foreign exchange and foreign exchange market

International Economics: Visit http://kubalyendas.blogspot.com Prepared by: Sir. Kubalyenda

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FOREIGN EXCHANGE AND FOREIGN EXCHANGE MARKET Visit http://goo.gl/Wt6yUz (Ctrl + Click)

Exchange rate:

The price of one currency in terms of another currency

The demand for country’s currency relative to the supply of its currency determines the exchange

rate

Exchange Rate Determination

Foreign exchange rate can be measured in two ways

The price of foreign currency (say, US$) in terms of domestic currency (say TZ shilling)

(commonly used)

The price of domestic currency (TZ shilling) in terms of foreign currency (say US $)

Exchange rates fluctuate considerably over time;

Appreciation, is an increase in the value of a currency

Depreciation, Is a decline in the value of the currency

Foreign Exchange Market This is where Foreign exchange transactions take place

It is a market within which individuals, business firms, governments and banks purchase and sell

foreign currency and other debt instruments

Market does not refer to specific meeting place, rather mean all locations and situations that

enable one country’s currency to be purchased and/or sold for other country’s currencies.

Functions of foreign exchange market

Enables one country’s currency to be transferred to other countries in their own currencies

It brings together parties who want to exchange their currencies and enable them to clear

their balances on the basis of the market exchange rates.

Participants in the Foreign Exchange Market (NISCCC) Nisisii

Non-Bank Financial Institutions

Individuals

Speculators

Central Bank

Commercial Banks

Corporations

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Central Bank is responsible for macroeconomic policies that affect exchange rates. In a

managed float exchange rate system.

It may buy or sell foreign currency in order to set the price (which is the exchange rate) at a

desired level.

Commercial Banks are at the center of the foreign exchange market since they bring together

those who demand and those who supply foreign currencies thus allow foreign exchange

transactions to take place.

When a commercial bank does not have its desire amount of foreign currency, it can turn to a

foreign exchange broker to purchase additional foreign currency or sell its unwanted surplus. The

foreign exchange brokers act as wholesalers of foreign currencies, operating in an interbank

market.

Non-Bank Financial Institutions, large pension funds and other institutional investors offer

Foreign exchange transactions

Corporations their operations in various countries frequently make or receive payments in

foreign currencies. That is, the international exchange of intermediate goods or final goods and

services always involve foreign exchange trading to pay for the activities.

Speculators are the individual foreign exchange traders, financial institutions, or nonfinancial

institution that buy and sell foreign exchange in order to make short-run profits.

Speculators are usually individual, or firms that undertake risks in anticipation of making profit.

Individuals, these include tourist, travelers, may also participate in the foreign exchange

markets.

Foreign Exchange Instruments (CCBLCO) sisi-biliko

Cable Transfer

Commercial Bill of Exchange

Time bill

Sight bill

Bank Drafts

Letter Of Credit

Other Means of Payment

On a cash basis

On an open account basis

Cable Transfer: Is an order transmitted by the bank in one country to its foreign correspondent

in another country, instructing the correspondent bank to pay out a specific amount to a

designated person or account.





Commercial Bill of Exchange: Is a written order by an exporter (the drawer) to an importer

(the drawee) instructing the importer to pay on demand, or on certain date, a specific amount to a

designated party (payee). The payee could be either the exporter or a local bank where the

exporter has an account.

There two types

Time bill, is a bill of exchange that is payable at some future date to the drawee

Sight bill, is a bill of exchange that is payable on presentation to the drawee

Bank Drafts, It is a written order by a drawer to a drawee instructing him or her to pay, on

demand or at certain date, a specified amount of money to a payee. In this case the drawee is a

bank rather than an importer.

A bank draft directs the exporter to receive payment directly from a bank designated by the

importer. Usually, it involves a bank in the importer’s country instructing its corresponding bank

in the exporter’s country to pay the specified amount to the exporter.

Letter Of Credit, it is a document issued by an importer’s bank declaring that payment will be

made to an exporter regarding a specific shipment of commodities.

Cash payment is especially done when the exporter is not trusting an importer hence considers

the transaction risky.

An open account is used when exporter trusts an importer; therefore, the exporter simply ships

the merchandise (product / a commodity offered for sale) to the importer along with the

necessary documents, without any prior payment or obligation on the part of the importer.

