earlier on 9 January 2003, it would have bought less than $105. As a given quantity of euros bought more dollars, the euro can be said to have appreciated in value. The corollary is that the dollar depreciated. To consider how exchange rates are determined we consider both demand for and the supply of foreign exchange.

7.7.1DEMAND IN THE FOREIGN EXCHANGE MARKET

In Figure 7.4 the demand curve for euros is shown in terms of dollars. Three different prices or exchange rates are shown. At the highest price of the euro, when it costs $2 to buy ¤1, the quantity demanded of euros is Q1. If the price were lower at ¤1 for $1, a higher quantity of euros is demanded at Q2 while if the price is only $0.50 for ¤1, the quantity demanded is higher again at Q3. Hence, as you would expect, when the price of the euro is high, the quantity demanded of euros is relatively low. At a high exchange rate (¤1/$2) holders of dollars would prefer to buy domestic goods and services, where possible, rather than those from Europe and so their demand for euros is relatively low. At cheaper exchange rates, the incentive to buy European goods and assets increases.

7.7.2SUPPLY IN THE FOREIGN EXCHANGE MARKET

Supply of foreign exchange is also derived and is shown in Figure 7.5. Holders of euros want dollars to buy US goods and services and US financial assets. When people buy goods/assets they supply euros in exchange (if they are going on holidays and exchange their currency, for example). Or European importers make purchases from US producers and pay in dollars.

The supply of US goods, services or financial assets is greater the cheaper the price of dollars in terms of euros, as shown in Figure 7.5. When ¤1 buys $2, Europeans have an increased incentive to buy US goods, services or financial assets compared to when the price is higher, e.g. when ¤1 buys only $0.50.

F I G U R E 7 . 4 F O R E I G N E X C H A N G E : D E M A N D

1/$2

1/$1

1/$0.5

Q

F I G U R E 7 . 5 F O R E I G N E X C H A N G E : S U P P L Y

7.7.3EXCHANGE RATE DETERMINATION

The exchange rate between any two currencies is based on their relative demands and supplies. Equilibrium in the foreign exchange market is found in the usual way, where demand and supply intersect, shown in Figure 7.6. From the demand and supply curves the equilibrium exchange rate is ¤1 = $1. We know that exchange rates change quickly, meaning information that changes either demand or supply of foreign exchange occurs frequently and the exchange rate required to clear the foreign exchange market changes quickly.

Consider what might happen to the exchange rate if holders of euros want to buy extra US goods and need to buy dollars to pay for them. This might happen if, for example, US computer producers use some new technology that allows them to produce better machines at a lower price than European competitors. If the supply of euros (for dollars) rises as shown in Figure 7.7, then at the original exchange rate, the market does not clear and supply is greater than demand and at the original exchange rate a surplus exists. This means that at the original exchange rate there are more euros on the market than people holding dollars wish to buy. This surplus of euros can only be eliminated if the exchange rate falls. As the

F I G U R E 7 . 6 D E T E R M I N A T I O N O F A N E X C H A N G E R A T E : T H E E U R O I N T E R M S O F D O L L A R S

F I G U R E 7 . 7 C H A N G E I N T H E E Q U I L I B R I U M E X C H A N G E R A T E

exchange rate falls, the quantity of euros demanded by holders of dollars increases. The new equilibrium emerges at Figure 7.7 point B.

7.7.4CAUSES OF CHANGES IN EXCHANGE RATES

Many different factors affect exchange rates, due to interdependencies of foreign exchange markets internationally. These can be examined using the demand and supply framework and considering equilibrium changes derived from changes in either currency demand, supply or in some cases changes in both currency demand and supply.

The main factors causing exchange rates to change include:

•interest rate differentials;

•inflation differentials;

•growth differentials;

•speculation.

An interest rate differential exists between the euro zone and the USA when their interest rates differ and would be expected to have an effect on the euro–dollar exchange rate. Take the case where the euro interest rate is set (by the European Central Bank) at a rate above that in the USA (set by the US Federal Reserve). Holders of dollars might wish to earn a higher interest rate on their savings, demand more euros and supply more dollars to the foreign exchange market. An increase in demand for euros would mean a rightward shift of the demand curve drawn in Figure 7.7, bringing about an appreciation of the euro.

Furthermore, if holders of euros are also less willing to buy US assets, fewer euros may be supplied and the supply curve may shift to the left (at each exchange

rate, the supply of euros falls). The result of a leftward shift in supply is, again, to increase in the value of the euro against the dollar. The net effect of the interest rate differential depends on the extent of the changes on both demand and supply but in this example brings about an appreciation of the euro. The appreciation of the euro results in reducing the benefit of the initial interest rate differential!

An inflation differential exists between the USA and Europe if prices are rising faster in one economy relative to the other. European goods become relatively more expensive if a positive inflation differential exists between the euro zone and the USA. As euro goods are more expensive, demand for them may fall, reducing demand for euros by holders of dollars – a leftward shift of the demand curve. If US goods also become more attractive for European buyers, the supply of euros increases also – a rightward shift in the supply curve. The net result is a depreciation in the value of the euro versus the dollar.

In the case where one economy is growing faster than another (e.g. faster growth of GDP in the EU) a growth differential exists. We know from earlier analysis that additional income results in extra consumption, some of which is met by imports. As import demand increases, so does the supply of euros to pay for them, resulting in a depreciation in the value of the euro for the dollar.

