16.2 Demand and Supply Shifts in Foreign Exchange Markets

Exchange rates are shaped by supply and demand in foreign exchange markets. Factors like inflation, interest rates, and economic growth influence currency supply and demand. Understanding these forces helps predict currency appreciation or depreciation.

Arbitrage and purchasing power parity play key roles in currency markets. Arbitrage keeps exchange rates consistent across markets, while PPP theory suggests rates should adjust to equalize purchasing power between countries. These concepts are crucial for grasping international finance dynamics.

Demand and Supply Shifts in Foreign Exchange Markets

Forces influencing exchange rates

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• Exchange rates determined by the interaction of supply and demand in foreign exchange markets
  • Supply of a currency determined by the domestic demand for foreign goods, services, and financial assets
    • Factors increasing supply include domestic inflation, increasing domestic interest rates, domestic economic growth, and foreign economic downturns
  • Demand for a currency determined by the foreign demand for domestic goods, services, and financial assets
    • Factors increasing demand include low domestic inflation, decreasing domestic interest rates, domestic economic downturns, and foreign economic growth
• Equilibrium exchange rate reached when quantity supplied equals quantity demanded
  • Appreciation occurs when there is an increase in the value of a currency due to market forces (US dollar strengthening against the euro)
  • Depreciation occurs when there is a decrease in the value of a currency due to market forces (Japanese yen weakening against the US dollar)
• Balance of payments influences exchange rates by reflecting the overall economic transactions between countries

Role of arbitrage in currency trading

• Arbitrage involves the simultaneous buying and selling of equivalent assets or goods in different markets to take advantage of a price difference
  • Profitable arbitrage opportunities are rare and short-lived in efficient markets (currency markets)
• Arbitrage plays a vital role in ensuring that exchange rates remain consistent across different markets
  • If exchange rates differ between markets, arbitrageurs will buy the currency in the lower-priced market and sell it in the higher-priced market (buying euros in London and selling them in New York)
  • This activity increases the demand in the lower-priced market and increases the supply in the higher-priced market, driving the prices together (equalizing exchange rates across markets)
• Interest rate parity theory suggests that arbitrage opportunities in currency markets are limited by differences in interest rates between countries

Purchasing power parity effects

• Purchasing Power Parity (PPP) is a theory stating that exchange rates between currencies should adjust to equalize the purchasing power of different countries
  • Absolute PPP: exchange rate between two countries should equal the ratio of the price levels in those countries
    • $S = P_1 / P_2$, where $S$ is the exchange rate, $P_1$ is the price level in country 1, and $P_2$ is the price level in country 2
  • Relative PPP: percentage change in the exchange rate between two countries should equal the difference in their inflation rates
    • $$, where $$ is the percentage change in the exchange rate, $$ is the inflation rate in country 1, and $$ is the inflation rate in country 2
• PPP is used for international price comparisons and determining the relative value of currencies
  • Overvalued currency occurs when the market exchange rate is higher than the PPP exchange rate (Swiss franc)
  • Undervalued currency occurs when the market exchange rate is lower than the PPP exchange rate (Chinese yuan)

Exchange Rate Systems and Capital Flows

• Floating exchange rate: currency value determined by market forces of supply and demand
• Fixed exchange rate: currency value pegged to another currency or basket of currencies
• Currency intervention: central banks buying or selling currencies to influence exchange rates
• Capital flows between countries can significantly impact exchange rates and are influenced by investment opportunities and economic conditions