The Foreign Exchange

Market

BFSM 1101-Week 9
Sources for information in these slides unless otherwise noted:
Cecchetti, Stephen G. and Redish, Angela. Money, Banking and Financial
Markets. Canadian edition. McGraw-Hill Ryerson, 2010.
Mishkin and Serletis, The Economics of Money, Banking and Financial Markets.
4th Canadian Edition, Pearson Education Canada, 2011.
Flows of Funds Through the
Financial System
Today’s Objectives
 Understand the mechanics and importance of the
foreign exchange market.

 Explain how exchange rates are determined.

Reading: Text, Chapter 18, pp. 460 - 476

Exchange Rates
 Exchange rate represents the price of one country’s
currency in terms of another

 Expressed in two ways:

 the amount of U.S.$ that can be purchased with one Cdn.$

 1Cdn$ = $0.80 U.S. – this means one Cdn$ buys $ 0.80 U.S.

 the amount of Cdn$ that can be purchased with one U.S.$

 1U.S.$ = $1.24 Cdn – this means that it will cost you

$1.24 Cdn to buy one U.S.$
Exchange Rates

 Depreciation
 A decline in the value of one currency relative to
another is called depreciation.

 Appreciation
 A rise in the value of one currency relative to
another is called an appreciation.

Note: When one currency appreciates in value relative

to another, the other currency must depreciate in
value.
Foreign Exchange Market

 Foreign currencies are purchased in the foreign exchange market.

 Foreign exchange market determines the rates at which foreign

currencies are exchanged.

 The foreign exchange rate determines what we pay for foreign

goods and assets and what foreigners pay for ours.

 The value of foreign exchange transactions is enormous -- $1.5

trillion daily.

 Major foreign exchange markets – London, New York, Tokyo,

Singapore
Why are exchange rates important?

 They determine how much we pay for imported

goods

 They determine how much we receive for our exports

 Consequently, they affect the competitiveness of

Canadian businesses in domestic and foreign
markets
How are exchange rates
determined?
 Long-term exchange rates (years)
 Theory of purchasing power parity (PPP)

 Short-term exchange rates (day-to-day)

 Supply and demand in foreign exchange market
Exchange Rate in the long-run –
Purchasing Power Parity (PPP)
 The dollar price of a basket of goods and services in the
United States should be the same as the dollar price of a
basket of goods and services in Canada, Japan, the
United Kingdom or anywhere else in the world.

 In reality, the same commodity or service sells for vastly

different prices in different countries.

 Over the long term, exchange rates move toward the

rate that equalizes the price of an identical basket of
goods in each country
PPP – Big Mac Index*
 A simple way of illustrating PPP and how
exchange rates adjust to changing price levels

 Implies that exchange rates will adjust so that in

the long run, the U.S.$ price of a Big Mac should
be the same in each country

 *Sources: The Economist. Cecchetti and Redish, p. 212.

PPP: Why the “Big Mac” Index?*
• Sold in over 120 countries around the world

• Is the same in each country…

“…two all beef patties, special sauce, lettuce, cheese, pickles,
onions on a sesame seed bun.”

• $U.S. dollar price should be the same regardless of

where you buy it

*Sources: The Economist. Cecchetti and Redish, p. 212.

PPP – Big Mac Index*
 In 2007, according to PPP

 If you pay $3.22 U.S. for a Big Mac in Buffalo

then…

 a Big Mac in Toronto should cost the equivalent of

$3.22 U.S. (or about $3.08 CDN). If this is not the
case then…

 Exchange rates will adjust in the long-run to

equalize the $U.S. dollar price
 *Sources: The Economist. Cecchetti and Redish, p. 212.
PPP – Big Mac Index Example (based on 2007
rates)*