Foreign Exchange Transactions

It is very risk to participate in exchange rate business as the price of currency fluctuation every

second. Due to this, one may choose to do business in either the spot market or forward

market. Other may engage either in hedging or speculation as the means to deal with risks

The spot market: the transaction is made immediately

The forward market: sign a contract payment to be done on today’s price in the future

Factors that cause the shift in demand and supply of foreign currencies

(ITIPI) hi-tipi

Differences in inflation rate.

Changes in tastes for foreign products

Change in domestic income

Changes in relative prices

Changes in country’s relative interest rates





If the inflation rate is lower in home country than in other countries, Ceteris Paribas, home

country’s products are cheaper than other countries products. This leads to the increase in

demand for home country’s products, causing demand for home currency to increase. The higher

demand for the currency, in turn, leads to its appreciation.

If a country’s taste for other country’s products increases Ceteris Paribas, the demand for

foreign currency will increase. This leads to an increase in the exchange rate or depreciation of

domestic currency.

If home country’s income increases, the demand for both foreign and domestic goods will

increase. The increase in demand for imported goods will cause an increase in demand for

foreign currency in the foreign exchange market. This leads to an increase in the price of foreign

currency, or depreciation of domestic currency.

If domestic prices rise relative to foreign prices, then the demand for foreign goods will

increase, this increases the demand for foreign currency leading to domestic currency

depreciation.

A high interest rate in one country compared with those in other countries, may encourage the

movement of short-term funds to that country. This causes an increase in demand for that

country’s currency, leading to its appreciation.

Two exchange rate system

Fixed / clean / free floating ERS

Flexible ERS

Flexible (freely fluctuating) Exchange Rate System

In a free market, Exchange rate for a currency is set/determined by the free market forces of

demand and supply for that currency. (There is the freely floating) clean-floating / floating

exchange rate system.

The exchange rate for a currency to fall or rise depending on the nature of the shift

If supply shifts to the right, the equilibrium exchange rate declines, that is, domestic

currency appreciates (Point E’). Let $1/2000TZSR and $2/1500TZSR

Appreciation is an increase in the value of a currency relative to another currency.

An appreciated currency is more valuable (more expensive) and therefore can be

exchanged for (can buy) a larger amount of foreign currency.

An appreciated currency means that imports are less expensive and domestically

produced goods and exports are more expensive. An appreciated currency raises

the price of exports relative to the price of imports.





If demand shifts to the right, the equilibrium exchange rate rises, that is, domestic

currency depreciates. Let $1/1500TZSR and $1/2000TZSR

Depreciation is a decrease in the value of a currency relative to another currency.

A depreciated currency is less valuable(less expensive) and therefore can be

exchanged for (can buy) a smaller amount of foreign currency.

A depreciated currency means that imports are more expensive and domestically

produced goods and exports are less expensive.

A depreciated currency lowers the price of exports relative to the price of imports.

NB: R=the price of US dollar in term of Tanzania shillings.

Demand curve for US dollars corresponds to the debit items in the home country’s BoP

arising from Tanzanians desire to import foreign goods and services or to invest in

foreign country.

E = equilibrium exchange rate

Advantages of FLEXIBLE ERS (Arguments in Favour of the System): EEETI It Eliminates the need for central banks to hold large international reserves,

Enhances efficiency in the economy,

Enhances the effectiveness of monetary policies

Takes care of the BoP problems.

Insulates an economy from external shocks

It eliminates the need for central banks to hold large international reserves, and thus allows

resources to be used more productively elsewhere in the economy.

It enhances efficiency in the economy, with freely fluctuating price for foreign exchange;

resources will be guided in a competitive framework towards their most efficient use.





It takes care of the BoP problems. A deficit (surplus) situation will set depreciation

(appreciation) of home currency into operation, hence removes the deficit (surplus).

It insulates an economy from external shocks. E.g. if there is sudden increase in demand for

home country’s exports the demand stimulus will be at least partially offset by the effect of

appreciation of domestic currency. The appreciation will reduce country’s exports and

increase the country’s imports, thus the aggregate demand moves back towards original

levels. Therefore country’s GNP has been insulated from external shock.

It enhances the effectiveness of monetary policies. An expansionary monetary policy

(increase in money supply) so as to increase national income generates depreciation of

home currency and this will act to reinforce increasing impact of the monetary expansion,

since trade balance improves.

Disadvantages of LERS(Arguments against Flexible Exchange Rate) WIRDTI It generates wasteful resource movements.

It reduce trade and investment

Inflation becomes self-perpetuating

It is characterized by destabilizing speculation.

It generates wasteful resource movements. Since it involves frequent change in the

exchange rate, which in turn will cause factors of production to move frequently into and

out of tradable goods sector. If resources are unwilling to undergo continuous movement,

there will be a more permanent misallocation and inefficiency.

NB: Tradable goods/sector – exportable goods (potential of being traded)

Non-tradable goods/sector – un-exportable (non-potential) goods

If domestic currency appreciates – Export decreases∴tradable goods shift to non-

tradable good viz

It reduce trade and investment due to increase in risk and uncertainty involved in foreign

trade and FDI

Inflation becomes self-perpetuating. If the economy is undergoing rapid inflation

country’s currency will depreciate adding to the aggregate demand in the economy,

thereby generate further inflationary pressure.

It is characterized by destabilizing speculation. If a currency depreciates, speculators

assume that depreciation will last longer, ∴they will sell the currency. This will worsen

depreciation.

But, an appreciation of currency will cause speculators to anticipate further appreciation,

thus buy the currency, causing more appreciation. ∴The appreciation will be > normal

because of the destabilizing speculation

Fixed Exchange Rate System The exchange rate is stable and can only fluctuate within the very limited band.





This is possible if, the central bank holds international resources, such as foreign currencies,

SDRs, and other assets that act as international media of exchange.

If the value of currency is pegged below the equilibrium exchange rate, an excess demand for

foreign currency occurs; central bank will thus sell foreign currency in question in order to re-

establish the equilibrium. Or, it will impose restrictions on the demand for foreign currency in

question.

If central bank decides to fill the gap out of its international reserves, the supply curve will shift

to the right thus, eliminates excess demand, and if the second option is implemented, demand

curve will shift to the left, the equilibrium will be re-established at lower quantities of foreign

currency.

NB: Price above E – Central bank buys foreign currency

Price below E - Central bank sells foreign currency

Advantages(Arguments for) Fixed Exchange Rate Less Uncertainty

Stabilizing Speculation

Avoids wasteful resources movements

Price discipline

Less Uncertainty: The system avoid fluctuations that are likely to occur

Stabilizing Speculation: since the rates are always kept fixed, hence speculations are almost

certain to be stabilizing.

Avoids wasteful resources movements: the system avoids the wasteful resource movements

associated with flexible system

Price discipline: under this system, a country with higher rate of inflation than the rest of the

world (other countries) is likely to face persistent deficit in its balance of payment and thus loss

of international reserves. Thus fixed exchange system provides more stability to an open

economy to large internal shocks.





Disadvantage (Arguments against) Fixed Exchange Rate System

It does not insulate the economy from external shocks.

Inefficiency in resources allocation in the economy.

Structural and Policies Differences among Countries.

Ties up resources in the form of international reserves.

Foreign Exchange Market

This is the market in which individuals, firms, and banks buy and sell foreign currencies or

foreign exchange.

The Spot Market

The spot exchange rate

Forward Market

Forward exchange rate

Hedging

Speculation

stabilizing or

detailing

Swaps

Arbitrage

The Spot Market: This is a foreign exchange market in which foreign currencies are

purchased and sold for immediate delivery, that is, within two business days after the

transaction agreement. Y 2 days?

This is to allow the traders to instruct their respective commercial banks to make the necessary

transfers in their account.

The spot exchange rate is the exchange rate at which the transaction takes place, e.g.

2200$/ USTZSR is a post rate

Its advantage: One can avoid the risk of fluctuations in the exchange rate that may result

when the foreign currency is delivered at a future date.

Forward Market: transactions take place at a specified future date.

This is the foreign exchange market in which foreign currencies are purchased and sold for

future delivery. It involves an agreement between two parties to purchase or sell a given

amount of foreign exchange at a specified future date at a pre-arranged rate.

This rate is known as forward exchange rate. E.g. quoted for one month, three months, or six

months

NB: At any point in time, the forward rate can be equal to, above, or below the

corresponding spot rate.

If the forward rate is higher than the current spot rate the foreign currency is said to

at a forward premium compared to the local currency.

If the forward rate is lower than the current spot rate, the foreign currency is said to

be at a forward discount compared to the local currency.





Formula for percentage discount or premium for the forward rate to the spot rate is

FP or 100360

NSR

SRFRFD

Where: 𝑆𝑅 − 𝑺𝒑𝒐𝒕 𝒓𝒂𝒕𝒆 𝑵 − number of days. (E. g. 3 months = 30days) 𝐹 /𝐷 /𝑃 /𝑅 − 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 →/𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕 / 𝒑𝒓𝒆𝒎𝒊𝒖𝒎/𝒓𝒂𝒕𝒆

Hedging usually takes place in the forward market in order to avoid the foreign exchange risk

The importer can hedge against the exchange risk by either buying or borrowing foreign

currency at the present spot rate and deposit the proceeds in the interest earning bank account for

say 90 days until the payment is due.

If importer chooses to borrow the funds, the cost involved will be the difference between the

higher interest rate that must be paid on the loan and the lowest interest that would be earned

from depositing the funds in the bank for 90 days.

If the importer uses his/her own funds to buy the foreign currency, transaction cost is the

difference between opportunity cost of the money used and the interest that would be earned

from depositing the funds in a bank account for 90 days.

Speculation is the opposite of hedging, whereas a hedger tries to avoid the foreign exchange

risk, the speculation purposely undertakes risk with expectation of a profit.

Speculation can occur in either the spot market or the forward market.

If a speculator expects the spot rate of a particular foreign currency to fall, he/she will

borrow that currency for, say 30 days, and immediately exchange it for domestic

currency at the currency spot rate. The speculator may then deposit the domestic currency

in an interest earning bank account.

After 30 days, the speculator may pay off the loan by using the bank deposit of domestic

currency at the prevailing spot rate. At the time of payment, if the new spot rate is lower

as expected, speculator earns profit. Note that, the speculator earns profit only when the

revenue earned > the cost of borrowing.

If a speculator believes that the spot rate of a particular foreign currency will rise, he or

she may borrow domestic currency, purchase the foreign currency at the current spot

rate, and hold it in an interest earning bank account for future resale.

If speculator’s predictions are correct, he/she earns a profit. If instead the spot rate falls,

the speculator incurs loss because he/she will have to re-sell the foreign currency at a

price lower than the purchase price

Speculation can be either stabilizing or detailing

Stabilizing Speculation refers to be purchase of foreign currency when its domestic price (the

exchange) is declining, in anticipation that it will soon increase and thus generate profit. It also





refers to the sale of foreign currency, when its domestic prices are rising/increasing in

anticipation that it will soon decline.

The stabilizing speculation moderates fluctuations in exchange rates over time, thus perform a

useful function due to the law of demand and supply.

Destabilizing Speculation refers to the sale of a foreign currency when exchange rate is falling

in anticipation that it will fall even lower in the future. It also refers to the purchase of a foreign

currency when exchange rate is rising or is high, in anticipation that it will increase even further

in the future.

Destabilizing speculation thus magnifies exchange rate fluctuation over time and can disrupt the

flow of international trade and investment.

A swap is an arrangement by which two parties exchange one currency for another and agree

that at certain future date, each party receives from the other the amount of the original currency

that was exchanged, when the swap took place.

Currency, swaps are very popular in large part because they have lower transaction costs than

other forms of currency transaction.

Arbitrage refers to the simultaneous purchase of a currency in one market where it is cheaper,

and sale in another market where it is more expensive, in order to make profit.

This riskless process results in equalization of exchange rate quotations in different monetary

centers. This happens because arbitrages raise demand for the foreign currency in the centers

where the currency is cheaper, causing the price of that currency to increase. At the same time

they increase supply of foreign currency in the financial center where the currency is expensive,

causing the price of that currency to fall.

E.g. if dollars are cheaper in New York than in London, Sir. Kubalyenda (people) will

buy dollars in New York and stop buying them in London. The price of dollars in New

York rises and the price of dollars in London falls, until the prices in the two markets are

equal.

BALANCE OF PAYMENTS

Balance of payments is a summary statement in which, in principle, all the transactions of the

residents of a nation with the residents of all other nations are recorded during a particular period

of time, usually a calendar year.

Credits and Debits in BoP

International transactions are classified as credits or debits.

Credit transactions are those that involve the receipt of payments from foreigners

Debit transactions are those that involve the making of payments to foreigners.





Credit transactions are entered with a positive sign, and debit transactions are entered with a

negative sign in the nation’s balance of payments.

