ECO 2013 Lecture Notes - Lecture 15: Foreign Exchange Market, The Foreign Exchange, Real Interest Rate
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Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether foreign funds will flow into or out of a country as a result of a particular economic circumstance. If foreigners wish to make domestic purchases or investments, the foreign currency must first be exchanged for the domestic currency. Thus, foreign funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause foreign funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate.
Domestic circumstance |
Funds flow in |
Funds flow out |
Currency appreciates |
Currency depreciates |
Real interest rates are higher than in other countries |
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Risk of civil war |
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Business taxes are raised above the world average |
X |
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Expected stock market returns are better than elsewhere |
||||
Inflation increases |
||||
A large deposit of rare earth minerals is discovered |
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Rapidly growing manufacturing sector imports more foreign raw materials |
Just as with the price of a good, the price, or exchange rate, of a currency is determined by supply and demand. However, rather than using a traditional supply and demand analysis as shown in Marthinsen, currency traders often consider whether foreign funds will flow into or out of a country as a result of a particular economic circumstance. If foreigners wish to make domestic purchases or investments, foreign currency must first be exchanged for the domestic currency. Thus, foreign funds flowing into a country increase the demand for the domestic currency and it appreciates. Funds flowing out reverse this process leading to depreciation of the domestic currency. In the table, place an X to indicate whether each economic condition will cause foreign funds to flow in or out of the country and whether the domestic currency will appreciate or depreciate.
Domestic circumstance |
Funds flow in |
Funds flow out |
Currency appreciates |
Currency depreciates |
Real interest rates are higher than in other countries |
||||
Risk of civil war |
||||
Business taxes are raised above world average |
||||
Expected stock market returns are better than elsewhere |
||||
Inflation increases |
||||
A large deposit of rare earth minerals is discovered |
||||
Rapidly growing manufacturing sector imports more foreign raw materials |
||||
World commodity prices (such as oil or grain) fall in a country that is a major commodity exporter |
||||
GDP increases |
||||
PI falls |