Learning Unit #15

Foreign Exchange Market Basics

Objectives of Learning Unit

• Foreign Exchange Rate• Foreign Exchange Rate and Economy• Demand and Supply Model of Foreign

Exchange Market• Determinants of Exchange Rate• Law of One Price

– Purchasing Power Parity– Interest Rate Parity

• Foreign Exchange Intervention

Foreign Exchange Rate• Foreign Exchange Market: Currencies of many

countries are traded and their prices (foreign exchange rates) are determined.

• (Foreign) Exchange Rate: the price of one country’s currency in terms of another’s.

Example: $1 = ¥100 or ¥1 = $0.01 (1¢)

• Spot (exchange) rate: Exchange rate for an immediate exchange of currencies.

• Forward (exchange) rate: Exchange rate on an agreement to exchange currencies in future.

Foreign Exchange Rates, 1990-2011Foreign exchange rates change from time to time. Each rate changes to a different direction.

In general, values of foreign currencies relative to US dollar declined early 2000s, then started to increase in 2003. This was due to a change in U.S. economic conditions, which affected the value of dollar.

A value of Japanese yen relative to US dollar declined significantly in mid-1990s due to its economic condition.

Changes in Exchange Rates• Appreciation: An increase in the value of a currency

against another currency. – This situation is often called “Strong currency.”

• Depreciation: A decrease in the value of a currency against another currency. – This situation is often called “Weak currency.”

• A change in its value (appreciation or depreciation) is measured by Rate of Appreciation/Depreciation:

(Pt+1-Pt)/Pt x 100

where P is a value of currency in terms of another.

Example of Changes in Exchange RatesInitially (t), $1 = ¥100 or ¥1 = $0.01 (1¢). Now (t+1), $1 = ¥200 or ¥1 = $0.005 (1/2¢) • A value of $ increased against ¥ ($1 can get more ¥

now) and a value of ¥ decreased against $ (¥1 can get less $ now).

• $ appreciated against ¥ and ¥ depreciated against $.• Rate of appreciation of $ = (¥200-¥100)/¥100x100 = +100% a positive sign “appreciation” Rate of depreciation of ¥ = ($0.005-$0.01)/$0.01 x 100 = -50% a negative sign “depreciation”

Foreign Exchange Rates on Barron’s

• Dow Jones’ publishes foreign exchange rates every day on the Wall Street Journal and weekly on Barron’s. – See “Reading Foreign Exchange Quotation

Information of Barron’s” on Blackboard

Exchange Rate and the Economy

• When U.S. dollar appreciates (depreciates) against foreign currency, a price of goods in U.S. becomes more expensive (cheaper) relative to the same goods in foreign country.

• As relative prices of goods, services, and financial assets (GS&FA) change, consumers in each country become more likely to buy one country’s GS&FA and less likely to buy other country’s GS&FA.

Trade deficit (surplus)

Example of Effects of Changes in Foreign Exchange RatesPrice of Toyota Prius in Japan = ¥2,500,000Price of Ford Explorer in U.S. = $30,000

Initially, $1 = ¥100 or ¥1 = $0.01 (1¢). Price of Prius in U.S. = ¥2,500,000/100 = $25,000Price of Explorer in Japan = $30,000/0.01= ¥3,000,000

Now, $1 = ¥80 or ¥1 = $0.0125 (1.25¢)Price of Prius in U.S. = ¥2,500,000/80 = $31,250Price of Explorer in Japan = $30,000/0.0125 = ¥2,400,000

When U.S. dollar depreciates against Japanese yen, what should happen to prices of Japanese goods in the U.S.? How about prices of American goods in Japan?

Demand and Supply Model of Foreign Exchange Market• A demand-supply model of foreign exchange

market is similar to any asset market model (e.g. bond or stock market).

• Along the horizontal axis, a quantity of currency demanded or supplied for exchange is measured.