NB: Payment received – recorded under Cr

The export of goods and services, unilateral transfers (gifts)

received from foreigners and capital inflows

Payment made – recorded under Dr

The import of goods and services, unilateral transfers or gifts made

to foreigners, and capital outflows

NB: When you export or import, payment should be done

Unilateral and gifts transfers / received no payment done

Four (4) key items of BoP

Current A/c

Capita A/c

Financial A/c

Compensating / Reserve A/c

Errors & Omissions/Official Reserves Accounts

Current A/c includes all international economic transactions with income or payment

flows occurring within one year, the current period. It consists of

Goods trade and import of goods

Services trade

Income

Current transfers

Capita A/c balance of payments measures all international economic transactions of

financial assets. It consists of

Capita transfer

Financial assets

Financial A/c consists of

Direct Investment - investor exerts some explicit degree of control over the assets

Security and portfolio investment - investor has no control over the assets

Claims and liabilities

Compensating / Reserve A/c consists of

Claims and liabilities

Errors & Omissions/Official Reserves Accounts

• When BoP fail to balance, a figure is put so as to bring balance

• Net Errors and Omissions account ensures that the BOP actually balances.





BoP can be at equilibrium when

0 KACABoP 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴/𝑐 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐴/𝑐 = 0

If CA>KA; current a/c register surplus: If KA>CA, Capital a/c register surplus

If capital a/c register surplus, current a/c must register deficit

• A surplus in the BOP implies that the demand for the country’s currency exceeded the

supply and that the government should allow the currency value to increase – in value –

or intervene and accumulate additional foreign currency reserves in the Official Reserves

Account.

• A deficit in the BOP implies an excess supply of the country’s currency on world

markets, and the government should then either devalue the currency or expend its

official reserves to support its value.

NB: A balance isn't always reflected in reported figures for the current and capital accounts,

which might, for example, report a surplus for both accounts, but when this happens it always

means something has been missed—most commonly, the operations of the country's

central bank—and what has been missed is recorded in the statistical discrepancy term

(the balancing item).

A nation’s BoP interacts with nearly all of its key macroeconomic variables

GDP = GDP = C + I + G + X – M

The exchange rate

Interest rates

Inflation rates

NB: Under a fixed exchange rate system, the government bears the responsibility to

ensure that the BOP is near zero

Under a floating exchange rate system, the government has no responsibility to peg

its foreign exchange rate

)..( eYYfMXCA >>Y = foreign income, Y = domestic income, e =exchange rate

).().( eYMeYXCA

iiKA >>>i and i are domestic and foreign interest rate respectively

NB: Physical capital has (-ve) relation with i

Portfolio capital has (+ve) relation with i

If i increase, investment will come in

iiKA

eYYCABoP

..

When our currency appreciate we expect CA

Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may not

remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an





imbalance in the balance of payment account. Such an imbalance is called the disequilibrium.

Disequilibrium may take place either in the form of deficit or in the form of surplus

Causes of Disequilibrium in Balance of Payment

Population Growth

Development Programmes

Demonstration Effect

Natural Factors

Inflation

Globalization

Population Growth: Most countries experience an increase in the population and in some like

India and China the population is not only large but increases at a faster rate. To meet their

needs, imports become essential and the quantity of imports may increase as population

increases.

Development Programmes: Developing countries which have embarked upon planned

development programmes require to import capital goods, some raw materials which are not

available at home and highly skilled and specialized manpower. Since development is a

continuous process, imports of these items continue for the long time landing these countries in a

balance of payment deficit.

Demonstration Effect: When the people in the less developed countries imitate the consumption

pattern of the people in the developed countries, their import will increase. Their export may

remain constant or decline causing disequilibrium in the balance of payments.

Natural Factors: Natural calamities such as the failure of rains or the coming floods may easily

cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial

production in the country. The exports may decline while the imports may go up causing a

discrepancy in the country's balance of payments.

Inflation: An increase in income and price level owing to rapid economic development in

developing countries, will increase imports and reduce exports causing a deficit in balance of

payments

Globalization: Due to globalization there has been more liberal and open atmosphere for

international movement of goods, services and capital. Competition has beer increased due to the

globalization of international economic relations. The emerging new global economic order has

brought in certain problems for some countries which have resulted in the balance of payments

disequilibrium.

