Foreign Exchange Market Dynamics

The foreign exchange market is a crucial component of international trade and finance, determining the value of currencies relative to one another.

Definition: Currency appreciation occurs when the value of a currency increases relative to other currencies, while currency depreciation is when its value decreases.

Key points about the foreign exchange market:

• Demand for a currency comes from other countries, while supply is provided by residents of the country.
• An increase in demand leads to currency appreciation, while a decrease causes depreciation.
• Currency depreciation is not necessarily negative, as it can boost net exports by making a country's goods more attractive to foreign buyers.

Example: If the US dollar depreciates, US exports would likely increase while imports decrease, as American goods become relatively cheaper for foreign buyers.

Factors affecting currency value:

1. Increased foreign travel to a country typically increases demand for its currency, leading to appreciation.
2. A recession in a foreign country can decrease demand for another country's currency, causing depreciation.
3. Higher price levels in a country can increase both demand and supply of its currency, often resulting in depreciation.
4. Relatively higher interest rates in a country tend to increase demand and decrease supply of its currency, leading to appreciation.

Quote: "What will happen to the US Dollar? 1. Europeans travel more to the US: D$↑ Appreciate. 2. A severe recession in Europe: D$↓ Depreciate. 3. Increase in price level in the US: D$ S$↑ Depreciate. 4. Relatively higher interest rate in US: D$↑ S$↓ Appreciate." - Jacob Clifford, ACDC Econ

Real Interest Rates and Capital Flows

The relationship between real interest rates and capital flows is a critical aspect of international finance and balance of payments economics.

Definition: Net Capital Outflow (NCO) refers to the flow of financial capital between countries.

Key points on real interest rates and capital flows:

• Higher real interest rates (RIR) in a country lead to more capital inflow and less outflow, as the currency becomes more attractive to foreign investors.
• This increased attractiveness typically results in currency appreciation.

The financial account can be in surplus or deficit:

• A financial account surplus occurs when outflows exceed inflows (Net Capital Outflow > 0).
• A financial account deficit happens when inflows exceed outflows (Net Capital Outflow < 0).

Highlight: The relationship between real interest rates and net capital outflow is inverse. As real interest rates increase, net capital outflow decreases, potentially leading to a financial account deficit.

Example: If the United States raises its interest rates relative to other countries, it may experience increased capital inflows as foreign investors seek higher returns, potentially causing the US dollar to appreciate.

Understanding these relationships is crucial for analyzing how foreign exchange markets affect trade deficits and the overall balance of payments. It also helps explain why higher interest rates attract foreign investment and can lead to currency appreciation.