. To buy British assets 8
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Demand for GBP in USD-GBP market If Price of GBP falls … … then British goods are cheaper than before for US residents Thus, US residents will buy more British goods Thus, quantity demanded for GBP rises Thus, downward sloping demand curve for GBP 9 USD Appreciates USD Depreciates
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Shifts in Demand for GBP in USD-GBP market 10 Factor Direction of shift in D GBP Rise in US Real GDP Left / Right Increased taste for British goods and services by US residents Left / Right Rise in US price level relative to British price level Left / Right Rise in US interest rate relative to British interest rate Left / Right GBP is expected to appreciate Left / Right
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Assume for simplicity that British residents are the only people who have GBP and want
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week13 single session - Exchange Rates and Macroeconomic...

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