NB: Policies that Shift the BP Line

Lower exchange rate, BP line shifts outward

Fewer imports, BP line shifts outward

More exports, BP line shifts outward





Fewer capital outflows, BP line shifts outward

Fewer capital inflows, BP line shifts inward

BoP curves

Point above BoP line is associated with surplus (Credit> Debit)

Point below BoP line is associated with deficit

For surplus i is higher than that i required to keep BoP in equilibrium

Viz

BoP is positively sloped because increase in Y will cause more imports to come in

i Will cause short term capital to come in causing

portfolio to come in = surplus

This (-ve) effect of Y and (+ve) effect of i will offset each other (effects means surplus viz

deficit)

The slope of BoP curve

Depends on MPI - Marginal propensity to Import

Interest elasticity of internal capital flow

If MPI is small and capital flow (short term capital) is interest elastic >> BoP curve will

be much flatter Viz>> Stepper

Capital Mobility





Perfect / Complete capital mobility>>>BoP curve is horizontal:BoP3

Perfect / Complete capital immobility >>> BoP curve is vertical:BoP0

Low capita mobility (High capital immobility) >>>BoP near Perfect capital immobility:BoP1

Low capita immobility (High capital mobility) >>>BoP near Perfect capital mobility:BoP2

Determinants of BoP

Export

Import

Interest rate

Exchange rate

If any of these factors change, BoP curve mush change

↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡 → 𝐵𝑜𝑃 𝑐𝑢𝑟𝑣𝑒 𝑠ℎ𝑖𝑓𝑡 𝑡𝑜 𝑟𝑖𝑔ℎ or

↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡 → 𝐵𝑜𝑃 𝑐𝑢𝑟𝑣𝑒 𝑠ℎ𝑖𝑓𝑡 𝑡𝑜 𝑟𝑖𝑔ℎ

Equilibrium in small / large open economy

Is attained when IS, LM, BoP intersect (when the 3 lines intersect)

BoP Adjustment (two options)

Do nothing (allow automatic correct mechanism) – Force of demand and supply

Take policy actions

Fiscal policy

Momentary policy

Both, their effectiveness depends on degree of K-mobility

Do nothing





From the figure above, Point E (home / domestic equilibrium) is formed above the BoP curve,

hence:

At point E is associated with surplus (Means we receive more than we pay out): Export >

Import NB: Deficit means we pay more than we receive: Imports >>> Exports

Policy used: BoP adjustment (Fixed Exchange rate system) Fiscal policy under different capital mobility

Case A: Perfect capital immobility

E0 is the initial equilibrium

If the government decide for any reason to apply expansionary fiscal policy, the IS curve will

shift from IS0 to IS1 form an equilibrium at point E1 where there is high Y and low i.

Since E1 is at the right of BoP, it is associated with deficit (i is lower than that necessary i

required to keep BoP at equilibrium).

The presence of deficit, it will lead to the depreciation of exchange rate. But Central bank will

not agree / allow exchange rate to depreciate, it will collect (buy) domestic currency from people

and increase foreign currency (this will lead↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↑↑ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift upward from LM0 up to LM1

where both 3 curves intersect at E2.

At E2, Crowding out effect is equivalent to government spending. Therefore, Fiscal policy is

useless in this case of Perfect capital immobility





Case B: Low capital mobility


If the government decide for any reason to apply / deploys expansionary policy (increase

spending or reduce taxation), the IS curve will shift from IS0 to IS1 form an equilibrium at point

E1 where there is high Y and low i.

Since E1 is at the right of BoP, it is associated with deficit (i is lower than that necessary i

required to keep BoP at equilibrium).

The presence of deficit, it will lead to depreciation of exchange rate. But Central bank will not

agree / allow exchange rate to depreciate, it will collect (buy) domestic currency from people and

increase foreign currency (this will lead↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↑↑ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift upward from LM0 up to LM1


At E2, 12 YY (there is low output than at E1): This is because of Crowding out effect

NB: Y falls from Y1 to Y2 due to fall in Investment and Investment falls due to high

interest rate (AD = C+I+G+X-M). Investment is the component of aggregate

demand (Y)

∴↑↑ 𝑖 →↓↓ 𝐼 →↓↓ 𝑌 Whenever there is Deficit, it will allow exchange rate to depreciate

Case C: Relative high capital mobility






If the government decide for any reason to apply / deploys expansionary policy (increase


E1 where there is high Y and i.

Since E1 is at the left of BoP, it is associated with surplus (people have plenty foreign

currency) (i is higher than that necessary i required to keep BoP at equilibrium).

