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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New demand = old demand + amount withdrawn New supply = old supply - inflow that stopped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Amount withdrawn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 4 of 22
The real wordsTheory

The chain, exactly as the slide draws it

Slide 5 is a four-box flow diagram. Describe it in words, because a pen-and-paper exam will ask you to draw it.

  1. A domestic firm exports to the United Kingdom.
  2. It receives payment in pounds sterling.
  3. It exchanges those pounds for its own currency at a commercial bank.
  4. The commercial bank sells the same pounds on to residents travelling to the United Kingdom.

The pounds never left the system. They moved from someone who had earned them to someone who needed them, and the bank stood in the middle. That is purchasing power being transferred.

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