Econ ch 9

• Exchange rate

  The price at which one currency exchanges for another
• Currency depreciation


  A fall in the value of one currency in terms of another currency
• Currency appreciation


  A rise in the value of one currency in terms of another currency
• Foreign exchange market


  • The market in which the currency of one country is exchanged for the currency of another
  • A competitive market with many traders and no restrictions
• Demand for Canadian dollars

  The amount that traders plan to buy during a given time period at a given exchange rate
• Factors influencing demand for Canadian dollars

  • Exchange rate
  • World demand for Canadian exports
  • Interest rates in the U.S. and other countries
  • Expected future exchange rate
• Law of demand for foreign exchange

  As the exchange rate rises, the quantity of Canadian dollars demanded in the foreign exchange market decreases
• Reasons for law of demand

  • Exports effect
  • Expected profit effect
• Lower exchange rate


  Greater value of Canadian exports, greater quantity of Canadian dollars demanded
• Lower exchange rate today

  Greater expected profit from buying Canadian dollars, greater quantity of Canadian dollars demanded
• Supply of Canadian dollars

  The amount that traders plan to sell during a given time period at a given exchange rate
• Factors influencing supply of Canadian dollars

  • Exchange rate
  • Canadian demand for imports
  • Interest rates in Canada and other countries
  • Expected future exchange rate
• Law of supply of foreign exchange

  As the exchange rate rises, the quantity of Canadian dollars supplied in the foreign exchange market increases
• Reasons for law of supply

  • Imports effect
  • Expected profit effect
• Higher exchange rate


  Greater value of Canadian imports, greater quantity of Canadian dollars supplied
• Lower exchange rate


  Greater expected profit from holding Canadian dollars, smaller quantity of Canadian dollars supplied
• Surplus of Canadian dollars

  Drives the exchange rate down
• Shortage of Canadian dollars

  Drives the exchange rate up
• Equilibrium exchange rate


  The rate at which there is neither a shortage nor a surplus
• Changes in demand for Canadian dollars

  • Changes in world demand for Canadian exports
  • Changes in the Canadian interest rate relative to the foreign interest rate
  • Changes in the expected future exchange rate
• Increase in world demand for Canadian exports

  Increases the demand for Canadian dollars
• Rise in Canadian interest rate differential

  Increases the demand for Canadian dollars
• Rise in expected future exchange rate

  Increases the demand for Canadian dollars
• Changes in supply of Canadian dollars

  • Changes in Canadian demand for imports
  • Changes in the Canadian interest rate relative to the foreign interest rate
  • Changes in the expected future exchange rate
• Increase in Canadian demand for imports

  Increases the supply of Canadian dollars
• Rise in Canadian interest rate differential

  Decreases the supply of Canadian dollars
• Rise in expected future exchange rate


  Decreases the supply of Canadian dollars
• Arbitrage


  The practice of seeking to profit by buying in one market and selling for a higher price in another related market
• Outcomes of arbitrage


  • The law of one price
  • No round-trip profit
  • Interest rate parity
  • Purchasing power parity
• Law of one price

  If an item can be traded in more than one place, the price will be the same in all locations
• No round-trip profit


  Using currency A to buy currency B, and then using B to buy A, with no profit
• Interest rate parity


  When the rates of returns on two currencies are equal, taking into account exchange rate changes
• A currency is worth what it can earn
• Return on a currency

  The interest rate on that currency plus the expected rate of appreciation over a given period
• When interest rates are equal, taking into account exchange rate changes, interest rate parity prevails
• Outcomes achieved by the interaction of the money and goods markets


  • The law of one price
  • No round-trip profit
  • Interest rate parity
  • Purchasing power parity
• The law of one price

  If an item can be traded in more than one place, the price will be the same in all locations
• No round-trip profit


  A round trip is using currency A to buy currency B, and then using B to buy A. Arbitrage removes profit from all transactions of this type.
• Interest rate parity


  The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period. When the rates of returns on two currencies are equal, interest rate parity prevails.
• Purchasing power parity (PPP)


  A currency is worth the value of goods and services that it will buy. When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity.