Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 20 The Foreign Exchange...

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 20

The Foreign Exchange Market

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.20-2

Why foreign exchange market

• International finance• International trade

– Currency conversion domestic currency exchanged for foreign currency

• Exchange rate affects domestic price and demand, i.e, inflation, production, et al


Foreign Exchange I

• Exchange rate: price of one currency in terms of another– Direct Quote - U.S. $ / foreign currency unit.– Indirect Quote - Foreign currency unit / $.

• Foreign exchange market: the financial market where exchange rates are determined– Spot transaction: immediate (two-day) exchange of bank

deposits• Spot exchange rate

– Forward transaction: the exchange of bank deposits at some specified future date

• Forward exchange rate (1, 3, 6 month(s))


Foreign Exchange Rate


Foreign Exchange II

• Currency value fluctuation– Appreciation: a currency rises in value relative to another

currency

– Depreciation: a currency falls in value relative to another currency

– When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive

• Over-the-counter market – Dealer are primarily banks

– Trade deposits


US Dollar – China Yuan


FIGURE 1 Exchange Rates, 1990–2008

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


Exchange Rates in the Long Run

• Law of one price– Identical good– Little transaction costs/trade barrier Same price

• Theory of Purchasing Power Parity:– Application of the law of one price– However, many goods and services are not

traded across borders



• Real exchange rate– The rate at which domestic goods can be

exchanged for foreign goods (rather than currency)

– Big Mac Index• An informal measure of PPP published by The

Economist

– A basket of goods



http://www.economist.com/blogs/dailychart/2011/07/big-mac-index


FIGURE 2 Purchasing Power Parity, United States/United Kingdom, 1973–2008 (Index: March 1973 = 100.)

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

1, Price of goods (CPI) – Exchange rate2, Long run – short run


Factors that Affect Exchange Rates in the Long Run

• Reasoning: demand for domestic goods increasing the value of domestic currency

• Factors:– Relative price levels of goods

• Price , Demand , Currency

– Trade barriers (Tariff and Quotas)• Barrier , Demand , Currency

– Preferences for domestic versus foreign goods

– Productivity


Summary Table 1 Factors That Affect Exchange Rates in the Long Run


Exchange Rates in the Short Run: A Supply and Demand Analysis

• An exchange rate is the price of domestic assets in terms of foreign assets

• Supply curve for domestic assets– Assume amount of domestic assets is fixed

(supply curve is vertical)

• Demand curve for domestic assets– Most important determinant is the relative

expected return of domestic assets– At lower current values of the dollar (everything

else equal), the quantity demanded of dollar assets is higher


FIGURE 3 Equilibrium in the Foreign Exchange Market

US as home country


Explaining Changes in Exchange Rates

• Supply curve fixed

• Shifts in the demand for domestic assets

– Depending on the expected return of dollar-dominated assets (U.S as home country)

• Domestic interest rate (dollar deposits)

• Foreign interest rate (foreign deposits)

• Expected future exchange rate


FIGURE 4 Response to an Increase in the Domestic Interest Rate, iD


FIGURE 5 Response to an Increase in the Foreign Interest Rate, iF


FIGURE 6 Response to an Increase in the Expected Future ExchangeRate, Ee

t+1


FIGURE 7 Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected Inflation


Summary Table 2 Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate


Application: Changes in the Equilibrium Exchange Rate

• Changes in Interest Rates– When domestic real interest rates raise, the

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

expected increase in inflation, the domestic currency depreciates.

• Changes in the Money Supply– A higher domestic money supply causes the

domestic currency to depreciate.


Application: Changes in the Equilibrium Exchange Rate

Exchange Rate Overshooting•Monetary Neutrality

– In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level

– Money supply – no effect on interest rate in the long run

•The exchange rate falls by more in the short run than in the long run (overshooting)

– Helps to explain why exchange rates exhibit so much volatility


FIGURE 8 Effect of a Rise in the Money Supply

Short run:1. Money supply , -> price , Result: exchange rate ;2. Money supply , -> domestic interest rate , -> domestic asset return Result: exchange rate ;

Long run:Interest rate goes back (M.S no effect on interest)


Application: Why exchange rate so volatile?

• Expected appreciation/depreciation of currency

• Expected change of price level, inflation, trade barrier, productivity

• Focus on assets rather than goods


FIGURE 9 Value of the Dollar and Interest Rates, 1973–2008

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

• Real interest rate – effective exchange rate

• Nominal interest rate


Application: The Subprime Crisis and the Dollar

• During 2007 interest rates fell in the United States and remained unchanged in Europe.

• The dollar depreciated

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

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

• The dollar appreciated


Application: The Subprime Crisis and the Dollar

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