FOREIGN EXCHANGE RATES

Most common contact with foreign exchange occurs when we travel or buy things in other countries. Suppose a U.S. tourist travelling in London wants to buy a sweater. Price tag is 100 pounds. Current exchange rate Price of sweater in dollars $1.45 to £1 $1.30 to £1 $1.60 to £1 Pound falls Pound rises 100 x 1.45 = $145.00 100 x 1.30 = $130.00 100 x 1.60 = $160.00 Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates becomes important. Stronger US dollar implies U.S. can buy foreign goods more cheaply è Cost of purchasing foreign goods falls Foreigners find U.S. goods more expensive and demand falls è Does not help firms that produce for exports Weaker U.S. dollar implies Foreigners buy more U.S. goods è Helps firms that rely on exports Foreign goods become more expensive è Demand for imports falls It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months. The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates. Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk. When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy: Affects the prices of imported goods Affects the overall level of price and wage inflation Influences tourism patterns May influence consumers’ buying decisions and investors’ long-term commitments.

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DETERMINATION OF FOREIGN EXCHANGE RATES

Exchange rates respond directly to all sorts of events, both tangible and psychological— Business cycles; Balance of payment statistics; Political developments; New tax laws; Stock market news; Inflationary expectations; International investment patterns; And government and central bank policies among others. At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall. The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its central bank), consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals. Too much money è inflation è value of money declines è prices rise Too little money è sluggish economic growth è rising unemployment Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply. Sources for currency demand on the FX market: The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports. Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them. FX traders speculate within the market about how different events will move the exchange rates. For example: News of political instability in other countries drives up demand for U.S. dollars as investors are looking for a "safe haven" for their money. A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries. Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

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