1. 1 The Foreign Exchange Market Chapter 17

2. 2 Foreign Exchange Definitions Exchange rate: price of one currency in terms of another Exchange rate: price of one currency in terms of another Foreign exchange market: the financial market where exchange rates are determined Foreign exchange market: the financial market where exchange rates are determined Spot transaction: immediate (two-day) exchange of bank deposits Spot transaction: immediate (two-day) exchange of bank deposits Spot exchange rate Spot exchange rate Forward transaction: the exchange of bank deposits at some specified future date Forward transaction: the exchange of bank deposits at some specified future date Forward exchange rate Forward exchange rate

3. 3 Foreign Exchange Appreciation: a currency rises in value relative to another currency Appreciation: a currency rises in value relative to another currency Depreciation: a currency falls 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 and vice versa When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa

4. 4 Exchange Rates Feb. 2, 2009 1 USD =.7786 EUR 1 USD =.7002 GBP 1 USD = 89.61 JPY Mar. 28, 2010 1 USD =.7471 EUR 1 USD =.6711 GBP 1 USD = 92.4700 JPY Calculate the appreciation and depreciation of each currency. Find the values for today and calculate the appreciation/depreciation.

5. 5 Exchange Rates, 1990–2008 Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist.

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7. 7 Factors that Affect Exchange Rates in the Long Run Relative price levels Relative price levels Trade barriers Trade barriers Preferences for domestic versus foreign goods Preferences for domestic versus foreign goods Productivity Productivity

8. 8 Price Changes Law of one price: for identical products Law of one price: for identical products Theory of Purchasing Power Parity Theory of Purchasing Power Parity Expanding the law of one price to all products Expanding the law of one price to all products All goods are identical in both countries All goods are identical in both countries Trade barriers and transportation costs are low Trade barriers and transportation costs are low Many goods and services are not traded across borders, undermining PPP Many goods and services are not traded across borders, undermining PPP

9. 9 Purchasing Power Parity, United States/United Kingdom, 1973–2008 (Index: March 1973 = 100.) Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt.

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11. 11 Factors That Affect Exchange Rates in the Long Run

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13. 13 Demand and Supply in the SR EUR/USD USD denominated assets In the short run, demand for USD is low when USD is strong because there is a high likelihood that USD will depreciate in the future. Holding an asset that will lose its value is very risky. In the short run the supply of USD in the FX market is fixed by the available bank deposits, bonds and stocks.

14. 14 Equilibrium in the Foreign Exchange Market At E 2 there is excess supply of dollar denominated assets. The foreign price of these assets fall to bring the market into equilibrium.

15. 15 Domestic Currency Appreciation EUR/USD USD denominated assets The foreign price of USD denominated assets increases.

16. 16 Domestic Currency Depreciation EUR/USD USD denominated assets

17. 17 Explaining Changes in SR Exchange Rates Shifts in the demand for domestic assets Shifts in the demand for domestic assets Domestic interest rate Domestic interest rate Foreign interest rate Foreign interest rate Expected future exchange rate Expected future exchange rate

18. 18 Increase in the Domestic Interest Rate, i D

19. 19 Increase in the Foreign Interest Rate, i F

20. 20 Increase in the Expected Future Exchange Rate, E e t+1

21. 21 Factors That Shift the Demand Curve for Domestic Assets

22. 22 Increase in Expected Inflation

23. 23 Interest Rates and FX Changes in Interest Rates Changes in Interest Rates When domestic real interest rates raise, the domestic currency appreciates. 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. When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates. Changes in the Money Supply Changes in the Money Supply A higher domestic money supply causes the domestic currency to depreciate. A higher domestic money supply causes the domestic currency to depreciate.

24. 24 Exchange Rate Overshooting Monetary Neutrality 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 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 The exchange rate falls by more in the short run than in the long run because interest rates fall in the short run in response to monetary expansion The exchange rate falls by more in the short run than in the long run because interest rates fall in the short run in response to monetary expansion

25. 25 Rise in the Money Supply

26. 26 Which Interest Rate? While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced

27. 27 Value of the Dollar and Interest Rates, 1973–2008 Sources: Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4.

28. 28 USD and the Subprime Crisis During 2007 interest rates fell in the United States and remained unchanged in Europe. During 2007 interest rates fell in the United States and remained unchanged in Europe. The dollar depreciated The dollar depreciated Starting in the summer of 2008 interest rated fell in Europe. Starting in the summer of 2008 interest rated fell in Europe. Increased demand for U.S. Treasuries “flight to quality” Increased demand for U.S. Treasuries “flight to quality” The dollar appreciated The dollar appreciated

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