• Along the vertical axis, a value of currency (in terms of other currency) is measured.– For U.S. dollar market, a value of one U.S. dollar is

measured along the vertical axis.– E.g. €0.8401 for one U.S. dollar

Demand for Currencies in Foreign Exchange Market

• Demand for currencies ($) in foreign exchange market ($ market) comes from people who want currencies (demand $) in exchange for their currencies (€).– A quantity demanded of currencies ($) increases as its

value ($) decreases.– As a value of currency ($) decreases, people get more

currencies ($) for their currencies (€) and are able to purchase more goods and services denominated in currency ($).

Ex. U.S. goods and services become cheap for European consumers as $ depreciates against €.

– So, people demand more currencies ($) to purchase more goods and services denominated in $.

Supply of Currencies in Foreign Exchange Market

• Supply of currencies ($) in foreign exchange market ($ market) comes from people who give up their currencies (supply $) in exchange for another currencies (€).– A quantity supplied of currencies ($) decreases as its

value ($) decreases. – As a value of currency ($) decreases, people have to

give up more currencies ($) to get another currencies (€) and are able to purchase less goods and services denominated in another currency (€).

Ex. European goods and services become expensive for U.S. consumers as $ depreciates against €.

– So, people supply less currencies ($) to purchase less goods and services denominated in €.

Demand-Supply Diagram of Foreign Exchange Market

• Supply curve of currency is upward-sloping, while demand curve of currency is downward-sloping.

• Demand and supply of currencies in foreign exchange market determines an equilibrium exchange rate.

Value of $

Quantity of $

Supply of $

U.S. dollar market

Demand for $

E€0.8401

Dual of Foreign Exchange Market

• Because in foreign exchange market a currency is exchanged for another currency, two currency markets are analyzed together.

• Demand for one currency ($) is supply of another currency (€), while supply of one currency ($) is demand for another currency (€).

Ex. If you are exchanging $ for €, then you are supplying $ and demanding €. If someone is exchanging € for $ with you, that person is supplying € and demanding $.

Demand and Supply Model of Foreign Exchange Market

P$: Value of US dollar in terms of foreign currency ($1=FC?)PFC: Value of foreign currency in terms of US dollar (FC1=$?)

S$ = DFC

D$ = SFC

Example of US Dollar vs. Euro Markets

Foreign Currency in US$ US$ in Foreign CurrencyThu. Wed Thu Wed

Euro 1.1919 1.1903 .8390 .8401

• On Thursday, one euro was traded for $1.1919 (€1=$1.1919), and one U.S. dollar was traded for €0.8390.

A value of U.S. dollar was €0.8390, while a value of euro was $1.1919.

• Note: 1/$1.1919 = €0.8390. Exchange rates are reciprocal.

Example of Diagrams of US Dollar and Euro Foreign Exchange Markets

€0.8401 $1.1903

Foreign Currency in US$ US$ in Foreign CurrencyThu. Wed Thu Wed

Euro 1.1919 1.1903 .8390 .8401

Changes in Foreign Exchange Rates

• From Wednesday to Thursday, a value of euro increased from $1.1903 to $1.1919, that is an appreciation of euro against U.S. dollar. At the same time, a value of U.S. dollar decreased from €0.8401 to €0.8390, that is a depreciation of U.S. dollar against euro.

• Any changes in demand or supply of currencies in foreign exchange markets affect foreign exchange rates.

Foreign Currency in US$ US$ in Foreign CurrencyThu. Wed Thu Wed

Euro 1.1919 1.1903 .8390 .8401

Changes in Foreign Exchange Rates

• An increase in value of euro maybe resulted from an increase in demand for euro (or a decrease in supply of euro). Since the demand for euro is the supply of U.S. dollar, there must be an increase in U.S. dollar, which resulted in a decrease in value of U.S. dollar.

€0.8390

€0.8401

$1.1919

$1.1903

Why Exchange Currencies?

Households and business firms want to exchange currencies because of– Trade in goods and services– Trade in financial assets (bonds & stocks)

Anything that affects trade in goods, services, and financial assets affects demand and supply of foreign currencies and its exchange rate.

