19.2 The Foreign-Exchange Market

Question 1

What does trade between countries normally require?

Answer 1

Trade between countries normally requires the exchange of one national currency for another.

Question 2

What is the exchange of one currency for another called?

Answer 2

The exchange of one currency for another is called a foreign-exchange transaction.

Question 3

In Canada, what is the exchange rate?

Answer 3

The exchange rate is the Canadian-dollar price of one unit of foreign currency. For example, in April 2021, the price of one U.S. dollar was 1.25 Canadian dollars. Thus, the Canada–U.S. exchange rate was 1.25.

Question 4

How is the exchange rate usually expressed in the media?

Answer 4

Note that in the Canadian news media the exchange rate is usually expressed in the opposite way—as the number of U.S. dollars that it takes to buy one Canadian dollar.

So instead of reporting that the Canadian–U.S. exchange rate in April 2021 was 1.25, the press would say that the Canadian dollar was “worth” 80 U.S. cents . ( 1/1.25)

Question 5

How are we always going to define the exchange rate in this book?

Answer 5

In this book we always define the exchange rate in the way Canadian economists usually do—as the Canadian-dollar price of one unit of foreign currency. This definition makes it clear that foreign currency, like any good or service, has a price expressed in Canadian dollars. In this case, the price has a special name—the exchange rate.

Question 6

What does an appreciation of the Canadian dollar mean?

Answer 6

An appreciation of the Canadian dollar means that the Canadian dollar has become more valuable so that it takes fewer Canadian dollars to purchase one unit of foreign currency.

For example, if the Canadian dollar appreciates against the U.S. dollar from 1.25 to 1.15, it takes 10 fewer Canadian cents to purchase one U.S. dollar.

Thus, an appreciation of the Canadian dollar implies a fall in the exchange rate.

Question 7

What does a depreciation of the Canadian dollar mean?

Answer 7

A depreciation of the Canadian dollar means that the Canadian dollar has become less valuable so that it takes more Canadian dollars to purchase one unit of foreign currency.

Thus, a depreciation of the Canadian dollar means a rise in the exchange rate.

Question 8

What does a demand and supply of forieign currency imply?

Answer 8

Because Canadian dollars are traded for euros in the foreign-exchange market, a demand for euros implies a supply of Canadian dollars, and a supply of euros implies a demand for Canadian dollars.

Question 9

Do we deal with supply or demand when learning theory of exchange rates?

Answer 9

For this reason, a theory of the exchange rate between dollars and euros can deal either with the demand and supply of dollars or with the demand and supply of euros; both need not be considered.

Question 10

What is the “product” and “price” in foreign-exchange?

Answer 10

Thus, the market we will be considering (in general terms) is the foreign-exchange market—the “product” is foreign exchange (euros in our case) and the “price” is the exchange rate (the Canadian-dollar price of euros).

Question 11

Are transations that generate a receipt for canada “supply” or “demand”?

Answer 11

recall that in the market for foreign exchange, transactions that generate a receipt for Canada in its balance of payments represent a supply of foreign exchange. Foreign exchange is being supplied by the foreigners who need Canadian funds to purchase Canadian goods or assets.

Question 12

Are transations that are a payment from Canada “Supply” or “Demand”?

Answer 12

Transactions that are a payment from Canada in the balance of payments represent a demand for foreign exchange.

Foreign exchange is being demanded by the Canadians who are purchasing foreign goods or assets.

Question 13

What assumption do we make concerning the Bank of Canada and the foreign-exchange market?

Answer 13

In what follows we make the (realistic) assumption that the Bank of Canada makes no transactions in the foreign-exchange market.

Question 14

What does the supply of foreign exchange arise from?

Answer 14

Whenever foreigners purchase Canadian goods, services, or assets, they supply foreign currency to the foreign-exchange market and demand, in return, Canadian dollars with which to pay for their purchases.

Thus, the supply of foreign exchange (and the associated demand for Canadian dollars) arises from Canada’s sales of goods, services, and assets to the rest of the world.

Question 15

What is an important sorce of supply of foreign exchange? What are some examples?

Answer 15

One important source of supply of foreign exchange is foreigners who wish to buy Canadian-made goods and services.

A French importer of Canadian lumber is such a purchaser; an Austrian couple planning a vacation in Canada is another; the Hungarian government seeking to buy Canadian engineering services is a third. All are sources of supply of foreign exchange, arising out of international trade.

Question 16

What is a second source of supply of foreign exchange?

Answer 16

A second source of supply of foreign exchange comes from foreigners who want to purchase Canadian assets, such as government or corporate bonds, real estate, or shares in a Canadian firm.

Question 17

How do holders of foreign currency buy Canadian assets?

