The Foreign Exchange Market

Chapter 13
The Foreign
Exchange
Market
Copyright 2006 Pearson Addison-Wesley. All
rights reserved.
13-2
Chapter Preview
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 ong Run
Exchange Rates in the !hort Run
Explaining "hanges in Exchange Rates

rights reserved.
13-3
Most countries of the world have their own

currencies: the #.!.$ France$ %ra&il$ and
'ndia$ (ust to name a few.
The trading of currencies and banks

deposits is what makes up the foreign
exchange market.
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13-4
The next slide shows exchange rates for

four currencies from )**+,-++..
/ote the difference in rate fluctuations

during the period. Which appears most
volatile0 The least0
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13-5
Foreign Exchange Market:
Historical Exchange Rates
"urrent foreign exchange rates
http:11www.federalreserve.gov1releases12)+1hist
Figure 13.1: Exchange Rates$ )**+3-++.
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13-6
The Foreign Exchange Market
4efinitions
). !pot exchange rate
-. Forward exchange rate
5. 6ppreciation
.. 4epreciation
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13-7
h! "re Exchange Rates #$portant%
When the currenc7 of 7our countr7

appreciates relative to another countr7$
7our countr78s goods prices abroad and
foreign goods prices in 7our countr7.
). Makes domestic businesses less competitive
-. %enefits domestic consumers 97ou:
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13-
How is Foreign Exchange Tra&e&%
F; traded in over,the,counter market

). Most trades involve bu7ing and selling bank
deposits denominated in different currencies.
-. Trades in the foreign exchange market
involve transactions in excess of <) million.
5. T7pical consumers bu7 foreign currencies
from retail dealers$ such as 6merican
Express.
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13-!
Exchange Rates in the 'ong Run
Exchange rates are determined in markets

b7 the interaction of suppl7 and demand.
6n important concept that drives the

forces of suppl7 and demand is the aw
of =ne >rice.
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13-10
Exchange Rates in the 'ong Run:
'aw o( )ne Price
The aw of =ne >rice states that the price

of an identical good will be the same
throughout the world$ regardless of which
countr7 produces it.
Example: 6merican steel <)++ per ton$

?apanese steel )+$+++ 7en per ton
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13-11
"# $ % 50 yen&' then pri(e are)
American Steel Japanese Steel
"n *.+. '100 '200
"n ,apan 5000 yen 10-000 yen
'aw o( )ne Price
aw of one price E @ )++ 7en1<

"# $ % 100 yen&' then pri(e are)
American Steel Japanese Steel
"n *.+. '100 '100
"n ,apan 10-000 yen 10-000 yen
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13-12
Exchange Rates in the 'ong Run: Theor!
o( Purchasing Power Parit! *PPP+
The theor7 of >>> states that exchange

rates between two currencies will ad(ust to
reflect changes in price levels.
>>> 4omestic price level )+A$

domestic currenc7 )+A
6pplication of law of one price to price levels
Works in long run$ not short run

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13-13
Exchange Rates in the 'ong Run: Theor!
o( Purchasing Power Parit! *PPP+
>roblems with >>>

). 6ll goods are not identical in both countries
9i.e.$ To7ota versus "hev7:
-. Man7 goods and services are not traded
9e.g.$ haircuts$ land$ etc.:
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13-14
PPP
Figure 13., >urchasing >ower >arit7$
#nited !tates1#nited Bingdom$ )*C53-++. 9'ndex: March )*C5 @ )++:
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13-15
Exchange Rates in the 'ong Run: Factors
"((ecting Exchange Rates in 'ong Run
%asic >rinciple: 'f a factor increases

demand for domestic goods relative to
foreign goods$ the exchange rate
The four ma(or factors are relative price

levels$ tariffs and Duotas$ preferences for
domestic v. foreign goods$ and productivit7.
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13-16
Relative price levels: a rise in relative

price levels cause a countr7Es currenc7
to depreciate.
Tariffs and Duotas: increasing trade barriers

