IB Econ Study Guide Internationals - Sunny Hills High School

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108 Demand for foreign lmagine the world consisting of only two countries, Japan and Australia. The Japanese currency is the yen (JPY) and the Australian currency is the Australian dollar (AUD). In this simplified setup the question is: who demands Australian dollars in the foreign exchange market? The answer is a lapanese entity (household or firm) which does not have Australian dollars but needs them. Why would a Japanese entity need Australian dollars? Some basic reasons include: A Japanese company planning to purchase Australian wool or iron ore (export of a good). A Japanese couple planning to visit Uluru in central Australia where the second largest monolith in the world is located (export of a service - tourism). A resident of Japan wishing to make a savings deposit in Australian dollars or to buy Australian government bonds (an investment into Australia). A resident of Japan wishing to buy shares in an Australian mining company (an investment into Australia). . A Japanese company establishing a presence in Australia (an investment into Australia). More generally, any foreigner wishing to buy Australian goods and services or to make investments in Australia will need to buy Australian dollars. The first two reasons are related to international trade flows whereas the rest are related to international investment flows. In summary . The demand and supply of currencies in foreign exchange markets reflect internationaltrade flows and crossborder investment flows. . The demand for a country's currency reflects the value of its exports of goods and services as well as the inflow of investments into the country Exchange rate To simplify the analysis letl assume that there are no cross-border investments so that only exports and imports of goods and servrces (trade f,ows) create a reed to exchange currencies. We'll take the example of the Us and the EU15 (the 15 countries in the European Union before the expansion on 1 May 2004). Americans demand euros to buy EU15 goods and services and Europeans supply euros to buy (dollars and thus) American goods and services (Fig. 4.1 0). At the exchange raie e7 the supply of euros e/b reflects the value of imports into the FU15 while the demand for euros is e7a and reflects the value of EU15 exports to the US. The EU15 has a trade deficit as M > X and an excess supply of euros exists in the market equal to line segment ab. This excess supply of euros ln the foreign exchange market creates pressure for the price of the euro to .la.ra>
Exchange rate This has two effeds: EU15 exports become cheaper and more competitive while imports become pricier and thus less attraqtive. Eventually the value of EU 15 exports will increase and the expenditures on imports will shrink, tending to balance trade flows. This will happen when the exchange rate reaches e*. At e*, demand for euros is equal to supply of euros per period and trade balance is restored. At the exchange rate e2 the supply of euros e2h reflects the value of imports into the EU15 while the demand for euros is eZ and reflecb the value of EU15 exports to the U5. The EU15 has a trade surplus as X > M and an excess demand for euros exists in the market equal to Iine segment hf. The excess demand for euros in the foreign exchange market creates pressure for the price of the euro to increase (to appreciate). This has two effects; EU'i5 exports become more expensive and thus less competitive while imports become cheaper and thus more attractive. Eventually the value of EU15 exports will decrease and the expenditures on Why do exchange Since we established that the demand and the supply of a currency in the foreign exchange market reflect trade flows and investment flows between countries, it follows that factors that may affect trade flows and factors that may affect investment flows will in turn tend to affect the exchange rate of a currency. Factors that may affect trade flows: changes in relative growth rates A higher groMh rate implies that incomes are rising faster Consumotion exDenditures rise when incomes rise and household consumption includes spending on both domestic and foreign goods and services. lt follows that in a growing economy, imports rise. In Fig.4.11 the price of the Indonesian rupiah is initially assumed at e7. lf Indonesian groMh accelerates then Indonesians' incomes are rising so their consumption expenditures will rise. This means that they will also buy more foreign products. Indonesians will thus have to supply more of their currency, the rupiah, in the foreign exchange market to buy the necessary dollars in order to buy more imports Supply of the rupiah will shift to the right to 52 as imports are now greater (M2 > M1). imports will increase, tending to balance trade flows. This will happen when the exchange rate reaches e*. At e", demand for euros is equal to supply of euros per period and trade balance is restored. . lt follows that a trade deficit creates pressure for the exchange rate to depreciate whereas trade surplus creates pressure for the exchange rate to appreciate. The above descriDtion oresents an idealized view. In the realworld a number of oroblems complicate matters. First of all exchange rates are very much affected by cross-border investments (the buying and selling of bonds and stocks and speculation) and not only by trade flows. Any change in interest rates or in investment sentiment may offset the equilibrating forces described earlier Lastly, whether a depreciating currency will increase the yalue of exports depends on the price elasticity of exports. The lower-priced exports will definitely increase the volume of exports per period but whether their value increases depends on the price elasticity of exports. Figure 4.'ll Effect of a growing economy on the exchange rate E T'1 ! ijc :ie EsC S'l o{ Rupiah (M1) Rupiah (M2 > M1) D tor Rupiah (x) Rupiah traded per p€riod As a result, the rupiah r4,/ill tend to depreciate 10 e2. This is a very interesting resull that is seemingly counterintuitive. A growing economy may witness a depreciating currency. 109
Page 1 and 2: International economics Free trade
Page 3 and 4: 100 Does it make sense? Economic ar
Page 5 and 6: Voluntary Voluntary export restrain
Page 7 and 8: The bilateral/regional . The region
Page 9: The terms strictly refer to offlc,a
Page 13 and 14: Why do Factors that may affect inve
Page 15 and 16: How does a fixed It will be maintai
Page 17 and 18: Current account The current account
Page 19 and 20: Current account Remember a current
Page 21 and 22: Terms of trade: causes and effects

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