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Sem 5 Prep
← Open Economy MacroWhat the foreign exchange market does

Formulas for this chapter

Market imbalance and the reserve consequence

Excess demand = total demand - total supply Fixed rate: reserve change = -(excess demand) Flexible rate: reserve change = 0, the currency depreciates

Any question that lists foreign exchange flows and asks what happens next. Sort every item into demand or supply first; the arithmetic is trivial once the sorting is right.

Demand
Import payments, investment abroad, outbound tourism, capital withdrawals: money leaving
Supply
Export receipts, inbound remittances, foreign investment received: money arriving
Excess demand
A BoP deficit on those flows, settled by reserves or by a price change

Effect of a capital reversal

New demand = old demand + amount withdrawn New supply = old supply - inflow that stopped

When portfolio investors reverse course. A withdrawal is not negative supply, so both sides of the market move and the pressure exceeds the size of the reversal.

Amount withdrawn
Repatriated capital, which must be converted out of the domestic currency, so it is fresh demand
Inflow that stopped
The investment that is no longer arriving, so it leaves the supply side
Step 3 of 22
The real wordsTheory

Function one: transfer purchasing power

The first and largest function is to transfer purchasing power from one nation and currency to another.

The slide splits it into the two sides of the market:

  • Demand for a currency arises when tourists visit another country, a domestic firm wants to import, or an individual wants to invest abroad.
  • Supply arises from foreign tourist expenditures, export earnings, and foreign investment received.

Anything that sends money out is demand for foreign currency. Anything that brings money in is supply.

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