chapter 7 The Foreign Exchange Market

Copyright © 2001 Addison Wesley Longman TM 7- 2 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

Copyright © 2001 Addison Wesley Longman TM 7- 3 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$100 In Japan10,000 yen10,000 yen Law of one price  E = 100 yen/$

Copyright © 2001 Addison Wesley Longman TM 7- 4 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

Copyright © 2001 Addison Wesley Longman TM 7- 5 PPP: U.S. and U.K

Copyright © 2001 Addison Wesley Longman TM 7- 6 Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 

Copyright © 2001 Addison Wesley Longman TM 7- 7 Expected Returns and Interest Parity RET e for FrancoisAl $ Depositsi D + (E e t+1 – E t )/E t i D F Depositsi F i F – (E e t+1 – E t )/E t Relative RET 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 F 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%

Copyright © 2001 Addison Wesley Longman TM 7- 8 Deriving RET F Curve Assume i F = 10%, E e t+1 = 1 euro/$ Point A:E t = 0.95RET F =.10 – (1 – 0.95)/0.95 =.048 = 4.8% B:E t = 1.00RET F =.10 – (1 – 1.0)/1.0 =.100 =10.0% C:E t = 1.05RET F =.10 – (1 – 1.05)/1.05 =.148 = 14.8% RET F curve connects these points and is upward sloping because when E t is higher, expected appreciation of F higher, RET F  Deriving RET D Curve Points B, D, E, RET D = 10%: so curve is vertical Equilibrium RET D = RET F at E* If E t > E*, RET F > RET D, sell $, E t  If E t < E*, RET F < RET D, buy $, E t 

Copyright © 2001 Addison Wesley Longman TM 7- 9 Equilibrium in the Foreign Exchange Market

Copyright © 2001 Addison Wesley Longman TM Shifts in RET F RET F curve shifts right when 1.i F  : because RET F  at each E t 2.E e t+1  : because expected appreciation of F  at each E t and RET F  Occurs: 1) Domestic P , 2) Tariffs and quotas  3) Imports , 4) Exports , 5) Productivity 

Copyright © 2001 Addison Wesley Longman TM Shifts in RET D RET D shifts right when 1. i D  ; because RET D  at each E t Assumes that domestic  e unchanged, so domestic real rate 

Copyright © 2001 Addison Wesley Longman TM Factors that Shift RET F and RET D

Copyright © 2001 Addison Wesley Longman TM Response to i  Because  e  1.  e , E e t+1 , expected appreciation of F , RET F shifts out to right 2. i D , RET D shifts to right However because  e  > i D , real rate , E e t+1  more than i D  RET F out > RET D out and E t 

Copyright © 2001 Addison Wesley Longman TM Response to M s  1. M s , P , E e t+1  expected appreciation of F , RET F shifts right 2. M s , i D , RET D shifts left Go to point 2 and E t  3. In the long run, i D returns to old level, RET D shifts back, go to point 3 and get Exchange Rate Overshooting

Copyright © 2001 Addison Wesley Longman TM Why Exchange Rate Volatility? 1. Expectations of E e t+1 fluctuate 2. Exchange rate overshooting

Copyright © 2001 Addison Wesley Longman TM 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