1. 1 The Foreign Exchange Market

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3. 3 Asian Currencies vs. U.S. Dollar

4. 4 The Foreign Exchange Market Definitions: 1.Spot exchange rate 2.Forward exchange rate 3.Appreciation 4.Depreciation Currency appreciates, country’s goods prices  abroad and foreign goods prices  in that country 1.Makes domestic businesses less competitive 2.Benefits domestic consumers FX traded in over-the-counter market 1.Trade is in bank deposits denominated in different currencies

5. 5 The Foreign Exchange Market Foreign exchange (dollars) Exchange rate Peso/$ S D Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos

6. 6 Currency Depreciation and Appreciation Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange

7. 7 Changes in the Equilibrium Exchange Rate Foreign exchange (dollars) Exchange rate Peso/$ S D Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos S’ $ -depreciation Peso- appreciation

8. 8 Exchange Rate Regimes Flexible (Floating) exchange rates. Fixed exchange rates. – Currency Board – Monetary Union Managed Float (Dirty Float) exchange rates.

9. 9 The Central Bank Can Intervene to Maintain Exchange Rates Foreign exchange (pounds) Exchange rate $/pound S D’’ D’

10. 10 China

11. 11 Currency Crisis Foreign exchange ($) Exchange rate Baht/$ S D’ D 25 52

12. 12 Asian Currencies vs. U.S. Dollar

13. 13 Law of One Price Example: American steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are: American SteelJapanese Steel In U.S.$100$200 In Japan5000 yen10,000 yen If E = 100 yen/$ then prices are: American SteelJapanese Steel In U.S.$100$100 In Japan10,000 yen10,000 yen Law of one price  E = 100 yen/$

14. 14 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

15. 15 Big Mac Index

16. 16 PPP: U.S. and U.K

17. 17 Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 

18. 18 Exchange Rates in the Short Run An exchange rate is the price of domestic assets in terms of foreign assets Using the theory of asset demand—the 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

19. 19 Comparing Expected Returns I

20. 20 Comparing Expected Returns II

21. 21 Comparing Expected Returns III

22. 22 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

23. 23 Demand and Supply for Domestic Assets Demand – Relative expected return – At lower current values of the dollar (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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28. 28 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 The exchange rate falls by more in the short run than in the long run – Helps to explain why exchange rates exhibit so much volatility

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30. 30 The Dollar and Interest Rates While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced

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32. 32 Exchange Rate Regimes Fixed exchange rate regime – Value of a currency is pegged relative to the value of one other currency (anchor currency) Floating exchange rate regime – Value of a currency is allowed to fluctuate against all other currencies Managed float regime (dirty float) – Attempt to influence exchange rates by buying and selling currencies

33. 33 Past Exchange Rate Regimes Gold standard – Fixed exchange rates – No control over monetary policy – Influenced heavily by production of gold and gold discoveries Bretton Woods System – Fixed exchange rates using U.S. dollar as reserve currency – International Monetary Fund (IMF)

34. 34 Past Exchange Rate Regimes (cont’d) Bretton Woods System (cont’d) – World Bank – General Agreement on Tariffs and Trade (GATT) World Trade Organization European Monetary System – Exchange rate mechanism

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37. 37 How a Fixed Exchange Rate Regime Works When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result, it loses international reserves When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves

38. 38 How Bretton Woods Worked Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments) Loans from IMF to cover loss in international reserves IMF encourages contractionary monetary policies Devaluation only if IMF loans are not sufficient No tools for surplus countries U.S. could not devalue currency

39. 39 Managed Float Hybrid of fixed and flexible – Small daily changes in response to market – Interventions to prevent large fluctuations Appreciation hurts exporters and employment Depreciation hurts imports and stimulates inflation Special drawing rights as substitute for gold

40. 40 European Monetary System 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar ECU value was tied to a basket of specified amounts of European currencies Fluctuated within limits Led to foreign exchange crises involving speculative attack

41. 41 Capital Controls Outflows – Promote financial instability by forcing a devaluation – Controls are seldom effective and may increase capital flight – Lead to corruption – Lose opportunity to improve the economy Inflows – Lead to a lending boom and excessive risk taking by financial intermediaries

42. 42 Capital Controls (cont’d) Inflows (cont’d) – Controls may block funds for productions uses – Produce substantial distortion and misallocation – Lead to corruption Strong case for improving bank regulation and supervision

43. 43 The IMF: Lender of Last Resort Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function May be able to prevent contagion The safety net may lead to excessive risk taking (moral hazard problem)

44. 44 How Should the IMF Operate? May not be tough enough Austerity programs focus on tight macroeconomic policies rather than financial reform Too slow, which worsens crisis and increases costs

45. 45 Direct Effects of the Foreign Exchange Market on the Money Supply Intervention in the foreign exchange market affects the monetary base U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market

46. 46 Balance-of-Payments Considerations Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong U.S. deficits mean surpluses in other countries  large increases in their international reserve holdings  world inflation

47. 47 Exchange Rate Considerations A contractionary monetary policy will raise the domestic interest rate and strengthen the currency An expansionary monetary policy will lower interest rates and weaken currency