The presence of surplus, it will lead to appreciation of exchange rate. But Central bank will not

agree / allow exchange rate to appreciate, it will collect (buy) foreign currency from people and

increase domestic currency (this will lead↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

∴ LM curve as a result of ↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift to the right from LM0 up to LM1


At E2, 12 YY (there is high output than at E1):

NB: Y increases from Y1 to Y2 due to raise in Investment and Investment raises due to

fall in interest rate (AD = C+I+G+X-M). Investment is the component of

aggregate demand (Y)

∴↓↓ 𝑖 →↑↑ 𝐼 →↑↑ 𝑌 Whenever there is surplus, it will allow exchange rate to appreciate

Case D: Perfect capital mobility


If the government decide for any reason to apply / deploy expansionary policy (increase


E1 where there is high Y and i.

Since E1 is at the left of BoP, it is associated with surplus (people have plenty foreign

currency) (i is higher than that necessary i required to keep BoP at equilibrium).

The presence of surplus, it will lead to appreciation of exchange rate. But Central bank will not

agree / allow exchange rate to appreciate, it will collect (buy) foreign currency from people and

increase domestic currency (this will lead↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

∴ LM curve as a result of ↑↑ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will shift to the right from LM0 up to LM1


At E2, 12 YY (there is high output than at E1): No crowding out effect





Compressive summary

Y0 to Y1 is an immediate effect of fiscal policy

Y1 to Y2 in an effect of monetary policy

For Relative high capital mobility and Perfect capital mobility, no crowding out

effect

Fiscal policy is 100% effective under Perfect capital mobility (Much I but less i)

The greater the K –mobility, the greater the effectiveness of fiscal policy

Since Investment (I) is the component of aggregate demand (Y)

∴↓↓ 𝑖 →↑↑ 𝐼 →↑↑ 𝑌viz

Whenever there is surplus, it will allow exchange rate to appreciate

Whenever there is deficit, it will allow exchange rate to depreciate

IS curve: The IS shifts right when there is (Increase in gvt spending) an

expansionary fiscal policy change or the exchange rate depreciates (i.e., e

increases). The IS curve shifts left when there is (decrease in gvt spending) a

contractionary fiscal policy change or when the exchange rate appreciates.

LM curve: The LM shifts right when there is (Increase in domestic money

supply) an expansionary monetary policy change. It shifts to the left when there

is (decrease in money supply) a contractionary monetary policy change.

BP curve: Fixed exchange rate system: The BoP does not shift, regardless of the

degree of capital mobility. The central bank must increase or decrease the money

supply to counter any surplus or deficit in the Balance of Payments.

Policy used: BoP adjustment (Fixed Exchange rate system) Monetary policy under different capital mobility



If the government for any reason decides to increase money supply the LM curve will shift

from LM0 to LM1 form equilibrium at point E1 where there is high Y.

Since E1 is at the right of BoP, it is associated with deficit (people lack foreign currency) (i is

lower than that necessary i required to keep BoP at equilibrium).





The presence of deficit will exert pressure on exchange rate to depreciate. But Central bank will


and increase foreign currency (this will lead↑↑ 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 & ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

∴ LM curve as a result of ↓↓ 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 it will again shift to the left from LM1 up to

LM0 (origin position) where both 3 curves intersect at E0.

Hence, Monetary policy is completely (100%) ineffective under Perfect K – Mobility

BoP and IS curves do not shift, just only LM curve do

Case B: Relatively low capital mobility



Since E1 is at the right of BoP, it is associated with deficit (people lack foreign currency) (i is

lower than that necessary i required to keep BoP at equilibrium).






Hence, Monetary policy is completely (100%) ineffective under Low K – Mobility






Case C: Relatively high capital mobility



Since E1 is at the right of BoP, it is associated with Balance of payment deficit (people lack

foreign currency) (i is lower than that necessary i required to keep BoP at equilibrium).











Since E1 is at the right of BoP, it is associated with Balance of payment deficit (people lack

foreign currency) (i is lower than that necessary i required to keep BoP at equilibrium).












Policy used: BoP adjustment (FLEXIBLE Exchange rate system) FISCAL policy under different capital mobility


If the economy starts at point 0E , and for any reason, if government deploy the expansionary

fiscal policy, the IS curve shifts to the right from 0IS to 1IS and form the new domestic

equilibrium at point 1E where new IS curve intersect with origin LM curve.

Since 1E is to the right of the BoP curve, therefore it is associated with deficit which will put

pressure for domestic currency to depreciate, Do to depreciation, export becomes less expensive

and imports much expensive (↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 thus causing further movement of

IS curve to the right, as it is flexible exchange market system (Central bank will does nothing).