Determinants of Foreign Exchange RateFive factors affecting foreign exchange rate:• Long-run (Factors affecting demand and

supply of currencies over long period of time)– Preferences for Domestic or Foreign Goods– Productivity– Trade Barriers– Price Level (Inflation)

• Short-run (Factors affecting demand and supply of currencies in short time period)– Interest Rate & Expected Return

Preferences of Domestic or Foreign Goods• Consumers’ preference of one good produced in one

country and denominated in that currency over another good produced in another country and denominated in another currency affects their demand for one currency over another.

• Example: U.S. consumers prefer to buy more foreign cars than American cars.

U.S. consumers need more foreign currencies to buy foreign cars

Demand for foreign currency increases and supply of U.S. dollar increases in foreign exchange markets.

Preferences of Domestic or Foreign Goods

• Then, U.S. dollar depreciates (from Po to P1 on P$) and foreign currencies appreciates (from Po to P1 on PFC).

Productivity• Productivity: amount of output produced by a given input.

When productivity increases, more output can be produced with the same amount of input. If it costs the same (because the same amount of input), then higher productivity means less cost of production per output.

• Ex. One worker costs $7 per hour. He makes 7 hamburgers an hour, so it costs $1 for each hamburger made. If his productivity increases to 14 hamburgers an hour, then it will cost $0.50 for each hamburger made.

• When costs of production of a good change, a price of product also changes.

• Ex. If the price of oil increases, then gasoline price will increase.

Productivity• Example: Productivity in U.S. increases more than other

countries Cost of production decreases in U.S. relative to other

countries. Prices of output decreases in U.S. relative to other

countries. U.S. consumers want to buy more (relatively cheap) U.S.

goods and less (relatively expensive) foreign goods. Demand for foreign currency decreases (as U.S.

consumers need less foreign currencies) and supply of U.S. dollar decreases.

Productivity

Then, U.S. dollar appreciates (from Po to P1 on P$) and foreign currency depreciates (from Po to P1 on PFC).

Trade Barriers• Trade barriers are impediments imposed by the

government on a particular import.• Two major types trade barriers are

– Tariffs: Tax on imports Ex. The U.S. government imposed 100% tariff (tax)

on luxury cars imported from Japan.– Quotas: Maximum amount of imports Ex. The U.S. government limits an import of

tomatoes from Mexico up to 1 million units each month.

• Trade barriers intend to raise prices of imports and discourage U.S. consumers to purchase imports and encourage them to purchase American goods.

Trade Barriers• Example: U.S. government imposes tariffs on imports

Foreign goods are more expensive in U.S. Demand fore foreign goods by U.S. consumers

decreases. Demand fore foreign currencies decreases and

supply of U.S. dollar decreases.

Trade Barriers

• Then, U.S. dollar appreciates and foreign currency depreciates.

Trade Barriers• Unintended consequence of trade barriers is an

appreciation of U.S. dollar against foreign currency.– As U.S. dollar appreciates, prices of all foreign goods

and services become relatively cheap for the U.S. consumers.

– U.S. consumers will purchase more foreign goods and services not subject to trade barriers and less of American goods and services.

• Ex. Imposing tariffs and quotas of tomatoes imports from Mexico, the U.S. dollar appreciates against Mexican peso, and U.S. wheat, apples, and beef will cost more for Mexican consumers. As a result, the U.S. wheat, apple, and beef farmers export less.

Price Level

• Inflation, a general rise in prices of goods and services, makes domestic goods and services relatively more expensive to foreign goods.

• Consumers prefer to purchase cheaper foreign goods and services.

• Inflation also means a purchasing power of money decreases, that is, its value relative to goods and services decreases.

Price Level

• Example: The prices of goods and services increase in U.S. (inflation).

Demand for foreign goods and services by U.S. consumers increases.

Demand for foreign currencies increases and supply of U.S. dollar increases

Price Level

Then, U.S. dollar depreciates and foreign currencies appreciate

Summary: Factors That Affect Exchange Rates in the Long Run

Changes in Exchange Rate in Short Run• Factors described above (Price level, Trade barriers,

Preference, and Productivity) affect the exchange rate through changes in demand for (trade of) goods and services between two countries. They may affect changes or a trend in the foreign exchange rate over long time period. However, they do not change every day, so these factors cannot explain changes in the foreign exchange rate everyday.