Answer 17

To buy Canadian assets, holders of foreign currencies must first sell their foreign currency in return for Canadian dollars. As we saw earlier in the chapter, when Canadians sell assets to foreigners, we say there is a capital inflow to Canada.

Question 18

How is reserve currency a supply of forgien exchange?

Answer 18

Firms, banks, and governments often accumulate and hold foreign-exchange reserves, just as individuals maintain savings accounts. These reserves may be in several different currencies. For example, the government of Poland may decide to increase its reserve holdings of Canadian dollars and reduce its reserve holdings of euros; if it does so, it will be a supplier of euros (and a demander of Canadian dollars) in foreign-exchange markets.

Question 19

What is the supply of foreign exchange the sum of?

Answer 19

The supply of foreign exchange (or the demand for Canadian dollars in the foreign-exchange market) is the sum of the supplies for all the purposes just discussed

- For purchases of Canadian goods and services
- Canadian assets.
- The purchase of Canadian dollars to add to currency reserves.

Question 20

What is the demand for any one currency a combination of?

Answer 20

Because people, firms, and governments in all countries purchase goods and assets from many other countries, the demand for any one currency will be the aggregate demand of individuals, firms, and governments in a number of different countries.

Question 21

How is the supply of foreign exchange represented graphically?

Answer 21

The supply of foreign exchange on the foreign-exchange market is represented by a positively sloped curve.

This figure plots the Canadian-dollar price of euros (the exchange rate) on the vertical axis and the quantity of euros on the horizontal axis.

Moving up the vertical axis, more dollars are needed to purchase one euro—the Canadian dollar is depreciating.

Moving down the vertical axis, fewer dollars are needed to purchase one euro—the dollar is appreciating.

Question 22

Graph of the Foreign-Exchange Market

Answer 22

The demand for foreign exchange is negatively sloped, and the supply of foreign exchange is positively sloped, when plotted against the exchange rate, measured as the Canadian-dollar price of one unit of foreign currency.

Question 23

What does the blue line on the Foreign-Exchange graph represent?

Answer 23

The demand for foreign exchange is given by the blue line D. It represents the sum of transactions on both current and capital accounts that require payments to foreigners.

Question 24

What does the red line in the Foreign-exchange graph represent?

Answer 24

The supply of foreign exchange is given by the red line S. It represents the sum of transactions on both current and capital accounts that represent receipts from foreigners.

Question 25

Why is the supply curve for foreign exchange positively sloped? Let’s consider what happens when Europeans are buying Canadian exports

Answer 25

If the Canadian dollar is depreciating (moving up the vertical axis), the euro prices of the Canadian exports are falling and so Europeans will want to buy more.

To make these additional purchases, they increase their supply of euros to the foreign-exchange market in order to acquire the Canadian dollars they need to pay for the Canadian products.

In the opposite case, when the dollar appreciates (moving down the vertical axis), the euro price of Canadian exports rises. European consumers will buy fewer Canadian goods and thus supply less foreign exchange

Question 26

What happens to Canadian securities and other assets when the Canadian dollar depreciates?

Answer 26

When the Canadian dollar depreciates (a higher exchange rate), Canadian securities and other assets become more attractive purchases, and the quantity purchased by foreigners will rise. With this rise, the amount of foreign exchange supplied to pay for the purchases will increase.

Question 27

What are the factors of The Supply of Foreign Exchange

Answer 27

Canadian Exports
Canadian Asset Sales: Capital Inflows
Reserve Currency

Question 28

What does the demand for foreign exchange arise from?

Answer 28

The demand for foreign exchange arises from all international transactions that represent a payment for Canada in our balance of payments.

Question 29

What sorts of international transactions generate a demand for foreign exchange (and a supply of Canadian dollars)?

Answer 29

Canadians seeking to purchase foreign products will be supplying Canadian dollars and demanding foreign exchange for this purpose.

Canadians may also seek to purchase foreign assets. If they do, they will supply Canadian dollars and demand foreign exchange.

Similarly, a country with reserves of Canadian dollars may decide to sell them in order to hold some other currency instead.

Question 30

What happens when the canadian dollar depreciates against another country.

Answer 30

When the Canadian dollar depreciates against the euro, the Canadian-dollar price of European goods rises.

Because it takes more dollars to buy the same European good at an unchanged euro price, Canadians will buy fewer of the now more expensive European goods.

The amount of foreign exchange being demanded by Canadians in order to pay for imported European goods will fall.

Question 31

What kind of slope does the demand curve for foreign exchange have? What does it imply?

Answer 31

The demand curve for foreign exchange is negatively sloped when it is plotted against the exchange rate; an appreciation of the Canadian dollar (a fall in the exchange rate) increases the quantity of foreign exchange demanded.