Effect of International funds flow on Exchange Rates
In the absence of international lending or borrowing or inflows and outflows of funds the supply and demand for currency in the exchange rate markets would flow from importers and exporters besides speculators and arbitragers. Importers of goods and services in the US would need to buy foreign currency and sell US dollars to make payments. The supply of dollars and demand for foreign currency would therefore come from importers. US Exporters would need to receive foreign currency as payments for goods and services. Overseas importers of US goods would therefore sell their domestic currency to buy USD creating the demand for dollars.
Fluctuations in Exchange rates make imports and exports more or less expensive causing imports or exports to increase or decrease till an equilibrium rate is reached. The equilibrium rate is where the demand and supply for dollars meet and is the rate at which the quantity demanded is the same as the quantity supplied.
When we add international investing to this scenario we need to look at how investing or lending add to the supply side and borrowing or disinvestments add to the demand side.
As mentioned before foreigners investing in the US must sell their currency in exchange for dollars adding to the demand side. This is the same side as US exports which makes sense since we can view exports as an investment by foreigners in US goods and services. International investments in the US therefore cause a shift of the dollar demand curve to the right. A shift of the curve to the right moves the equilibrium rate of the dollar higher. This is a very important concept to understand.
This shift in the equilibrium rate causes US exports to become more expensive and therefore fall. Due to a stronger dollar imports become cheaper and therefore rise causing the supply for dollars to rise. With the introduction of international funds flows it is no longer true that exports must equal imports at the equilibrium rate. If imports exceed exports there is said to be a trade deficit and if exports exceed imports it is said to be a trade surplus. At the equilibrium rate if the supply of dollars is to equal the demand for dollars then the deficit must be financed by the international lending. This is a very important concept to understand in international finance or economics so spend some time on it, maybe watch the video again if required.
Lets quickly take a look at the demand and supply curve for foreign exchange. Lets take the example of dollar against the yuan. As we have mentioned the supply of dollars is due to US imports and the demand for dollars is on account of US exports. The demand for dollars is downward or negative because sloping because if the dollar exchange rate falls against the Yuan US exports become cheaper.
If the equilibrium dollar yuan rate is 6.45, an iPhone exported costs $1000, then the Chinese would pay 6450 yuan for an iPhone. At this rate the supply of iPhones in this example is say 100,000 iPhones amounting to $100 million in exports. Lets assume that the dollar now falls against the yuan and the rate is now 6.15. At 6.15, the $1000 iPhone now costs the Chinese importers 6150 . Given this price drop Chinese imports of iPhones and therefore US exports now increase from a 100,000 to a 130,000 amounting to 130 million in exports. So the lower the exchange rate the better for US exporters.
Lets look at the supply side. If at the equilibrium rate of 6.45 imports of toys from China totalled say $100 million, when the exchange rate falls to 6.15 Chinese imports become more expensive since every dollar can buy only 6.15 yuan, imports of toys falls to $150 million. Hence the supply curve is upward positive sloping.
The demand and supply curve for the total imports and exports can be seen as below. Where the two lines meet is when total exports equals total imports. The rate at which both are equal is called the equilibrium exchange rate.
Now that we understand the demand and supply for currency in the exchange markets lets add the net investments by foreigners to this scenario with an example.
Net Foreign Investment Added to the Exchange Markets
We have seen that exports adds to the demand side for US dollars. We can view exports as investments by foreigners in US goods and services. Net lending or investments by foreigners in US assets is similar to exports since foreigners have to sell their holding currency to buy USD to invest in US markets. Therefore this additional demand for dollars must be added to the total demand for dollars. This additional demand for dollars now causes the demand curve to shift upwards to the right.
Lets assume total dollar exports is a $100 billion with China and imports is also at $100 billion. With the introduction of net foreign investments the exchange rate moves from 6.45 yuan to now 6.85 yuan. At 6.85 yuan US exports fall to $70 billion as we have see due to an exchange rate rise exports become more expensive for Chinese importers and US imports from China rise to $130 billion since imports have become cheaper for US citizens. This forms a trade deficit of $60 billion. This $60 billion is the net foreign investment in US assets.
For those who have studied the Balance of Payments account in the Tradeonomics course can now relate the current account with the capital account. The trade deficit in the current account ie exports minus imports is financed by the surplus on the capital account ie net lending by foreigners.