Chapter 13_The Foreign Exchange Market

1. Chapter 13 The Foreign Exchange Market

In the mid-1980s, American businesses became less competitive relative to their foreign counterparts.By the 2000s, though, competitiveness increased.Why?

Part of the answer can be found in exchange rates.In the 1980s, the dollar was strong, and US goods were expensive to foreign buyers.

By the 1990s and 2000s, the dollar weakened, so American goods became cheaper and American businesses became more competitive.

In this chapter, we develop a modern view of exchange rate determination that explains recent behavior in the foreign exchange market.Topics include:

Foreign Exchange Market

Exchange Rates in the Long Run

Exchange Rates in the Short Run

Explaining Changes in Exchange Rates

Most countries of the world have their own currencies: the U.S dollar., the euro in Europe, the Brazilian real, and the Chinese yuan, just to name a few.

The trading of currencies and banks deposits is what makes up the foreign exchange market.

Two kinds of exchange rate transactions make up the foreign exchange market:

Spot transactionsinvolve the near-immediate exchange of bank deposits, completed at thespot rate .

Forward transactionsinvolve exchanges at some future date, completed at theforward rate .

The next slide shows exchange rates for four currencies from 1990-2006.

Note the difference in rate fluctuations during the period.Which appears most volatile?The least?

When the currency of your country appreciates relative to another country, your country's goods pricesabroad and foreign goods pricesin your country.

Makes domestic businesses less competitive

Benefits domestic consumers (you)

For example, in 1999, the euro was valued at $1.18.On April 26, 2006, it was valued at $1.36.

Euro appreciated 15% (1.36-1.18) / 1.18

Dollar depreciated 13% (0.75-0.85) / 0.85

Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18

We can see exchange rates in the WSJ.

FX traded in over-the-counter market

Most trades involve buying and selling bank deposits denominated in different currencies.

Trades in the foreign exchange market involve transactions in excess of $1 million.

Typical consumers buy foreign currencies from retail dealers, such as American Express.

FX volume exceeds $3 trillion per day.

Exchange rates are determined in markets by the interaction of supply and demand.

An important concept that drives theforces of supply and demand is the Lawof One Price.

The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.

Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.

Law of one price E= 100 yen/$

The theory of PPP states that exchange rates between two currencies will adjust to reflect changes in price levels.

PPPDomestic price level10%, domestic currency10%

Application of law of one price to price levels

Works in long run, not short run

Problems with PPP

All goods are not identical in both countries(i.e., Toyota versus Chevy)

Many goods and services are not traded (e.g., haircuts, land, etc.)

Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate

The four major factors are relative price levels, tariffs and quotas, preferences for domestic v. foreign goods, and productivity.

Relative price levels: a rise in relativeprice levels cause a countrys currencyto depreciate.

Tariffs and quotas: increasing trade barriers causes a countrys currency to appreciate.

Preferences for domestic v. foreign goods: increased demand for a countrys good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate.

Productivity: if a country is more productive relative to another, its currency appreciates.

The following table summarizes these relationships.By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.

In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits.

Because of this, we will rely on the tools developed in Chapter 4 for the determinants of asset demand.

We will illustrate this with a simple example

Fran ois the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank.The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

Al the American has a similar problem.He can deposit excess dollars locally, or he can convert them to euros and deposit them in a foreign bank.The difference in expected returns depends on two things: local interest rates and expected future exchange rates.

What this shows is simple.As the relative expected return on dollar assets increases (decreases), both Fran ois and Al respond by holding more (fewer) dollar assets and fewer (more) foreign assets.

This leads us to our formal title for what is going on here: Interest Parity

Interest Parity Condition

$ and F deposits perfect substitutes

Example: ifi D= 6% (US interest rate) andi F= 3% (foreign currency interest rate), what is the expected appreciation of the foreign currency?

Several things to recognize about the interest rate parity condition:

Expected returns are the same in both dollars and foreign assets

Equilibrium condition for the foreign exchange market

Next, we will develop supply/demand curves to explain how the exchange rate is determined.