• Short-term changes (daily volatility) in the foreign exchange rate are primarily caused by changes in demand and supply of financial assets in two countries, which are affected by interest rates and return/risk of financial assets.

Interest Rate

• If two bonds have identical characteristics except for interest rates, savers will prefer one with higher interest rate.

• Depending on domestic economic condition, each country may have different interest rates.

• U.S. savers as well as foreign savers will put their funds in a country with the highest interest rate.

Interest Rate

• Example: The interest rate in U.S. decreases. Demand for U.S. financial assets by U.S. savers

decreases and demand for foreign financial assets by U.S. savers increases.

Demand for foreign currencies increases and supply of U.S. dollar increases.

Interest Rate

Then, U.S. dollar depreciates and foreign currencies appreciate.

Value of the Dollar and Interest Rates, 1973–2008

From 1973 to 2008, the value of the dollar (Effective exchange rate) and the measure of real interest rates tend to rise and fall together

Asset Demand and Foreign Exchange RateAny factors affecting demand for domestic (U.S.) and/or foreign financial assets (e.g. stocks, bonds), including interest rates, will affect the foreign exchange rate in the short run.

•Expected return: Higher expected return on domestic (U.S.) financial assets relative to foreign financial assets leads to higher demand for domestic currency (U.S.$) and an appreciation of domestic currency (U.S.$) against foreign currencies.

Asset Demand and Foreign Exchange Rate

• Liquidity: Higher liquidity of domestic (U.S.) financial assets relative to foreign financial assets leads to higher demand for domestic currency (U.S.$) and an appreciation of domestic currency (U.S.$) against foreign currencies.

• Risk: Higher risk on domestic (U.S.) financial assets relative to foreign financial assets leads to lower demand for domestic currency (U.S.$) and a depreciation of domestic currency (U.S.$) against foreign currencies.─ Flight to quality: When the global financial markets

experience financial crises, investors seek the safest assets (e.g. U.S. Treasury securities) and the U.S. dollar tends to appreciate against foreign currencies.

Asset Demand and Foreign Exchange Rate• Expectations: Expectations on domestic and/or

foreign financial assets and markets as well as foreign exchange rates can affect the foreign exchange rate.

• As you learned in Learning Unit 14 (Chapter 7) about rational expectations, any new information about domestic and foreign economies and financial markets can affect the foreign exchange rates.─ Financial crisis in Greece, Spain, and Italy since

2011 has caused a continuous depreciation of euro against U.S. dollar.

Demand-Supply Analysis from Foreigners’ Perspectives

• All demand-supply analysis in this section is based on U.S. consumers’ or savers’ perspectives, where they demand more or less foreign currencies in response to changes in factors.

• Foreign consumers and savers also respond to changes in factors. Although it will involve changes in demand for U.S. dollar and supply of foreign currencies (rather than demand for foreign currencies and supply of U.S. dollar), the final conclusion (appreciation or depreciation of currency) will be the same.

Example of Demand-Supply Analysis from Foreigners’ Perspectives

• Example: The prices of goods and services increase in U.S. (inflation).

Demand for U.S. goods and services by foreign consumers decreases.

Demand for U.S. dollar decreases and supply of foreign currencies decreases.

U.S. dollar depreciates against foreign currencies, while foreign currencies appreciate against U.S. dollar.

This is identical conclusion!

$ FCSFC

D$

Law of One Price

• Law of One Price: the price of a good in one country must be equal to the price of the same good in other country after taking account of the exchange rate between two countries.

• Arbitrage guarantees that prices of identical goods must be equal in two markets (countries) at equilibrium.– Of course from time to time prices could be different.

However, whenever such discrepancy occurs, an arbitrage will take places and equalize their prices.

Example of Law of One Price

• The price of BMW is $50,000 in U.S. and the price of the same BMW is €100,000 in Germany.

• The exchange rate between U.S. dollar and euro is $1= €2.