48. 48 Advantages of Exchange-Rate Targeting Contributes to keeping inflation under control Automatic rule for conduct of monetary policy Simplicity and clarity

49. 49 Disadvantages of Exchange-Rate Targeting Cannot respond to domestic shocks and shocks to anchor country are transmitted Open to speculative attacks on currency Weakens the accountability of policymakers as the exchange rate loses value as signal

50. 50 Exchange-Rate Targeting for Industrialized Countries Domestic monetary and political institutions are not conducive to good policy making Other important benefits such as integration

51. 51 Exchange-Rate Targeting for Emerging Market Countries Political and monetary institutions are weak Stabilization policy of last resort

52. 52 Currency Boards Solution to lack of transparency and commitment to target Domestic currency is backed 100% by a foreign currency Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate Money supply can expand only when foreign currency is exchanged for domestic currency

53. 53 Currency Boards (cont’d) Stronger commitment by central bank Loss of independent monetary policy and increased exposure to shock from anchor country Loss of ability to create money and act as lender of last resort

54. 54 Dollarization Another solution to lack of transparency and commitment Adoption of another country’s money Even stronger commitment mechanism Completely avoids possibility of speculative attack on domestic currency Lost of independent monetary policy and increased exposure to shocks from anchor country

55. 55 Dollarization (cont’d) Inability to create money and act as lender of last resort Loss of seignorage

56. 56 Appendix Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book. They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.

57. 57 Expected Returns and Interest Parity R e for FrancoisAl $ Depositsi D + (E e t+1 – E t )/E t i D Euro Depositsi F i F – (E e t+1 – E t )/E t Relative R e i D – i F + (E e t+1 – E t )/E t i D – i F + (E e t+1 – E t )/E t Interest Parity Condition: $ and Euro deposits perfect substitutes i D = i F – (E e t+1 – E t )/E t Example:if i D = 10% and expected appreciation of $, (E e t+1 – E t )/E t, = 5%  i F = 15%

58. 58 Deriving R F Curve Assume i F = 10%, E e t+1 = 1 euro/$ Point A:E t = 0.95,R F =.10 – (1 – 0.95)/0.95 =.048 = 4.8% B:E t = 1.00,R F =.10 – (1 – 1.0)/1.0 =.100 =10.0% C:E t = 1.05,R F =.10 – (1 – 1.05)/1.05 =.148 = 14.8% R F curve connects these points and is upward sloping because when E t is higher, expected appreciation of F higher, R F  Deriving R D Curve Points B, D, E, R D = 10%: so curve is vertical Equilibrium R D = R F at E* If E t > E*, R F > R D, sell $, E t  If E t < E*, R F < R D, buy $, E t 

59. 59 Equilibrium in the Foreign Exchange Market

60. 60 Shifts in R F R F curve shifts right when 1.i F  : because R F  at each E t 2.E e t+1  : because expected appreciation of F  at each E t and R F  Occurs E e t+1  i F : 1) Domestic P , 2) Trade Barriers  3) Imports , 4) Exports , 5) Productivity 

61. 61 Shifts in R D R D shifts right when 1. i D  ; because R D  at each E t Assumes that domestic  e unchanged, so domestic real rate 

62. 62 Foreign Exchange I Exchange rate—price of one currency in terms of another 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

63. 63 Foreign Exchange II 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 and vice versa Over-the-counter market mainly banks

64. 64 Exchange Rates in the Long Run Law of one price Theory of Purchasing Power Parity – Assumes all goods are identical in both countries – Trade barriers and transportation costs are low – Many goods and services are not traded across borders

65. 65 Factors that Affect Exchange Rates in the Long Run Relative price levels Trade barriers Preferences for domestic versus foreign goods Productivity

66. 66 Factors that Shift R F and R D

67. 67 Response to i  Because  e  1.  e , E e t+1 , expected appreciation of F , R F shifts out to right 2. i D , R D shifts to right However because  e  > i D , real rate , E e t+1  more than i D  R F out > R D out and E t 

68. 68 Response to M s  1. M s , P , E e t+1  expected appreciation of F , R F shifts right 2. M s , i D , R D shifts left Go to point 2 and E t  3. In the long run, i D returns to old level, R D shifts back, go to point 3 and get Exchange Rate Overshooting

69. 69 Why Exchange Rate Volatility? 1. Expectations of Ee t+1 fluctuate 2. Exchange rate overshooting

70. 70 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

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76. Chapter 18 The International Financial System

77. 77 Unsterilized Foreign Exchange Intervention A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base Federal Reserve System AssetsLiabilitiesAssetsLiabilities Foreign Assets -$1BCurrency in circulation -$1BForeign Assets -$1BDeposits with the Fed -$1B (International Reserves) (reserves)

78. 78 Unsterilized Intervention An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

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80. 80 Sterilized Foreign Exchange Intervention To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation There is no effect on the monetary base and no effect on the exchange rate Federal Reserve System AssetsLiabilities Foreign AssetsMonetary Base (International Reserves)-$1B(reserves)0 Government Bonds+$1B

81. 81 Balance of Payments Current Account – International transactions that involve currently produced goods and services Trade Balance Capital Account – Net receipts from capital transactions Sum of these two is the official reserve transactions balance