12.2: The foreign exchange market

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The foreign exchange market is the market in which the currencies of different countries are bought and sold and the prices of currencies, the foreign exchange rates, are established. Consider the market for US dollars as the foreign currency. The sources of supply and demand for foreign exchange are shown by the balance of payments in Table 12.1. Exports of goods, services, and financial assets generate a supply of foreign currencies that are sold in the foreign exchange market for Canadian dollars. Imports of goods, services, and securities must be paid for in foreign currencies. The demand for foreign exchange is derived from this demand for imports. Without intervention by governments, demand and supply determine the exchange rate, as, for example, er₀=1.05 in Figure 12.1.

Different economic and financial conditions would change supply and demand for foreign exchange and result in a different exchange rate. In May of 2017, for example, the Canadian dollar price of the US dollar was $1.36. By contrast when energy and commodity prices were high in 2010 the price of a US dollar was $1.0299 Canadian dollars.

Figure 12.1 The foreign exchange market

The supply of US dollars on the foreign exchange market comes from US purchases of Canadian goods, services and assets. The demand for US dollars comes from Canadian demand for imports of goods, services and assets. Supply and demand determine the equilibrium exchange rate er₀.

Figure 12.1, the demand curve for US dollars D₀ *slopes downwards*. More US dollars are demanded to buy more imports at a lower Cdn$/US$ exchange rate.

The US dollars supplied on the foreign exchange market are the receipts from the export of goods, services, and securities to US residents. From the discussion of the current and financial accounts of the balance of payments, exports of goods and services depend on foreign income, the relative prices of domestic and foreign goods and services, and the exchange rate. Net exports of securities depend on the difference between domestic and foreign interest rates, for given expectations of the future exchange rate.

Figure 12.1 assumes that the demand for Canadian exports and the Canadian demand for imports are price elastic. Price increases caused by changes in the exchange rate reduce total revenue. Price reductions caused by changes in the exchange rate increase total revenue. These conditions give the slopes shown for the supply and demand curves.

At the equilibrium exchange rate er₀, the quantities of US dollars supplied and demanded are equal. In terms of the balance of payments, the balance is zero. Receipts equal payments.

In practice, as seen in Table 12.2, the balance of payments is recorded in domestic currency. However, the equality of receipts and payments still holds. Both are easily converted to Canadian dollars by multiplying the US dollar amounts by the exchange rate. In terms of Figure 12.1, multiplying U₀ on the horizontal axis by the exchange rate er₀ on the vertical axis gives the area of the rectangle er₀AU₀O, the Canadian dollar value of total receipts or total payments recorded in the balance of payments.

What would change the equilibrium in Figure 12.1? A change in any of the factors held constant in order to draw the supply and demand curves will shift one or the other or both curves. We see this in both the net export and capital flow functions. A rise in United States income would increase US imports from Canada and shift the supply of foreign exchange to the right. As discussed above and in Chapter 9, a change in interest rates in Canada or the United States would change the trade in financial assets and affect both the supply curve and the demand curve. In short, a change in any market condition other than the exchange rate er will change supply and demand conditions in the market. The exchange rate will then change to a new equilibrium. Figure 12.2 and 12.3 provide examples.

The effect of a recession in the US economy on the exchange rate

The demand and supply curves in the foreign exchange market of Figure 12.2 are drawn on the assumption that tastes, incomes, prices of goods and services, interest rates, and expectations of future exchange rates are constant. The flows of payments and receipts under these conditions result in the equilibrium exchange rate er₀. This would be a Canadian dollar price for the US dollar of, for example, $1.35. From the United States perspective, a Canadian dollar costs a United States resident about $0.74US.

Figure 12.2 The effect of a recession in the US on the exchange rate

A recession in the US reduces Canadian exports to the US and reduces the supply of US$ on the foreign market. S shifts from S₀ to S₁. The exchange rate rises as the Can$ depreciates.

