Unit 7 - Mechanics of Foreign Exchange (5-3-16)

Mechanics of Foreign Exchange

• The buying and selling of currency
• Any transactions that occurs in the Balance of Payments necessitates foreign exchanges
• The exchange rate is determined in the foreign currency market

Changes in Exchange Rates

• Exchange rates (e) are a function of the supply and demand for currency
• An increase in supply of a currency will decrease exchange rate of currency
• A decrease in supply of currency will increase exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases

Exchange Rate Determinants

• Consumer Tastes
• Relative Income
• Relative Price Level
• Speculation

Exports & Imports

• Exchange rate is a determinant of both exports and imports
• Appreciation of the dollar causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports
• Depreciation of the dollar causes American goods to be relatively cheaper and foreign goods to be relatively more expensive thus increasing exports and reducing imports

Floating/Flexible Rates

• Based upon supply and demand of that currency vs other currencies
• Very sensitive to business cycle and provides options for investments

Fixed Rate

• Based on a country's willingness to distribute currency and to control the amount