The vast majority of demand for and supply of foreign exchange takes place not in order to pay for goods or services but for the purpose of speculation, which amounts to gambling on the future movements of an exchange rate. We know this because the amount of foreign exchange traded greatly exceeds the value of international purchases of goods and services (including tourism). In 1998, for example, the average daily turnover in foreign exchange markets was equivalent to the annual GDP of Germany! Estimates of the amount of foreign exchange transacted worldwide on a daily basis over the period 1998 to 2001 are $1.2tr. (This figure is down 14% from 1998, as quoted by the Bank for International Settlements in their Central Bank Survey of Foreign Exchange and Derivatives Market Activity available from http://www.bis.org.) The most traded currencies are the dollar, euro, Japanese yen and sterling. In percentage terms each currency’s respective share of foreignexchange trade is 90%, 38%, 23% and 13% (note that the sum of all foreign currency shares adds to 200% not 100% since two currencies are involved in each transaction).

People trade in foreign exchange because of arbitrage opportunities.

Arbitrage is the possibility of buying an asset (e.g. foreign exchange) in one market and selling it at a higher price in another market.

Speculators speculate on the price they expect to earn on an asset in another market or in the future. Given the ease and speed with which traders in foreign exchange gather and receive information on exchange rates, currency exchange rates tend to converge quickly between the various foreign exchange markets (London being the largest) so that arbitrage opportunities in money markets are less common.

7 . 8 S P E C U L A T I O N I N M A R K E T S

Speculators can only make a profit if they have information not available to the rest of the market. We argued earlier that holders of specific information should use it for their economic decision-making to make best use of economic resources. We also considered that the market system allowed individuals to use their specific information and generated incentives for them to use such information. Hence, speculators must guess (and bet on) changes in exchange rates from which they can benefit. Since speculators cannot know future currency rates with certainty, speculation is a risky activity.

In many cases speculators can act in such a way as to bring about their expectations. If speculators believe that a currency will fall in value, the rational action is to sell any holdings of that currency and buy others. If a large number of speculators follow the same strategy and sell a particular currency, its supply on the market increases and so the price of the currency will fall as supply exceeds demand. The role played by speculators in exchange rate determination is quite substantial and estimates for the level of speculation on the London ForEx (foreign exchange) market are up to 80% of all trades.

Despite the actions of speculators, economists argue that if a country’s economic fundamentals are right, its currency should not be too volatile and the exchange rate should remain steady. Quite often we hear economic commentary that a currency is overor under-valued based on an economy’s fundamentals.

Economic fundamentals is a very broad term and includes such economic measures as interest rates, the government’s budget deficit, the country’s balance of trade account (relating to exports and imports), the level of domestic business confidence, the inflation rate, the state of (and confidence in) the banking and wider financial sector, and consumer confidence.

The fundamentals are elements of the economic system that need to ‘fit’ well together or else speculators might try to sell the currency. If speculators see any of the fundamentals as a potential problem, they may sell the currency, changing its

exchange rate(s). Speculators operate across all kinds of markets such as art, rare coins, property (real estate), and agriculture. Some speculative activities relate to futures markets.

In futures markets agreements are made relating to a payment that will be made for delivery of goods in the future.

In spot or cash markets money changes hands today for goods or services received today.

The usual goods exchanged on futures markets are primary (unprocessed) commodities like agricultural output, wheat, barley, corn, coffee as well as stocks and bonds. Futures markets provide information to growers/producers today about how prices are expected to change in the future. If the futures price of a kilo of wheat in 12 months’ time is £3.50, and is £2.50 today, this indicates that given predictions about future plantings, expected weather conditions (and whatever other factors affect corn output) the expert opinion based on the best specific information available is that wheat prices will rise.

Speculators often receive bad press as individuals or businesses that exploit the market system to make a profit. Interestingly, however, speculators who accurately predict the future price of corn, as an example, can help to stabilize the price and output in a market. Take the case for the corn market shown in Figure 7.8. The market for this year and next year are considered respectively in panels A and B. Demand is considered to be the same for both years. Initially we examine the situation if no speculation occurs but there is an expectation that next year’s crop will be smaller than this year’s. If no speculation occurs, the contraction in production of corn from S1 to S2 results in different equilibrium prices and output over both periods.

However, if speculators are correct in predicting that prices will rise in period 2 their rational behaviour would be to buy at the cheaper price this year and hold onto some of the output until the following year, selling it at the higher price. This activity would change supply for periods 1 and 2 as shown in Figure 7.8 panels C and D. For year 1, supply drops back (to SS 1) as shown in panel C, if speculators store some of the wheat. For year 2 supply expands in panel D (to SS 2) and the outcome is an equilibrium price that is equalized over the two periods – the price is £3 in both periods and consumption is 50 million kilos. If speculators were completely correct in predicting year 2’s supply then prices and output (and hence, consumption) could remain stable over time. Both price and consumption would be smoother over both periods compared to the situation that would prevail without speculative activity.

Without speculation:

F I G U R E 7 . 8 S P E C U L A T I O N A N D

C O N S U M P T I O N S M O O T H I N G

When speculators’ expectations are incorrect, however, they can exacerbate problems further. This occurs if a speculator buys at one price, expecting it to rise. If the price is already high and speculators are wrong about future price rises, their purchase today of goods will drive today’s price higher still (because of the leftward shift of the supply curve, ceteris paribus). If prices in the future fall, the speculator sells their purchases and drives the price further down (as the supply curves moves rightwards) by releasing their goods onto the market. In such circumstances the speculators only serve to magnify the trend in prices and consumption over both periods.

A similar analysis can be conducted for the money market although we know currencies to be considerably more volatile than other prices. A key difference with speculation in currencies is the possibility that comprehensive financial crises can result with devastating consequences for the affected economies. It is little solace