1. The Foreign Exchange Market
Chapter 20
The Foreign Exchange Market

2. Why foreign exchange market
International finance
International trade
Currency conversion  domestic currency exchanged for foreign currency
Exchange rate affects domestic price and demand, i.e, inflation, production, et al

3. Foreign Exchange I
Exchange rate: price of one currency in terms of another
Direct Quote - U.S. $ / foreign currency unit.
Indirect Quote - Foreign currency unit / $.
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 (1, 3, 6 month(s))

4. Foreign Exchange Rate

5. Foreign Exchange II Currency value fluctuation Over-the-counter market
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
Over-the-counter market
Dealer are primarily banks
Trade deposits

6. US Dollar – China Yuan

7. FIGURE 1 Exchange Rates, 1990–2008
Source: Federal Reserve: 7

8. Exchange Rates in the Long Run
Law of one price
Identical good
Little transaction costs/trade barrier
 Same price
Theory of Purchasing Power Parity:
Application of the law of one price
However, many goods and services are not traded across borders

9. Exchange Rates in the Long Run
Real exchange rate
The rate at which domestic goods can be exchanged for foreign goods (rather than currency)
Big Mac Index
An informal measure of PPP published by The Economist
A basket of goods

10. Exchange Rates in the Long Run

11. 1, Price of goods (CPI) – Exchange rate
FIGURE 2 Purchasing Power Parity, United States/United Kingdom, 1973–2008 (Index: March 1973 = 100.)
1, Price of goods (CPI) – Exchange rate
2, Long run – short run
Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt. 11

12. Factors that Affect Exchange Rates in the Long Run
Reasoning: demand for domestic goods increasing the value of domestic currency
Factors:
Relative price levels of goods
Price , Demand , Currency 
Trade barriers (Tariff and Quotas)
Barrier , Demand , Currency 
Preferences for domestic versus foreign goods
Productivity

13. Summary Table 1 Factors That Affect Exchange Rates in the Long Run13

14. Exchange Rates in the Short Run: A Supply and Demand Analysis
An exchange rate is the price of domestic assets in terms of foreign assets
Supply curve for domestic assets
Assume amount of domestic assets is fixed (supply curve is vertical)
Demand curve for domestic assets
Most important determinant is the relative expected return of domestic assets
At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher

15. FIGURE 3 Equilibrium in the Foreign Exchange Market
US as home country 15

16. Explaining Changes in Exchange Rates
Supply curve fixed
Shifts in the demand for domestic assets
Depending on the expected return of dollar-dominated assets (U.S as home country)
Domestic interest rate (dollar deposits)
Foreign interest rate (foreign deposits)
Expected future exchange rate

17. FIGURE 4 Response to an Increase in the Domestic Interest Rate, iD17

18. FIGURE 5 Response to an Increase in the Foreign Interest Rate, iF18

19. FIGURE 6 Response to an Increase in the Expected Future ExchangeRate, Eet+119

20. FIGURE 7 Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected Inflation 20

21. Summary Table 2 Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate21

22. Application: Changes in the Equilibrium Exchange Rate
Changes in Interest Rates
When domestic real interest rates raise, the domestic currency appreciates.
When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates.
Changes in the Money Supply
A higher domestic money supply causes the domestic currency to depreciate.

23. Application: Changes in the Equilibrium Exchange Rate
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
Money supply – no effect on interest rate in the long run
The exchange rate falls by more in the short run than in the long run (overshooting)
Helps to explain why exchange rates exhibit so much volatility

24. FIGURE 8 Effect of a Rise in the Money Supply
Short run:
1. Money supply , -> price ,
Result: exchange rate ;
2. Money supply , -> domestic interest rate , -> domestic asset return 
Long run:
Interest rate goes back (M.S no effect on interest) 24

25. Application: Why exchange rate so volatile?
Expected appreciation/depreciation of currency
Expected change of price level, inflation, trade barrier, productivity
Focus on assets rather than goods

26. FIGURE 9 Value of the Dollar and Interest Rates, 1973–2008
Real interest rate – effective exchange rate
Nominal interest rate
Sources: Federal Reserve: real interest rate from Figure 1 in Chapter 4. 26

27. Application: The Subprime Crisis and the Dollar
During 2007 interest rates fell in the United States and remained unchanged in Europe.
The dollar depreciated
Starting in the summer of 2008 interest rated fell in Europe.
Increased demand for U.S. Treasuries “flight to quality”
The dollar appreciated

28. Application: The Subprime Crisis and the Dollar