• Then, the U.S. dollar price of German BMW should be $50,000(= € 100,000/ €2).

• Law of one price holds!

Law of One Price and Foreign Exchange• When the price of a good in one country changes, prices

are no longer same in two countries.• Then, the exchange rate between two counties changes in

a way that prices become equal again in two countries after taking account of new exchange rate between two countries.– Arbitrage activity between two countries causes a

change in exchange rate between two currencies.– An arbitrager purchases goods in a low price country

(Europe), demanding more of its currency (€), causing an appreciation of that currency (€), while he sells the goods in a high price country (U.S.), selling more of its currency ($), causing a depreciation of that currency ($).

Example of Law of One Price and Exchange Rate Change

• The price of BMW in U.S. increases to $100,000, while the price of the same BMW in Germany remains at €100,000.

• At $1=€2 exchange rate, the U.S. dollar price of German BMW is still $50,000. – Law of one price does not holds any more (German

BMW is cheaper than American BMW)!• U.S. consumers want cheaper German BMW.• Demand for euro and supply of U.S. dollar increase in

foreign exchange markets.• U.S. dollar depreciates against euro and euro appreciates

against U.S. dollar to $1=€1.• At $1=€1 exchange rate, the U.S. dollar price of German

BMW becomes $100,000 (= €100,000/€1).• Law of one price holds again!

Two Variations of Law of One Price

• Law of one price is extended to two situations: one for overall prices of (tradable) goods between two countries, and the other for interest rates on similar bonds in two countries. – Purchasing Power Parity (PPP) Theory: an exchange

rate between two currencies adjusts to reflect differences in the price levels in the two countries.

– Interest Rate Parity (IRP) Theory: an expected change in exchange rate between two currencies reflects differences in the interest rates in the two countries.

Two Versions of PPP

• Two versions of purchasing power parity theory– Absolute PPP: The exchange rate is equal to the

ratio of the price levels in the two countries.– Relative PPP: The change in the exchange rate is

proportional to the relative change in the price levels in the two countries.

Absolute PPP• The exchange rate is equal to the ratio of the price levels

in the two countries.

E = Pf / Pus E: value of one US dollar in terms of foreign currency Pf: price level in foreign country Pus: price level in US

• CPI or GDP deflator is often used to measure a price level in economy. [See Learning Unit 1]

• The absolute PPP is a simple extension of “Law of One Price” that is, prices must be equal between two countries after taking into account of exchange rate.– The equation above is equivalent to PUS = Pf/E

where Pf/E is a U.S. dollar price of foreign good.

Example of Absolute PPP

• CPI in US = 100 and CPI in Euro-zone = 80 Then, E = 80/100 = 0.8 Therefore, the exchange rate between U.S. dollar and

euro is $1 = €0.8.• The CPIs indicate that if a set of goods commonly

purchased by households costs $100 in U.S., it will cost €80 in Eurozone. If an arbitrage takes place in the set of goods in CPI, then their prices must be equal. Therefore, the absolute PPP postulates that the exchange rate between two currencies must be one which make two CPIs equal.

Shortcomings of Absolute PPP

• Absolute PPP may not hold exactly for many reasons.– Goods included in CPI in different countries are not

same or consumed in same quantity.Ex. French may drink more wine and drive small cars, while American drink more beer and drive large SUVs.

– Some goods included in CPI cannot be traded, so an arbitrage will not take place.Ex. Housing, medical service, education, and personal services (e.g. hair cut) are major components of CPI, but not many consumers bother to get those services from other countries.

Relative PPP• The change in the exchange rate is proportional to the

relative change in the price levels in the two countries. (Et – Et-1)/Et-1 x 100 = πf - πus

(Et – Et-1)/Et-1 x 100: rate of appreciation/depreciation of US dollar

against foreign currencyπf: inflation rate in foreign countryπus: inflation rate in US

• An inflation rate may be computed from CPI or GDP deflator. [See Learning Unit 1]

• Relative PPP does not assume that prices of goods are equal after taking account of exchange rate. It postulates that if one country experiences an inflation (general price increases), its currency must depreciate proportionally.