To determine the equilibrium condition, we must first determine the expected return in terms of dollars on foreign deposits, RF.

Next, we must determine the expected return in terms of dollars on dollardeposits, RD.

The demand curve connects these points and is downward sloping because whenE tis higher, expected appreciation of the dollar is higher.

Deriving the Supply Curve

There isnt really anything to derive.We will take the quantity of bank deposits, bonds, and equities as fixedwith respect to exchange rates .

Equilibrium

Supply=DemandatE *

IfE t>E *,Demand

IfE tSupply , sell $,E t

The following figure illustrates this.

To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits.

We will examine these separately, as well as changes in the money supply and exchange rate overshooting.

Demandcurve shifts right when

i D : because people want to hold more dollars

This causes domestic currency to appreciate.

Demandcurve shifts left when

i F : because people want to hold fewer dollars

This causes domestic currency to depreciate.

Demandcurve shifts left when

: because people want to hold more dollars

This causes domestic currency to appreciate.

Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing

Expected fall in relative U.S. price levels

Expected increase in relative U.S. trade barriers

Expected lower U.S. import demand

Expected higher foreign demand for U.S. exports

Expected higher relative U.S. productivity

These are summarized in the following slides.

Our analysis allows us to take a look at the response of exchange rates to a variety of macro-economic factors.For example, we can use this framework to examine (1) the impact of changes in interest rates, and (2) the impact of money growth.

Changes in domestic interest rates are often cited in the press as affecting exchange rates.

We must carefully examine the source of the change to make such a statement.Interest rates change because either (a) the real rate or (b) the expected inflation is changing.The effect of each differs.

When thedomestic real interest rateincreases, the domestic currency appreciates.We have already seen this situation in Figure 4 (slide 37).

When thedomestic expected inflationincreases, the domestic currency reacts in the opposite direction it depreciates.This is shown on the next slide.

Changes in domestic money supply are a bit more complicated.We summarize the results on the next slide.However, you may want to read the text on this section to fully digest the effects.

M s ,P ,E e t +1 , shifting demand curve from D 1to D 2 .

In long run,i Dreturns to old level, and demand shifts from D 2to D 3( exchange rate overshooting)

Exchange rate overshootingis important because it helps explain why foreign exchange rates are so volatile.

Another explanation deals with changes in the expected appreciation of exchange rates.Asanythingchanges our expectations (price levels, productivity, inflation, etc.), exchange rates will change immediately.

Our analysis also allows us to take a look at the weak dollar in the 1980s, and (partially) explain why it became stronger in the 1990s and 2000s.We present a summary in Figure 9, on the next slide.

Value of $ and real rates rise and fall together, astheory predicts

No association between $ and nominal rates:$ falls in late1970s as nominal rate rises

The euro debuted in 1999 at $1.18 / euro.It declined to $0.83 by October 2000, but has recovered, trading at $1.35 by the end of 2007.

Initially, the European countries had relatively weaker economies, but that has reversed in recent years, weakening the dollar relative to the euro.

The figure on the next slide shows the Currency Trading column from the Wall Street Journal on July 11, 2007.

Some highlights include:

Warnings from Home Depot and other sectors that the economy is weakening signaling possible Fed rate cuts (did that happen?)

Dollar returns expected to be lower in the future dollar expected to depreciate

Forecasters look at factors discussed here

FX forecasts affect financial institutionsmanagers' decisions

If forecast yen appreciate, yen depreciate,

Sell franc assets, buy euro assets

Make more euros loans, less yen loans

FX traders sell yen, buy euros

Foreign Exchange Market: the market for deposits in one currency versus depositsin another.

Exchange Rates in the Long Run: driven primarily by the law of one price as it affects the four factors discussed.

Exchange Rates in the Short Run: short-run rates are determined by the demand for assets denominated in both domestic and foreign currencies.

Explaining Changes in Exchange Rates: factors leading to shifts in the demand and supply schedules were explored.

Chapter 13_The Foreign Exchange Market

Business

Transcript of Chapter 13_The Foreign Exchange Market