Now suppose, as occurred in early 2008 and 2009, a recession in the United States lowers United States real income. United States imports fall, based on the US marginal propensity to import. United States imports are Canadian exports, and the US dollar receipts of Canadian exporters are reduced. The recession and difficult household financial conditions reduce US residential construction and Canadian lumber exports decline. Recession also reduces travel by US residents, and the Canadian tourism industry suffers a decline in bookings and receipts. If expenditures on new cars in the United States are reduced, Canadian auto industry sales to the United States market are reduced. In the balance of payments, the balance on trade in goods and services falls, and in the foreign exchange market the supply of US dollars on the market is reduced.

The supply curve in Figure 12.2 shifts leftward to S₁. At the initial exchange rate er₀, the demand for US dollars exceeds the supply, putting upward pressure on the exchange rate. In terms of the balance of payments, the excess demand for US dollars represents a balance of payments deficit. In the example shown here, the Canadian dollar depreciates and the exchange rate rises to restore equilibrium in the foreign exchange market and the balance of payments. A higher price for the US dollar reduces Canadian imports and increases the Canadian dollar receipts of Canadian exporters. The effects of the US recession on the Canadian balance of payments are offset by the exchange rate change.

The rise in the exchange rate in this case is a depreciation of the Canadian dollar and a corresponding appreciation of the US dollar.

Currency depreciation: a fall in external value of the domestic currency that raises domestic currency price of foreign currency.

Currency appreciation: a rise in external value of the domestic currency that lowers the domestic currency price of foreign currency.

Before the recession of 2009, Canadian experience was the opposite of this example. High GDP growth rates in the US and Asia created very strong international demand for Canadian commodities and crude oil at high international prices. Strong oil and commodity exports increased the supply of foreign currencies on the Canadian foreign exchange market. The Canadian dollar appreciated strongly, with the exchange rate falling from $1.57Cdn/$1US in 2002 to an average of $0.9994 Cdn/$1US in May of 2008, a fall of about 60 percent over the six year period. Exchange rate changes led to a restructuring of both exports and imports to maintain equilibrium in the balance of payments as Canada's international trade changed dramatically.

The effect of a fall in foreign interest rates on the foreign exchange rate

In the previous example a change in foreign income and the supply of foreign exchange disrupted the equilibrium in the foreign exchange market and changed the exchange rate. As an alternative to that example, consider the effects of a cut in foreign interest rates.

In Figure 12.3 the foreign exchange market is in equilibrium, initially at an exchange rate er₀. A fall in foreign interest rates, other things constant, disrupts this equilibrium. Now lower foreign rates make domestic (Canadian) bonds more attractive to foreign portfolios than they were previously. The demand for domestic bonds rises. The supply of US dollars on the market to pay for these bond exports increases, shifting S₀ to S₁ in the diagram. At the same time, the attractiveness of foreign bonds for domestic portfolios is reduced, reducing the demand for US dollars to pay for them. The demand curve shifts from D₀ to D₁. The equilibrium exchange rate falls to er₁.

Figure 12.3 The effect of a cut in foreign interest rates

A cut in foreign interest rates shifts portfolios toward the Canadian bond market and away from foreign markets. The supply of foreign currency increases from the increased export of bonds at the same time as the demand for foreign currency to buy foreign bonds falls. The domestic currency appreciates and the exchange rate falls.

In balance of payments terms the net capital inflow, the balance on financial account, is increased. The change in the exchange rate causes an offsetting change in the current account that restores equilibrium in the foreign exchange market and the balance of payments. A lower nominal exchange rate lowers the real exchange rate. Imports are now cheaper and exports, priced internationally in US dollars, are less profitable. Export receipts are reduced. As we saw in Chapter 9, changes in the exchange rate are one channel by which changes in financial conditions impact AD and equilibrium GDP.

Figures 12.2 and 12.3 provide two examples of adjustments in the foreign exchange rate. The underlying assumption is that exchange rates are flexible and allow the market to adjust freely and quickly to changing circumstances.

However, there are alternative exchange rate arrangements. To understand how the foreign exchange rate operates in different countries, we need to consider the different exchange rate policies governments can adopt. These result in different foreign exchange rate regimes, different ways that the balance of payments adjusts to change, and different roles for monetary and fiscal policies.

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