causes a countr7Es currenc7 to appreciate.
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13-17
>references for domestic v. foreign goods:

increased demand for a countr7Es good
causes its currenc7 to appreciateF
increased demand for imports causes the
domestic currenc7 to depreciate.
>roductivit7: if a countr7 is more productive

relative to another$ its currenc7
appreciates.
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13-1
The following table summari&es these

relationships. %7 convention$ we are
Duoting$ for example$ the exchange rate$ E$
as units of foreign currenc7 1 ) #! dollar.
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13-1!
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13-20
Exchange Rates in the -hort Run
'n the short run$ it is ke7 to recogni&e that

an exchange rate is nothing more than the
price of domestic bank deposits in terms of
foreign bank deposits.
%ecause of this$ we will rel7 on the tools

developed in "hapter . for the
determinants of asset demand.
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13-21
Exchange Rates in the -hort Run: Expecte&
Returns on .o$estic an& Foreign .eposits
We will illustrate this with a simple example
Francois the Foreigner can deposit excess

euros locall7$ or he can convert them to
#.!. dollars and deposit them in a #.!.
bank. The difference in expected returns
depends on two things: local interest rates
and expected future exchange rates.
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13-22
Exchange Rates in the -hort Run:
Expecte& Returns an& #nterest Parit!
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13-23
i
D
= i
F
E
t +1
e
E
t
E
t
E
t +1
e
E
t
E
t
= 5%i
F
= 15%
Example: if i
D
@ )+A and expected appreciation of <$
'nterest >arit7 "ondition
< and F deposits perfect substitutes

9-:
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13-24
To determine the eDuilibrium condition$ we

must first determine the expected return in
terms of dollars on foreign deposits$ RF.
/ext$ we must determine the expected

return in terms of dollars on dollar
deposits$ R4.
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13-25
.eriving R
F
Curve
R
F
curve connects these points and is upward sloping
because when E
t
is higher$ expected appreciation
of F higher$ R
F

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13-26
.eriving R
D
Curve
4eriving R
D
"urve
>oints %$ 4$ E$ R
D
@ )+A$ so curve
is vertical
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13-27
E/uili0riu$
EDuilibrium
R
D
@ R
F
at EG
'f E
t
H EG$ R
F
H R
D
$ sell <$ E
t

'f E
t
I EG$ R
F
I R
D
$ bu7 <$ E
t

The following figure illustrates this.

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13-2
Figure 13.3 EDuilibrium in the Foreign Exchange Market
E/uili0riu$
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13-2!
Explaining Changes
in Exchange Rates
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 separatel7$ as well

as changes in the mone7 suppl7 and
exchange rate overshooting.
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13-30
Figure 13.1 !hifts in the !chedule
for the Expected Return on Foreign 4eposits RF
Explaining Changes in Exchange
Rates: -hi(ts in R
F
1. R
F
curve shifts right
when
i
F
: because R
F
at
each E
t
E
e
t+1
: because
expected appreciation
of F at each E
t
and R
F

-. =ccurs: ). 4omestic P
F -. Restrictions on
trade F 5. 'mports F
.. Exports F
J. >roductivit7
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13-31
Figure 13.2 !hifts in the !chedule
for the Expected Return on 4omestic 4eposits R4
Rates: -hi(ts in R
D
1. R
D
shifts right when
i
D
$ because R
D

at each E
t
6ssumes that
domestic
e

unchanged$ so
domestic real
rate
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13-32
Rates: Factors that -hi(t R
F
an& R
D
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13-33
Explaining Changes in Exchange Rates:
Factors that -hi(t R
F
an& R
D
*cont.+
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13-34
Figure 13.3 Effect of a Rise in the 4omestic
/ominal 'nterest Rate as a Result of an 'ncrease in Expected 'nflation
Rates: Response to i 4ecause
e

1.
e
$ E
e
tK)
$ expected
appreciation of F $
R
F
shifts out to right
2. i
D
$ R
D
shifts to right
5. 2owever because
e

