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chapter 7
The Foreign Exchange Market
Foreign
Exchange
Rates
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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
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Law of One Price
Example: Canadian steel $100 per ton, Japanese steel 10,000
yen per ton
If E = 50 yen/$ then prices are:
In Canada
In Japan
Canadian Steel
Japanese Steel
$100
5000 yen
$200
10,000 yen
If E = 100 yen/$ then prices are:
In Canada
In Japan
Canadian Steel
Japanese Steel
$100
10,000 yen
$100
10,000 yen
Law of one price  E = 100 yen/$
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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
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PPP: Canada and U.S.
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Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods relative
to foreign goods, E 
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Expected Returns and Interest
Parity
RETe for
$ Deposits
F Deposits
Francois
iD + (Eet+1 – Et)/Et
iF
Al
iD
iF – (Eet+1 – Et)/Et
Relative RETe
iD – iF + (Eet+1 – Et)/Et
iD – iF + (Eet+1 – Et)/Et
Interest Parity Condition:
$ and F deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example:
if iD = 10% and expected appreciation of $,
(Eet+1– Et)/Et, = 5%  iF = 15%
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Deriving RETF Curve
Assume iF = 10%, Eet+1 = 1 euro/$
Point
A: Et = 0.95 RETF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00 RETF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05 RETF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RETF curve connects these points and is upward sloping because when Et
is higher, expected appreciation of F higher, RETF 
Deriving RETD Curve
Points B, D, E, RETD = 10%: so curve is vertical
Equilibrium
RETD = RETF at E*
If Et > E*, RETF > RETD, sell $, Et 
If Et < E*, RETF < RETD, buy $, Et 
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Equilibrium in the Foreign Exchange Market
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Shifts in RETF
RETF curve shifts right
when
1. iF : because RETF 
at each Et
2. Eet+1 : because
expected appreciation
of F  at each Et and
RETF 
Occurs:
1) Domestic P ,
2) Tariffs and quotas 
3) Imports ,
4) Exports ,
5) Productivity 
Figure 7-4
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Shifts in RETD
RETD shifts right when
1. iD ; because RETD 
at each Et
Assumes that domestic e
unchanged, so domestic
real rate 
Figure 7-5
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Factors
that
Shift
RETF
and
RETD
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Response to i  Because e 
1. e , Eet+1 , expected
appreciation of F ,
RETF shifts out to
right
2. iD , RETD shifts to
right
However because e  > iD
, real rate , Eet+1  more
than iD 
RETF out > RETD out and
Et 
Figure 7-6
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Response to Ms 
1. Ms , P , Eet+1 
expected appreciation
of F , RETF shifts
right
2. Ms , iD , RETD shifts
left
Go to point 2 and Et 
3. In the long run, iD
returns to old level,
RETD shifts back, go
to point 3 and get
Exchange Rate
Overshooting
Figure 7-7
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Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
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