Do to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 will cause movement of BoP curve to the right until 2E

where both three lines intersect each other

Note: the fiscal policy is effective

LM curve does not shift









Since 1E is to the right of the BoP curve, therefore it is associated with BoP deficit which will

put pressure for domestic currency to depreciate, Do to depreciation, export becomes less

expensive and imports much expensive (↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 thus causing further

movement of IS curve to the right, as it is flexible exchange market system (Central bank will

does nothing).

Do to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 will cause movement of BoP curve to the right until 2E

where both three lines intersect each other

Note: the fiscal policy is effective










Since 1E is above of the BoP curve, therefore it is associated with BoP surplus which will put

pressure for domestic currency to appreciate, Do to appreciation, imports becomes less expensive

and exports much expensive ( ↑↑ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 thus causing back movement of IS

curve and leftward shift of BoP curve until the meet LM curve, and thus intersection of three

Note: the fiscal policy is less effective






Since 1E is above the BoP curve, therefore it is associated with BoP surplus which will put

pressure for domestic currency to appreciate, Do to appreciation, Imports becomes less

expensive and export much expensive ( ↑↑ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 thus causing back

movement of IS curve to the origin position, as it is flexible exchange market system (Central

bank will does nothing).

Note: the fiscal policy is ineffective

LM curve and BoP do not shift

IS curve move temporarily from 0IS to 1IS and back to 0IS

Policy used: BoP adjustment (FLEXIBLE Exchange rate system) Monetary policy under different capital mobility







monetary policy, the LM curve shifts to the right from 0LM to 1LM and form the new domestic

equilibrium at point 1E where new LM curve intersect with origin IS curve.

Since 1E is below the BoP curve, therefore it is associated with BoP deficit which will put

pressure for domestic currency to depreciate, Do to depreciation, exports becomes less expensive

and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓𝐼𝑚𝑝𝑜𝑟𝑡𝑠 IS curve and BoP curve to shift to the right until at point 1E , where both new LM,

BoP and IS curves intersect each other

Note: the monetary policy is effective

LM, IS and BoP shift











and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . Due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓𝐼𝑚𝑝𝑜𝑟𝑡𝑠 IS curve and BoP curve to shift to the right until at point 1E , where both new LM,










and import much expensive ( ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓ 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 . Due to ↑↑ 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 𝑎𝑛𝑑 ↓↓𝐼𝑚𝑝𝑜𝑟𝑡𝑠 IS curve and BoP curve to shift to the right until at point 1E , where both new LM,









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Review questions

Why Tanzania shilling has recently been depreciating? What are the possible effect on

investors, exporters, importers and public as a whole?

High demand for foreign goods and services which leads to demand for highly

convertible currency (dollar), therefore this leads to excess demand for dollar. So

many people will be rushing for few available foreign currency, hence price of

dollar raise (appreciates)

The demand for foreign exchange arises from

The desire to import or purchase goods and services from other nations and to

make investments abroad.

The supply of foreign exchange comes from

Exporting or selling goods and services to other nations and from the inflow of

foreign investments.

If the domestic currency price of the foreign currency rises, we say that the domestic

currency has

Depreciated.

In the opposite case, we say that the domestic currency has

Appreciated (and the foreign currency depreciated).

What are foreign exchange markets? What is their most important function?

What are the four different levels of participants in foreign exchange markets?

What is meant by the exchange rate? How is the equilibrium exchange rate determined

under a flexible exchange rate system?

What is meant by a depreciation of the domestic currency? An appreciation?

What is arbitrage? What is its result?

Why is the measure of the balance-of-payments deficit or surplus not strictly appropriate

under a flexible exchange rate?

What is meant by a spot transaction and the spot rate? A forward transaction and the

forward rate? What is meant by a forward discount? Forward premium? What is a

currency swap? What is a foreign exchange futures? A foreign exchange option?

What is meant by foreign exchange risk? How can foreign exchange risks be covered in

the spot, forward, futures, or options markets? Why does hedging not usually take place

in the spot market?

What is meant by speculation? How can speculation take place in the spot, forward,

futures, or options markets? Why does speculation not usually take place in the spot

market? What is stabilizing speculation? Destabilizing speculation?

Assume that the three month FR = $2.00/￡1 and a speculator believes that the spot rate

in three months will be SR = $2.05/￡1. How can a person speculate in the forward

market? How much will the speculator earn if he or she is correct?

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foreign exchange and foreign exchange market

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