FOREIGN EXCHANGE MARKET

Exchange rates
Nominal Exchange rates
• Nominal exchange rate is the rate at which a person can trade the currency of
one country for the currency of another.
• A nominal exchange rate can be expressed in 2 ways:

➢Indirect Exchange rate (UK, US): the value of the unit of home currency
quoted in terms of foreign currency (denoted as e)
𝑒 = 𝐹𝐶 Τ𝐷𝐶
➢Direct Exchange rate: the value of a unit of foreign currency quoted in terms
of the money of the home country (denoted as E)
𝐸 = 𝐷𝐶/𝐹𝐶
Exchange rates
Nominal Exchange rates
• Appreciation

➢E.g. 𝐸1 = 30,282 𝑉𝑁𝐷/GBP, 𝐸2 = 29,805 𝑉𝑁𝐷/𝐺𝐵𝑃

→ E ↓: VND appreciates
• Depreciation

➢E.g. 𝐸1 = 23,000 𝑉𝑁𝐷/𝑈𝑆𝐷, 𝐸2 = 23,230 𝑉𝑁𝐷/𝑈𝑆𝐷

→ E ↑: VND depreciates
• Revaluation

• Devaluation
Exchange rates
Real Exchange rates
• Real exchange rate is the rate at which a person can trade the goods

and services of one country for the goods and services of another.

• Real and nominal exchange rates are closely related.

➢E.g.

❑Vietnamese rice: 20,000 VND/kg

❑Japanese rice: 160 JPY/kg

❑E= 210 VND/JPY

❑What is the real exchange rate between Vietnamese rice and Japanese rice?
Exchange rates
Real Exchange rates
• A real exchange rate can be expressed in 2 ways :

➢The value of a unit of foreign goods / services quoted in terms of the

domestic goods / services

𝑃∗ × 𝐸
𝐸𝑟 =
𝑃
➢The value of the unit of domestic goods / services quoted in terms of foreign
goods / services

𝑃×𝑒
𝑒𝑟 =
𝑃∗
Exchange rates
Real Exchange rates
• Appreciation: 𝐸𝑟 ↓: VN goods have become more expensive

compared to foreign goods.

• Depreciation: 𝐸𝑟 ↑: VN goods have become cheaper relative to

foreign goods.
Foreign Exchange Market
• The currency of one country is exchanged for the currency of

another in the foreign exchange market.

Foreign Exchange Market
• Demand of USD:

➢To buy U.S.-produced goods and services / to import.

➢To buy U.S. assets such as bonds, stocks, businesses, and real estate.

➢To keep part of the money holding in a U.S. dollar bank account

• Supply of USD:

➢…

➢…

➢…
Foreign Exchange Market
• Demand curve for U.S. Dollars
Foreign Exchange Market
• Supply Curve for U.S. Dollars
Foreign Exchange Market

E SFX

Eo

DFX

Qo Q
13
Foreign Exchange Market
Foreign Exchange Market
Exchange Rate Policy
• Flexible / Floating exchange rate

• Fixed exchange rate

• Crawling peg
Exchange Rate Policy
• Flexible / Floating Exchange Rate

➢An exchange rate is determined by demand and supply in the

foreign exchange market

➢No direct intervention by the central bank

Exchange Rate Policy
• Fixed Exchange Rate

➢An exchange rate that is determined by a decision of the

government or the central bank

➢Achieved by central bank intervention in the foreign exchange

market
Exchange Rate Policy
• Crawling Peg

➢An exchange rate that follows a path determined by a decision of

the government or the central bank

➢Achieved by central bank intervention in the foreign exchange

market
Balance of Payments (BoP)
• A country’s balance of payments accounts records its international

trading, borrowing, and lending in 2 accounts:

➢Current account

➢Capital and financial account

Balance of Payments (BoP)
➢Current account (CA)

❑𝑁𝑋 = 𝑋 − 𝑀

❑Net interest income

❑Net transfers

➢Capital and financial account (KA)

❑Foreign investment minus investment abroad

Balance of Payments (BoP)
𝐵𝑜𝑃 = 𝐶𝐴 + 𝐾𝐴 + 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐𝑎𝑙 𝑑𝑖𝑠𝑐𝑟𝑒𝑝𝑎𝑛𝑐𝑦

• Zero

• Surplus → official reserves (the government’s holdings of foreign

currency) increase

• Deficit → official reserves (the government’s holdings of foreign

currency) decrease
Balance of Payments (BoP)
𝐵𝑜𝑃 = 𝐶𝐴 + 𝐾𝐴 + 𝑠𝑡𝑎𝑡𝑖𝑠𝑡𝑖𝑐𝑎𝑙 𝑑𝑖𝑠𝑐𝑟𝑒𝑝𝑎𝑛𝑐𝑦

• The official settlements account: records the change in official

reserves (the government’s holdings of foreign currency)

𝑜𝑓𝑓𝑖𝑐𝑖𝑎𝑙 𝑠𝑒𝑡𝑡𝑙𝑒𝑚𝑒𝑛𝑡𝑠 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 = −𝐵𝑜𝑃
Exercise 1
• How do the following transactions affect Vietnamese exports, imports,
and net exports?
a. A Vietnamese art professor visits European museums during his
summer break.
b. Paris students see “Bố già” at the cinema.
c. You uncle bought a new Volvo.
d. A bookstore at the Netherlands’ University sells a Thai Tuan ao dai.
e. A Chinese buys goods at Tan Thanh market (Lang Son, Vietnam) to
avoid Chinese VAT.
Exercise 2

• Would the following group of people be happy or unhappy if the

VND appreciates?

a. The Dutch pension funds who are holding Vietnamese

government bonds.

b. Vietnam’s textile and garment industry (when consider exports)

c. American tourists who are planning to travel to Vietnam.

d. A Vietnamese firm who is about to buy foreign assets.

Exercise 3
• What happens to Vietnam’s real exchange rate in each of the following cases?
Explain.
a. The nominal exchange rate is unchanged, but Vietnamese price level
increases more rapidly than foreign price level.
b. The nominal exchange rate is unchanged, but foreign price level
increases more rapidly than Vietnamese price level.
c. VND depreciates while the price levels in Vietnam and abroad are both
unchanged.
d. VND appreciates while the price levels in Vietnam and abroad are both
unchanged.
Exercise 4

• A country has a current account surplus of $10 billion, a capital

account deficit of $6 billion.

a. How is the country’s balance of payments?

b. Do the country’s official reserves increase or decrease?

c. Is the central bank buying or selling local currency? Explain.

Exercise 5
• Suppose that an IBM laptop costs USD 2000 in the U.S. and CAD 3000 in
Canada.
a. Where would you buy an IBM laptop if the nominal exchange rate
between is 0.8 USD to 1 CAD? Where would you sell the laptop if you
want to make a profit?
b. If all speculators act like you, and if the exchange rate is fixed, what would
happen to the price of the laptop in each of the 2 countries?
c. If all speculators act like you, and if the exchange rate is flexible, what
would happen to the exchange rate?