H i
D
$ real rate $
E
e
tK)
more than i
D

R
F
shifts out H R
D

shifts out and E
t

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13-35
Figure 13.5 Effect of a Rise in the Mone7 !uppl7
Rates: Changes in the Mone! -uppl!
1. M
s
$ P $ E
e
tK)
$
expected appreciation
of F $ R
F
shifts right
2. M
s
$ i
D
$ R
D
shifts
leftLgo to point -
and E
t

5. 'n long run$ i
D
returns
to old level$ R
D
shifts
back$ go to point 5
and get exchange
rate overshooting
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13-36
Case: h! are Exchange Rates
-o 6olatile
Expectations of E
e
tK)
fluctuate
Exchange rate overshooting

rights reserved.
13-37
Figure 13.7 Malue of the 4ollar
and 'nterest Rates$ )*C53-++.
4ail7 foreign exchange rate
http:11Duotes.ino.com1exchanges10e@F=RE;
The .ollar an& #nterest Rates
). Malue of < and real
rates rise and fall
together$ as
theor7 predicts
-. /o association
between < and
nominal rates:
< falls in late
)*C+s as nominal
rate rises
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13-3
The Practicing Manger:
Pro(iting (ro$ F8 Forecasts
Forecasters look at factors discussed here
F; forecasts affect financial institutions

managers8 decisions
'f forecast 7en appreciate$ 7en depreciate$
!ell 7en assets$ bu7 euro assets
Make more euros loans$ less 7en loans
F; traders sell 7en$ bu7 euros

rights reserved.
13-3!
Chapter -u$$ar!
Foreign Exchange Market: the market for

deposits in one currenc7 versus deposits
in another.
Exchange Rates in the ong Run: driven

primaril7 b7 the law of one price as it
affects the four factors discussed.
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13-40
Chapter -u$$ar! *cont.+
Exchange Rates in the !hort Run: short,

run rates are determined b7 the demand
for assets denominated in both domestic
and foreign currencies.
Explaining "hanges in Exchange Rates:

factors leading to shifts in the RF and R4
schedules were explored.

The Foreign Exchange Market

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The Foreign Exchange Market

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Chapter 13

We develop a modern view of exchange

Foreign Exchange Market

Exchange Rates in the ong Run

Exchange Rates in the !hort Run

Explaining "hanges in Exchange Rates

Most countries of the world have their own

The trading of currencies and banks

The next slide shows exchange rates for

/ote the difference in rate fluctuations

When the currenc7 of 7our countr7

F; traded in over,the,counter market

Exchange rates are determined in markets

6n important concept that drives the

The aw of =ne >rice states that the price

Example: 6merican steel <)++ per ton$

aw of one price E @ )++ 7en1<

The theor7 of >>> states that exchange

>>> 4omestic price level )+A$

6pplication of law of one price to price levels

Works in long run$ not short run

>roblems with >>>

%asic >rinciple: 'f a factor increases

The four ma(or factors are relative price

Relative price levels: a rise in relative

Tariffs and Duotas: increasing trade barriers

>references for domestic v. foreign goods:

>roductivit7: if a countr7 is more productive

The following table summari&es these

'n the short run$ it is ke7 to recogni&e that

%ecause of this$ we will rel7 on the tools

We will illustrate this with a simple example

Francois the Foreigner can deposit excess

'nterest >arit7 "ondition

< and F deposits perfect substitutes

To determine the eDuilibrium condition$ we

/ext$ we must determine the expected

The following figure illustrates this.

To understand how exchange rates shift in

We will examine these separatel7$ as well

Exchange rate overshooting

Forecasters look at factors discussed here

F; forecasts affect financial institutions

'f forecast 7en appreciate$ 7en depreciate$

!ell 7en assets$ bu7 euro assets

Make more euros loans$ less 7en loans

F; traders sell 7en$ bu7 euros

Foreign Exchange Market: the market for

Exchange Rates in the ong Run: driven

Exchange Rates in the !hort Run: short,

Explaining "hanges in Exchange Rates:

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