Example of Relative PPP

• Inflation rate in US=5% & inflation rate in Eurozone=3% Then, πf - πus = 3% - 5% = -2% = (Et – Et-1)/Et-1 x 100

Therefore, the U.S. dollar should depreciate against euro by 2%.

• When one country experiences an inflation, consumers find foreign goods cheaper and demand more foreign goods, and in turn, more foreign currencies, leading to a depreciation of the currency.

Inflation and Exchange Rate

• Since most countries experience inflation, what matters is a relative inflation rate. Relative PPP postulates that a country with high inflation experiences its currency to depreciate, while a country with low inflation experiences its currency to appreciate.

• Higher the inflation, greater the depreciation of currency.• Ex. In October 2007, Zimbabwe experienced an annual

inflation rate of 14,840%. The exchange rates between U.S. dollar and Zimbabwe dollar were $1 = Z$300,000 in July 2007 and $1= Z$724,346,000,000 in July 2008. Can you compute a rate of depreciation of Zimbabwe dollar from July 2007 to July 2008?

Relative PPP: 1973 - 2011Relative PPP does not hold year by year. Foreign exchange rate tends to fluctuate much more than inflation rates in a short period of time. However, the relative PPP indicates a trend of foreign exchange rate over a long period of time.

Exchange Rate and PPP

• Although relative PPP indicates a trend of foreign exchange rate, it does not fully explain changes in exchange rates in a long period of time.

• There are other factors which affect foreign exchange rates and inflation rates, which leads to imperfection of relative PPP.– Goods are not perfectly identical in two countries– Transportation costs– Trade barriers– Some goods and services are not-tradable

Foreign Exchange Rate in Short Run

• In a short period of time most foreign exchanges are dominated by trade of financial assets rather than goods.

• Capital mobility: foreigners can easily purchase American assets and Americans can easily purchase foreign assets. (due to financial globalization)– Foreign exchange transactions in the U.S. are

well over 25 times greater than the amount of U.S. exports and imports.

Interest Rate Parity

• Assumption: domestic and foreign assets are perfect substitutes (they are alike in terms of risk, liquidity, and other characteristics).– Savers purchase whichever providing a higher

return.– If interest rates are higher in one country than

another, savers around the world want to purchase financial assets (e.g. bonds) in that country, and in turn, demand the currency of the country, leading an appreciation of the currency.

Interest Rate Parity Condition• Because financial assets (e.g. bonds) involve cash flows,

the interest rate parity condition involves more than one exchange rate in different time period.

• Interest Rate Parity (IRP) Theory: an expected change in exchange rate between two currencies reflects differences in the interest rates in the two countries.

i$ = iF - (Et+1-Et)/Et x 100i$: Interest rate in U.S.iF: Interest rate in foreign country(Et+1-Et)/Et x 100: Expected rate of appreciation/depreciation of U.S. dollarEt+1 : Value of U.S. dollar at time period t+1

Et : Value of U.S. dollar at time period t

Interest Rate Parity Condition• IRP condition shows that an expected return (interest rate)

on domestic financial assets must be equal to an expected return (interest rate) on similar foreign financial assets once a change in foreign exchange rate is taken into account.

i$ = iF - (Et+1-Et)/Et x 100• The left hand side of the condition (i$) is an expected return

(interest rate) from dollar denominated financial assets.• The right hand side of the condition is an expected return

(interest rate) from foreign currency denominated financial assets as sum of its expected return in foreign country (iF) and an expected rate of appreciation/depreciation of U.S. dollar against the foreign currency [- (Et+1-Et)/Et x 100].

Example of IRP: Assumptions• Interest rates of 1-year CDs are 10% in the U.S. and 5%

in the U.K.• Exchange rates between U.S. dollar and U.K. pound are

$1=£1 for spot rate and $1=£0.95 for 1-year forward rate.

• As savers you have two choices: save your $100 in the U.S., or save your $100 in the U.K.– The second choice involves exchanging currencies

since U.K. banks pay 5% interest rate on U.K. pound deposit.

