2. Chapter Twelve The Foreign Exchange Market

3. Copyright © 2004 Pearson Education Canada Inc. Slide 12–3 Exchange Rates, 1974–2002

4. Copyright © 2004 Pearson Education Canada Inc. Slide 12–4 The Foreign Exchange Market Definitions 1.Spot exchange rate 2.Forward exchange rate 3.Appreciation 4.Depreciation

5. Copyright © 2004 Pearson Education Canada Inc. Slide 12–5 The Foreign Exchange Market 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

6. Copyright © 2004 Pearson Education Canada Inc. Slide 12–6 Law of One Price Example: Canadian steel $100 per ton, Japanese steel, 10 000 yen per ton

7. Copyright © 2004 Pearson Education Canada Inc. Slide 12–7 Law of One Price Law of one price  E = 100 yen/$

8. Copyright © 2004 Pearson Education Canada Inc. Slide 12–8 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 (i.e., Toyota versus Chevy) 2.Many goods and services are not traded (e.g., haircuts)

9. Copyright © 2004 Pearson Education Canada Inc. Slide 12–9

10. Copyright © 2004 Pearson Education Canada Inc. Slide 12–10 PPP: Canada and U.S.

11. Copyright © 2004 Pearson Education Canada Inc. Slide 12–11 Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 

12. Copyright © 2004 Pearson Education Canada Inc. Slide 12–12 Expected Returns and Interest Parity

13. Copyright © 2004 Pearson Education Canada Inc. Slide 12–13 –Example: if i D = 10% and expected appreciation of $, Expected Returns and Interest Parity Interest Parity Condition –$ and F deposits perfect substitutes (2)

14. Copyright © 2004 Pearson Education Canada Inc. Slide 12–14 Deriving 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 

15. Copyright © 2004 Pearson Education Canada Inc. Slide 12–15 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 

16. Copyright © 2004 Pearson Education Canada Inc. Slide 12–16 Equilibrium in the Foreign Exchange Market

17. Copyright © 2004 Pearson Education Canada Inc. Slide 12–17 Shifts 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  2.Occurs: 1. Domestic P  ; 2. Restrictions on trade  ; 3. Imports  ; 4. Exports  ; 5. Productivity  Figure 4: Shifts in the Schedule for the Expected Return on Foreign Deposits R F

18. Copyright © 2004 Pearson Education Canada Inc. Slide 12–18 Shifts in R D 1.R D shifts right when –i D , because R D  at each E t –Assumes that domestic π e unchanged, so domestic real rate 

19. Factors that Shift R F and R D Copyright © 2004 Pearson Education Canada Inc. Slide 12–19

20. Copyright © 2004 Pearson Education Canada Inc. Slide 12–20 Response to i  Because π e  1.π e , E e t+1 , expected appreciation of F , R F shifts out to right 2.i D , R D shifts to right 3.However because π e  > i D , real rate , E e t+1  more than i D   R F shifts out > R D shifts out and E t 

21. Copyright © 2004 Pearson Education Canada Inc. Slide 12–21 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 long run, i D returns to old level, R D shifts back, go to point 3 and get exchange rate overshooting

22. Copyright © 2004 Pearson Education Canada Inc. Slide 12–22 Why Exchange Rate Volatility? Expectations of E e t+1 fluctuate Exchange rate overshooting

23. Copyright © 2004 Pearson Education Canada Inc. Slide 12–23 Profiting from FX Forecasts Forecasters look at factors discussed here FX forecasts affect financial institutions managers' decisions If forecast yen appreciate, yen depreciate, –Sell franc assets, buy euro assets –Make more euros loans, less yen loans –FX traders sell yen, buy euros