1. Topics in Exchange Rates & Interest Rates

2. Extra Reading Carry Trade DownloadDownload Effective Exchange Rate: Macau Download Download

3. Effective Exchange Rates When thinking about the exchange rate of the economy, we have considered only the exchange rate with the US$. This is an abstraction, since a country has many trading partners. Define S X to be the number of domestic currency units needed to buy 1 unit of country X currency. Define d X as the depreciation rate of the domestic currency rate relative to country X.

4. Effective Exchange Rates Pt2. Define w X as the weight on country x’s currency. Effective depreciation of currency is Choose base year and chain to get effective exchange rate index S EFF

5. Effective Exchange Rates

6. Uncovered Interest Parity

7. Saving It is January 1 st, and you have RMB1 to save for 1 year. You can put it into: 1.Put it into a domestic currency bank account at an interest rate i. 2.a foreign currency bank account at interest rate i F.

8. Payoff to strategy #2 Strategy two has three parts. 1.Buy foreign exchange at spot rate S t to get {1/ S t } US dollars. 2.Put {1/S t } into bank account. After 1 year get US$(1+i F )×{1/S t } 3.Convert these funds into RMB at exchange rate prevailing in 1 year.

9. Uncovered Interest Parity If > 1+i, deposit funds then deposit in US$ account. If < 1+i, deposit funds then deposit in HK$ account. Then in equilibrium

10. Interest Rate Parity The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rate would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. Approximately

11. International Interest Rates

12. Exchange Rate Appreciation

13. Thai Interest Rates and the Dollar/Baht Rate

14. Covered Interest Parity An investor has $1 for saving. Consider two investment strategies: 1.Invest RMB1 in a domestic bond with interest rate 1+i. 2.Use RMB1 to buy 1/S t foreign dollars in spot markets. Invest 1/S t in foreign bonds at interest rate 1+i *. Agree on a forward contract to sell (1+i * )/S t foreign currency for domestic dollars. Arbitrage implies that the two strategies will have the same pay-off. This implies a forward price.

15. Fixed Exchange Rate If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then. If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. i = i F

16. HIBOR vs. Fed Funds Rate

17. Costs & Benefits of Fixed Exchange Rates Benefits –Stable currency for international trade & finance Costs –Cannot adjust interest rates for domestic stabilization of business cycles.

18. Managed Floating Most developed/OECD central banks set domestic interest rates in response to domestic price levels. Many emerging markets or developing economies either set a fixed exchange rate or simply use the currency of another country – “Dollarization” Many other emerging markets also practice “managed floating” which sometimes adjusts the interest rate in response to domestic conditions and sometimes intervenes in foreign currency markets to stabilize the price level.

19. Source http://www.imf.org/external/np/mfd/er/2005/eng/1205.htmhttp://www.imf.org/external/np/mfd/er/2005/eng/1205.htm

20. Learning Outcomes Students should be able to: Calculate a effective exchange rate index. Use interest differentials to predict future depreciations and future spot spreads.