– If you want to save your $100 in the U.K., you must exchange your U.S. dollar to U.K. pound first, then later exchange back to U.S. dollar from U.K. pound.

Interest Rates and Exchange Rates• Since interest rates of 1-year CDs are 10% in U.S. and

5% in U.K., everyone seems to earn more in U.S.• If foreigners want to save in the U.S. to take an

advantage of higher interest rate, then they will demand more U.S. dollar now (so they can deposit U.S. dollar in the U.S.) and will need to exchange back to U.K. pound (supplying U.S. dollar) one year later when CDs mature.

• This leads to an appreciation of U.S. dollar in a spot (foreign exchange) market and a depreciation of U.S. dollar in a forward (foreign exchange) market.

• Therefore, exchange rates between U.S. dollar and U.K. pound are $1=£1 for spot rate and $1=£0.95 for 1-year forward rate.

Example of IRP: Two Alternatives • If you purchase $100 CD in the U.S., you will get back

$110 next year. [Remember FV formula?] • If you want to purchase CD in the U.K.,

– you must exchange $100 to U.K. pound at $1= £1 spot rate to get £100 today,

– you purchase £100 CD today at 5% interest rate,– next year the CD matures and you will get £105,– finally, you exchange £105 back to U.S. dollar at

$1=£0.95 forward rate to receive $110. • Therefore, you get the same interest rate on the similar

financial assets once a change in exchange rate is taken into account!

Example of IRP: IRP Condition• Exchange rates between U.S. dollar and U.K. pound are

$1=£1 for spot rate and $1=£0.95 for 1-year forward rate. – US dollar is expected to depreciate by 5% next year.

(Et+1-Et)/Et x 100 = (0.95-1)/1x100 = -5%• The interest rate of 1-year CDs is 5% in U.K.

– An expected return on U.K. pound denominated financial assets for American savers is 10%.iF - (Et+1-Et)/Et x 100 = 5% - (-5%) = 10%

• The expected return on U.K. pound denominated financial assets must be equal to an expected return on U.S. dollar denominated financial assets.i$ = 10% = iF - (Et+1-Et)/Et x 100

IRP condition holds!

IRP Condition and Foreign Exchange Rate• The IRP condition can be used to explain changes in

foreign exchange rates.• The IRP condition can be modified as

i$ - iF = - (Et+1-Et)/Et x 100• The left hand side of the equation is a difference in

interest rates in two countries, while the right hand side is an expected rate of depreciation of US dollar against foreign currency (it has a negative sign, indicating a depreciation).

• For example, if interest rates of 1-year CDs are 10% in U.S. and 5% in U.K..– i$ - iF = 10% - 5% = 5%. – (Et+1-Et)/Et x 100 = -5%, so the U.S. dollar is expected

to depreciate by 5% next year

Interest Rate Parity: 1973 - 2008The IRP condition based on real interest rates can explain many changes in foreign exchange rate, but not perfect. There are many other factors affecting the exchange rates.

Foreign Exchange Intervention

• Beside households and business firms, governments may sell or purchase foreign currencies in attempt to affect foreign exchange rates.

• Foreign Exchange Intervention: An international financial transaction in which a central bank buys or sells currency to influence foreign exchange rates.

• Ex. The Fed sells or purchases U.S. dollar in order to influence the value of U.S. dollar relative to other currencies.

Foreign Exchange Intervention

• Since the Fed has unlimited power to issue U.S. dollars, it is simply to issue new U.S. dollars and sell them in the foreign exchange market.

• When the Fed wants to purchase U.S. dollars in the foreign exchange market, it must sell foreign currencies that it holds.

• International Reserves: Central bank holdings of assets denominated in foreign currencies.

Example of Government Intervention

• Ex. The Fed sells U.S. dollar and purchases euro in the foreign exchange market. Supply of US dollar increases in the US

dollar market and demand for euro increases in the euro market.

US dollar depreciates and euro appreciates.

Disclaimer

Please do not copy, modify, or distribute this presentation without author’s consent.

This presentation was created and owned byDr. Ryoichi Sakano

North Carolina A&T State University