 In February 2007, the average $U.S price of a Big Mac in the U.S. was
$U.S. 3.22
 In Canada, a Big Mac cost $3.63 Cdn or $U.S. 3.08 based on an
exchange rate of $1.18 Cdn. per $US dollar ($3.63 / 1.18 = $3.08)
 Therefore, it costs more to buy a Big Mac in the U.S. than in Canada
($3.22 vs. $3.08), suggesting the Cdn dollar is undervalued
 PPP states that over the long-term, exchange rates will adjust to
equalize the $U.S. price of a Big Mac in Canada and the U.S.
 This rate is the “Implied PPP” and equals $1.13 CDN ($3.63 / $3.22)
 If PPP holds, then $1 U.S. should buy $1.13 CDN -- since $1
U.S. buys $1.18 CDN, then the Cdn. Dollar is undervalued by 4.5% (1.13
– 1.18 / 1.18)
PPP states that Cdn dollar should appreciate to $1.13 CDN
What happened to the Cdn dollar in 2007?

*Sources: The Economist. Cecchetti and Redish, p. 212.

PPP: Summary
 Big Mac Index
 Changes in exchange rates are tied to differences in prices
of Big Macs from one country to another

 If prices of Big Macs are higher (lower) in one country,

relative to another country, then country with higher (lower)
prices will experience a currency depreciation (appreciation)
PPP Summary

 More broadly, exchange rates reflect price

differences between two countries
 If one country’s prices (inflation) rise relative to another
country’s prices, then the country with the higher prices will
see its currency depreciate (and the other country’s
currency will appreciate)

 PPP is a useful indicator of long-term exchange rate

movements
Exchange Rate Changes: Short-
Term
 How do we explain short-term exchange rate volatility
(eg. Daily, weekly changes)

 Like any other commodity, exchange rates are

determined by interaction of supply and demand

 If demand for $Cdn exceeds supply, value of $Cdn will

rise

 If supply exceeds demand, dollar will fall

Exchange Rate in the Short-run

 The supply curve for dollars slopes upward.

 The more valuable the dollar (ie. the more euros one
Cdn dollar buys), the cheaper foreign goods,
services, and assets will be, and the higher the
supply of dollars in the dollar-euro market

 That is, people sell Cdn dollars in exchange for

Euros
Exchange Rate in the Short-run
 The demand curve for dollars is downward sloping

 As the price of the Cdn dollar falls, (purchases fewer Euros),

Canadian-made goods and services become cheaper.

 The cheaper a good or service, the higher the demand for it.
 The cheaper the dollar - the lower the dollar-euro exchange rate
 the more attractive are Canadian goods and services and the higher
the demand for dollars with which to buy them
Short-Run Exchange Rates

 Any factor that causes the demand for Canadian

dollars to increase on foreign exchange markets
results in an appreciation of the Cdn$.

 Any factor that causes the supply of Canadian

dollars to increase on foreign exchange markets
will result in a depreciation of the Cdn$.
Short-Run Exchange Rates – Factors
affecting supply and demand
Increased Supply of $Cdn
- leads to depreciation in
value of $Cdn
- decrease in Canadian
interest rates
-Increase in Canadian
preference for foreign goods
(Imports)
- Increase in Canadian wealth
(eg. increased travel, purchase
of foreign goods
Increased Demand
for $Cdn
-leads to appreciation in value
of $Cdn
- increase in Cdn interest rates
-Increase in foreign preference for
Cdn goods (exports)
-Increase in foreign wealth
(increased travel, purchase of
Canadian goods
- Canadian economic growth
Government Policy and Foreign Exchange
Intervention
 Government officials can intervene in foreign exchange
markets in several ways
 adopting a fixed exchange rate and act to maintain it at a level of
their choosing.

 policymakers will buy or sell currency in an attempt to affect

demand or supply (foreign exchange intervention) - rarely used in
Canada

 Bank of Canada indirectly influences exchange

rate through monetary policy and changes to interest rates
Next Class

 Midterm Exam – December 4th

 December 11th - Financial Intermediation and

Financial Institutions