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The Foreign Exchange Market

Chapter 17

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Foreign Exchange DefinitionsForeign Exchange Definitions

Exchange rate: price of one currency in terms of Exchange rate: price of one currency in terms of anotheranother

Foreign exchange market: the financial market Foreign exchange market: the financial market where exchange rates are determinedwhere exchange rates are determined

Spot transaction: immediate (two-day) exchange of Spot transaction: immediate (two-day) exchange of bank depositsbank deposits Spot exchange rateSpot exchange rate

Forward transaction: the exchange of bank Forward transaction: the exchange of bank deposits at some specified future datedeposits at some specified future date Forward exchange rateForward exchange rate

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Foreign ExchangeForeign ExchangeAppreciation: a currency rises in value Appreciation: a currency rises in value

relative to another currencyrelative to another currencyDepreciation: a currency falls in value Depreciation: a currency falls in value

relative to another currencyrelative to another currencyWhen a country’s currency appreciates, When a country’s currency appreciates,

the country’s goods abroad become more the country’s goods abroad become more expensive and foreign goods in that expensive and foreign goods in that country become less expensive and vice country become less expensive and vice versaversa

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Exchange RatesExchange RatesFeb. 2, 20091 USD = .7786 EUR1 USD = .7002 GBP1 USD = 89.61 JPY

Mar. 28, 20101 USD = .7471 EUR1 USD = .6711 GBP1 USD = 92.4700 JPY

Calculate the appreciation and depreciation of each currency.Calculate the appreciation and depreciation of each currency.

Find the values for today and calculate the appreciation/depreciation.Find the values for today and calculate the appreciation/depreciation.

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Exchange Rates, 1990–2008Exchange Rates, 1990–2008

Source:Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist. Federal Reserve: www.federalreserve.gov/releases/h10/hist.

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Factors that Affect Exchange Factors that Affect Exchange Rates in the Long RunRates in the Long Run

Relative price levelsRelative price levels

Trade barriersTrade barriers

Preferences for domestic versus foreign Preferences for domestic versus foreign goodsgoods

ProductivityProductivity

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Price ChangesPrice Changes

Law of one price: for identical productsLaw of one price: for identical products

Theory of Purchasing Power ParityTheory of Purchasing Power ParityExpanding the law of one price to all productsExpanding the law of one price to all productsAll goods are identical in both countriesAll goods are identical in both countriesTrade barriers and transportation costs are Trade barriers and transportation costs are

lowlowMany goods and services are not traded Many goods and services are not traded

across borders, undermining PPPacross borders, undermining PPP

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Purchasing Power Parity, United Purchasing Power Parity, United States/United Kingdom, 1973–2008 States/United Kingdom, 1973–2008

(Index: March 1973 = 100.)(Index: March 1973 = 100.)

Source:Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt. ftp.bls.gov/pub/special/requests/cpi/cpiai.txt.

1010

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Factors That Affect Exchange Factors That Affect Exchange Rates in the Long RunRates in the Long Run

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Demand and Supply in the SRDemand and Supply in the SR

EUR/USD

USD denominated assets

In the short run, In the short run, demand for USD is low demand for USD is low when USD is strong when USD is strong because there is a high because there is a high likelihood that USD will likelihood that USD will depreciate in the future. depreciate in the future. Holding an asset that Holding an asset that will lose its value is very will lose its value is very risky. risky. In the short run the In the short run the supply of USD in the supply of USD in the FX market is fixed by FX market is fixed by the available bank the available bank deposits, bonds and deposits, bonds and stocks.stocks.

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Equilibrium in the Foreign Equilibrium in the Foreign Exchange MarketExchange Market

At EAt E22 there is excess there is excess

supply of dollar supply of dollar denominated assets. denominated assets. The foreign price of The foreign price of these assets fall to these assets fall to bring the market into bring the market into equilibrium.equilibrium.

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Domestic Currency AppreciationDomestic Currency Appreciation

EUR/USD

USD denominated assets

The foreign price of USD The foreign price of USD denominated assets denominated assets increases.increases.

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Domestic Currency Domestic Currency DepreciationDepreciation

EUR/USD

USD denominated assets

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Explaining Changes in SR Explaining Changes in SR Exchange Rates Exchange Rates

Shifts in the demand for domestic assetsShifts in the demand for domestic assets

Domestic interest rateDomestic interest rate

Foreign interest rateForeign interest rate

Expected future exchange rateExpected future exchange rate

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Increase in the Domestic Increase in the Domestic Interest Rate, Interest Rate, iiDD

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Increase in the Foreign Increase in the Foreign Interest Rate, Interest Rate, iiFF

2020

Increase in the Expected Future Increase in the Expected Future Exchange Rate, Exchange Rate, EEeet+1t+1

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Factors That Shift the Demand Factors That Shift the Demand Curve for Domestic AssetsCurve for Domestic Assets

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Increase in Expected InflationIncrease in Expected Inflation

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Interest Rates and FXInterest Rates and FX

Changes in Interest RatesChanges in Interest RatesWhen domestic real interest rates raise, the When domestic real interest rates raise, the

domestic currency appreciates.domestic currency appreciates.When domestic interest rates rise due to an When domestic interest rates rise due to an

expected increase in inflation, the domestic expected increase in inflation, the domestic currency depreciates.currency depreciates.

Changes in the Money SupplyChanges in the Money SupplyA higher domestic money supply causes the A higher domestic money supply causes the

domestic currency to depreciate. domestic currency to depreciate.

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Exchange Rate OvershootingExchange Rate Overshooting

Monetary NeutralityMonetary Neutrality In the long run, a one-time percentage rise in In the long run, a one-time percentage rise in

the money supply is matched by the same one-the money supply is matched by the same one-time percentage rise in the price leveltime percentage rise in the price level

The exchange rate falls by more in the short The exchange rate falls by more in the short run than in the long run because interest run than in the long run because interest rates fall in the short run in response to rates fall in the short run in response to monetary expansionmonetary expansion

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Rise in the Money SupplyRise in the Money Supply

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Which Interest Rate?Which Interest Rate?

While there is a strong correspondence While there is a strong correspondence between real interest rates and the between real interest rates and the exchange rate, the relationship between exchange rate, the relationship between nominal interest rates and exchange rate nominal interest rates and exchange rate movements is not nearly as pronouncedmovements is not nearly as pronounced

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Value of the Dollar and Value of the Dollar and Interest Rates, 1973–2008Interest Rates, 1973–2008

Sources:Sources: Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4. Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4.

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USD and the Subprime CrisisUSD and the Subprime CrisisDuring 2007 interest rates fell in the United During 2007 interest rates fell in the United

States and remained unchanged in Europe. States and remained unchanged in Europe. The dollar depreciatedThe dollar depreciated

Starting in the summer of 2008 interest rated Starting in the summer of 2008 interest rated fell in Europe.fell in Europe.

Increased demand for U.S. Treasuries “flight Increased demand for U.S. Treasuries “flight to quality”to quality”

The dollar appreciatedThe dollar appreciated

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