# The exchange rate

We now include capital flows between countries. We denotes the foreign currency by the symbol \$ while € denotes the domestic currency. Remember that the exchange rate E is the units of € we need to by one unit of \$. For example, E = 0.8 €/\$ means that \$1 costs 0.8€. That in turn means that €1 costs \$1.25. Note that if E is the exchange rate in €/\$ then 1/E is the exchange rate in \$/€.

In principle, there are two reasons for selling or buying currency:

• Foreign investment

Domestic firms that import goods from abroad must pay for the goods using \$. Since they are paid in €, they will continuously need to sell € and buy \$. Domestic import firms create a demand for \$. People in our country that visits foreign countries will also contribute to this demand.

Foreign firms that import goods from our country must pay in €. They thereby create a demand for €. Whenever there is a demand for €, there will be a simultaneous supply of \$. Foreign importers create a supply of \$ (foreign tourists also contribute to this supply). Note that even though foreign importers pay in \$, the end result will be the same. If domestic exporters receive payments in \$, they will contribute to the supply of \$ as they have expenses in €.

Imports create a demand for \$ Exports create a supply of \$

## Capital flows

Another factor that contributes to the demand and supply of \$ are capital flows. If someone in our country wants to invest abroad, she must first buy \$ thereby adding to the demand for \$. In the same way, foreigners who want to invest in our country must first buy € and they will contribute to the supply of \$.

Domestic investments abroad adds to the demand for \$. Foreign investing in our country adds to the supply of \$.

We begin by analyzing how E affects exports and imports (X and Im). Imagine first that E = 0.8 €/\$. A product that costs \$100 abroad will cost €80 in our country (ignoring transportation costs and other factors affecting the validity of PPP). A domestic product costing €100 will cost \$125 abroad.

Say that E increases to 0.9 €/\$ (everything else the same). € has depreciated or has been devalued and is now weaker against \$. The \$100 good now costs €90 in our country. Foreign-produced goods have become more expensive in our country and imports will decrease. The €100 good will now cost \$111 abroad. Domestically produced goods have become cheaper abroad and exports will increase.

Depreciation or devaluation (E up = weaker currency): X increases, Im decreases Appreciation or revaluation (E down = stronger currency): X decreases, Im increases

This is true if everything else is the same, an important qualification as we will soon see.

## Investment and the exchange rate

When you invest money abroad, the future exchange rate at the time when you want to transfer your funds back to your country is important. Say for example that you invest €1 million in the foreign country at a 10% interest rate. When you make the investment, E = 0.8 €/\$ which means that you invest \$1.25 million. After one year, this amount has increased to \$1.375 million.

If the exchange rate is the same one year later, this amount is equal to €1.1 million and your return is 10%. If, however, our currency has strengthened and E = 0.4 €/\$, the amount \$1.375 million will only give you €0.55million, and you have lost 45% of your investment! On the other hand, if € has weakened and E = 1.6 €/\$ a year later, you will now receive €2.2 million, a nice return of 120%.

From this example, we can figure out how E affects capital flows. Suppose that the expected exchange rate one year from now is 0.8 €/\$. If E = 0.8 €/\$ today, we expect to neither gain nor loose from changes in the exchange rate from investments within the next year.

If E increases to 0.9 €/\$ today while the expected exchange rate remains at 0.8 €/\$, those who want to invest abroad for one year will expect to make a currency loss (they buy the \$ for 0.9€ and can expect to sell it a year later for 0.8€). At the same time, foreigners who invest in our country can expect to profit from the expected change in the exchange rate. When the current E increases (with a fixed future E), investing abroad will be less attractive while investments in our country will be more attractive.

E up = weaker currency: less investments abroad, more investments in our country E down = stronger currency: more investments abroad, less in our country

Again, this assumes that everything else is the same (in particular, the expected future exchange rate).

## Supply and demand for the foreign currency

We denote the supply and demand for the foreign currency by S\$ and D\$. S\$ will depend positively on the E and D\$ will depend negatively on E. The reason is as follows:

1. When E increases (weaker currency) exports will increase, imports will fall, investments abroad will fall and investments in our country will increase.

2. Increasing export will increase the supply of \$ (S\$ up)

3. Decreasing imports will decrease the demand for \$ (D\$ down)

4. More investments in our country will increase the supply of \$ (S\$ up)

5. Less investments abroad will decrease the demand for \$ (D down) \$

With a completely floating exchange rate, the exchange rate is determined in the same way as any other price:

Fig. 16.2: Exchange rate determination.

E* is the equilibrium exchange rate, the exchange rate where S\$ is equal to D\$. If the currency market is a free market, E will be equal to E*. With a fixed exchange rate, the central bank must be prepared to buy and sell currency at the predetermined exchange rate.

## Factors affecting E*

A large number of factors may affect E*. Some examples:

• Higher growth in domestic productivity. This would make domestic products cheaper and the demand for € would increase. This would increase the supply of \$ and E* would fall (stronger currency).

• Higher domestic inflation. This would make domestic products more expensive and the domestic currency would depreciate.

• Higher domestic interest rates. This would increase the demand for € and the currency would strengthen.