Chapter 20: The Foreign Exchange Market

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Chapter 20 The Foreign Exchange Market

• Exchange rateprice of one currency in terms of
  another
• Foreign exchange marketthe financial market
  where exchange rates are determined
• Spot transactionimmediate (two-day) exchange of
  bank deposits
• Spot exchange rate
• Forward transactionthe exchange of bank deposits
  at some specified future date
• Forward exchange rate

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• Appreciationa currency rises in value relative
  to another currency
• Depreciationa currency falls in value relative
  to another currency
• In this class, exchange rate is defined as
  foreign currency per domestic currency (other
  classes or textbooks may have opposite
  definition)
• Exchange rate ? ? domestic currency appreciation
• Exchange rate ? ? domestic currency depreciation
• Currency appreciates, domestic goods prices ?
  abroad and foreign goods prices ? in the domestic
  country
• 1. Makes domestic businesses less competitive
• 2. Benefits domestic consumers

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How are exchange rates determined?
Examples of Foreign Exchange Rates

• In the long run
• Purchasing Power Parity (Application of Law of
  One Price)
• In the short run
• Interest Parity

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Law of One Price

• Example American steel 100 per ton, Japanese
  steel 10,000 yen per ton
• American Steel Japanese Steel
• In U.S. 100 ?
• In Japan ? yen 10,000 yen
• If E 50 yen/ then prices are
• American Steel Japanese Steel
• In U.S. 100 200
• In Japan 5000 yen 10,000 yen
• If E 100 yen/ then prices are
• American Steel Japanese Steel
• In U.S. 100 100
• In Japan 10,000 yen 10,000 yen
• Law of one price ? E 100 yen/

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Purchasing Power Parity (PPP)
PPP ? Domestic price level ? 10, domestic
currency ? 10 1. Application of law of one price
to price levels 2. Works in long run, not short
run Problems with PPP 1. All goods not identical
in both countries Toyota vs Chevy 2. Many goods
and services are not traded e.g. haircuts
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Factors Affecting E in Long Run

• Basic Principle If factor increases demand for
  domestic goods relative to foreign goods, E ?

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Exchange Rates in the Short Run Interest Parity

• An exchange rate is the price of domestic assets
  in terms of foreign assets
• Using the theory of asset demandthe most
  important factor affecting the demand for
  domestic (dollar) assets and foreign (euro)
  assets is the expected return on these assets
  relative to each other

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Exchange Rates in the Short Run Interest Parity

• RETe for (in terms of domestic currency)
• Deposits iD
• F Deposits iF (Eet1 Et)/Et
• RETe for (in terms of foreign currency)
• Deposits iD (Eet1 Et)/Et
• F Deposits iF
• Interest Parity Condition
• and F deposits perfect substitutes
• iD iF (Eet1 Et)/Et
• Example if iD 10 and expected appreciation of
  , (Eet1 Et)/Et, 5 ? iF 15

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Interest Parity Condition

• Capital mobility with similar risk and liquidity
  ? the assets are perfect substitutes
• The domestic interest rate equals the foreign
  interest rate minus the expected appreciation of
  the domestic currency
• Expected returns are the same on both domestic
  and foreign assets
• An equilibrium condition

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Demand and Supply for Domestic Assets

• Demand
• Depends on the relative expected return
• iD - iF (Eet1 Et)/Et
• At lower current values of the dollar Et
  (everything else equal), the quantity demanded of
  dollar assets is higher
• Supply
• The amount of bank deposits, bonds, and equities
  in the U.S.
• Vertical supply curve

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Recall Demand depends on the relative expected
return iD - iF (Eet1 Et)/Et
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Recall Demand depends on the relative expected
return iD - iF (Eet1 Et)/Et
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Recall Demand depends on the relative expected
return iD - iF (Eet1 Et)/Et
Eet1 ? Occurs when 1) Domestic P ?, 2)
Tariffs and quotas ? 3) Imports ?, 4) Exports
?, 5) Productivity ?
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Response to iD ?

• Recall Fisher Effect iD rD ?e.iD ?, assuming
  ?e unchanged ? Demand curve shifts to the right.
  But if iD ? is caused by ?e ?
• ?e ?, Eet1 ?, Demand curve shifts to the left
• Therefore, it is possible that iD ? ? Et ?, when
  rD ?.

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The Dollar and Interest Rates
1. Value of and real rates rise and fall
together, as theory predicts 2. No association
between and nominal rates falls in late 70s
as nominal rate rises