1. Foreign Exchange Markets,
Purchasing Power Parity, and Real Interest Parity
ECO Money & Banking - Dr. D. Foster

2. Perspective! The U.S. We want to buy foreign exchange.
We don’t really want the “money.”
We want the goods/services/financial assets
We pay $ to get foreign exchange.
When the $ appreciates, we can buy more i.e. the price is lower.
When the $ appreciates, the £ depreciates.
When $ depreciates … price is higher.

3. Perspective! The U.S. We demand foreign exchange - £, Ұ, € $ (per £)
The market for pounds (£)
E = $2
Demand shows: our demand for British goods and services (our imports)
E = $1
D £
At higher prices…
it takes more dollars to buy a pound,
British goods are more expensive,
the dollar is depreciating (and the £ is appreciating).
At lower prices … Q£

4. Perspective! The U.S. $ (per £)
What would shift the demand for British pounds?
The market for pounds (£)
The Fed may buy pounds!
A change in our tastes and preferences for their goods.
A change in our income.
A change in trade restrictions.
A change in monetary policy...
D’£
D £
D”£ Q£

5. Perspective! The U.S. Foreigners supply foreign exchange - £, Ұ, € S £Q£
E = $2
E = $1
Supply shows: British demand for dollars to buy our goods (our exports). To acquire $ they must supply £.
The market for pounds (£)
At higher prices…
pounds buy more dollars,
American goods are cheaper,
the dollar is depreciating (and the £ is appreciating).
At lower prices …

6. Perspective! The U.S. S £ $ (per £) Q£ S’£
What would shift the supply of British pounds?
S’£
A change in their tastes and preferences for our goods.
A change in their income.
A change in trade restrictions.
A change in monetary policy...
The Fed may sell pounds!
The market for pounds (£)

7. Perspective! The U.S. $ depreciates; the price rises; we buy less
$ appreciates; the price falls; we buy more
D £
S £
$ (per £) Q£ E
Equilibrium in the market for pounds (£)
Exchange rate changes as S & D change . . .

8. Perspective! The U.S. Q - What if we want less British goods?
A - Increase Demand; E rises; $ depreciates E’ S’
A - Increase Supply; E falls; $ appreciates E’ D’
A - Decrease Demand; E falls; $ appreciates
D £
S £
$ (per £) Q£ E
Q - What if our incomes rise?
Q - What if Brits want more US goods?

9. Perspective! Britain They want to buy foreign exchange ($).
They don’t really want the “money.”
They want our goods/services/financial assets
They pay £ to get $ (foreign exchange).
When the £ appreciates, they can buy more i.e. the price is lower.
When the £ appreciates, the $ depreciates.
When £ depreciates … price is higher.

10. Exchange rate changes as S & D change . . .
Perspective! Britain
£ depreciates; the price rises; we buy less
D $
S $
£ (per $) Q$
1 E
$ appreciates
£ appreciates; the price falls; we buy more
$ depreciates
Exchange rate changes as S & D change . . .

11. Perspective! Britain Q - What if we want less British goods?
A - Increase Demand; 1/E rises; $ appreciates
1/E’ D’
1/E’ S’
A - Increase Supply; 1/E falls; $ depreciates
1/E’ S’
A - Decrease Supply; 1/E rises; $ appreciates
Q - What if U.S. incomes rise?
D $
S $
£ (per $) Q$
1/E
Q - What if Brits want more US goods?

12. Current Exchange Rates
D $
S $
£ (per $) Q$
$ (per £)
S £
.7994
1.251
D £ Q£

13. Real Exchange Rates Nominal: What we see reported.
SFr/US $: – – 1.171
Nominal %Δ: – 4.72%
(1.171−1.229) 1.229

14. Real Exchange Rates Nominal: What we see reported.
Real: Adjusted for price level changes.
Real = Nominal*(CPIUS/CPISFr)
SFr/US $: – – 1.171
CPI (Swiss):
CPI (US):
1.1825
Nominal %Δ: – 4.72%
Real %Δ: – 3.785%
(1.171−1.229) 1.229
1.171∗
(1.1825−1.229) 1.229

15. Real Exchange Rates Who’s perspective? Draw it out . . . SFr/$ S$
So, the $ is . . .
1.171
1.229
. . . depreciating in value.

16. Purchasing Power Parity
Where . . .
transportation costs are zero.
tax differentials do not exist.
there are no trade restrictions.
goods are homogeneous.
Law of One Price: A unit of goods in one country trades for the same price in another country.

17. Example - Apples in U.S. & Britain
U.S. price = $.50; British = £.75
If exchange rate is .667 ($/£) then the apple sells for the same price in both.
What if the exchange rate is .75?
Sell apple in Britain for .75 (£) and convert to $: (£.75)*(.75) = $.562 for a 6.2 cent profit!
What happens . . .?

18. Arbitrage results U.S. -  demand for apples -  apple prices
Britain -  supply of apples -  apple prices
.667
.75 S£
S£1 D£
S/£ Q£
In U.S. foreign exchange market,  S£ as arbitrageurs convert back to $.
On your own - show this from the British perspective.

19. Different PPP models Absolute PPP: CPIUS = E(CPIBrit)
if this can be applied to all goods,
assumes goods mix the same in both.
Solve for rate: E = (CPIUS)/(CPIBrit)
Relative PPP: %ΔE = %Δ(CPIUS) - %Δ(CPIBrit)
differences in inflation rates explain . . .
appreciating/depreciating exchange rates.
Long-run data tends to confirm this.

20. Hedging your bets - Futures Market
Buying Future Dollars
Hedging your bets - Futures Market
You want to buy British bonds . . .
earning iBrit
but you face the risk of changing E . . .
So, you buy $ futures contract.
Locks in your financial outcome . . .

21. What if the risk premiums differed? Wait …
Buying Future Dollars
Let iUS=6% and iBrit=8% with E=1.2
E aka “spot rate.”
Let the forward rate be Ef=1.18
With $1200, should you invest in US bonds or British bonds?
British bonds buy £1000 bond;
in one year, worth £1080;
converts back at (1.18)*(1080) = $1274;
In US, would make $1272.
What if the risk premiums differed? Wait …

22. (Ee - E)/E = (ius-reUS) - (iBrit-reBrit)
Buying Future Dollars
British bond earns:
iBrit + [(Ef - E)/E]
in equilibrium, this equals ius
Noting relative PPP: %Ee = eUS - eBrit
where e=expected and =inflation.
Using r to represent real interest, rewrite as:
(Ee - E)/E = (ius-reUS) - (iBrit-reBrit)

23. Real Interest Rate Parity
Substituting for iUS
(Ee - E)/E = (iBrit + [(Ef - E)/E] -reUS) - (iBrit-reBrit)
Canceling for iBrit cancel out and if Ee=Ef, then:
reUS = reBrit

24. Revisit Bond Problem
What if the UK bond had a risk premium of +0.3% over the US bond?
U.K. return = $74/1200 = 6.17% … but adjusted for risk = 5.87%
U.S. return = 6%; take the U.S. bond!!!

25. Foreign Exchange & Monetary Policy
Gold Standard
Fixed X∆ rates, K flows, $ policy
Bretton Woods System
Fixed X∆ rates, K flows, $ policy
Unmanaged free floating rates
Volatile X∆ rates, K flows, $ policy
Managed rates
Semi-fixed X∆ rates, K flows, ???$ policy

26. Foreign Exchange Markets,
Purchasing Power Parity, and Real Interest Parity
ECO Money & Banking - Dr. D. Foster