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Chapter 17 The Foreign Exchange Market Foreign Exchange I • Exchange rate: price of one currency in terms of another • 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 14-2 © 2013 Pearson Education, Inc. All rights reserved. Foreign Exchange II • 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 and vice versa • Over-the-counter market mainly banks 14-3 © 2013 Pearson Education, Inc. All rights reserved. Figure 1 Exchange Rates, 1990– 2014 Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/. 14-4 © 2013 Pearson Education, Inc. All rights reserved. Exchange Rates in the Long Run • Law of one price • Theory of Purchasing Power Parity assumptions: – All goods are identical in both countries – Trade barriers and transportation costs are low – Many goods and services are not traded across borders 14-5 © 2013 Pearson Education, Inc. All rights reserved. Factors that Affect Exchange Rates in the Long Run • Relative price levels • Trade barriers • Preferences for domestic versus foreign goods • Productivity 14-6 © 2013 Pearson Education, Inc. All rights reserved. Figure 2 Purchasing Power Parity, United States/United Kingdom, 1973–2014 (Index: March 1973 = 100.) Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/. 14-7 © 2013 Pearson Education, Inc. All rights reserved. Summary Table 1 Factors That Affect Exchange Rates in the Long Run 14-8 © 2013 Pearson Education, Inc. All rights reserved. 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 14-9 © 2013 Pearson Education, Inc. All rights reserved. Figure 3 Equilibrium in the Foreign Exchange Market 14-10 © 2013 Pearson Education, Inc. All rights reserved. Explaining Changes in Exchange Rates • Shifts in the demand for domestic assets – Domestic interest rate – Foreign interest rate – Expected future exchange rate 14-11 © 2013 Pearson Education, Inc. All rights reserved. Figure 4 Response to an Increase in the Domestic Interest Rate, iD 14-12 © 2013 Pearson Education, Inc. All rights reserved. Figure 5 Response to an Increase in the Foreign Interest Rate, iF 14-13 © 2013 Pearson Education, Inc. All rights reserved. Figure 6 Response to an Increase in the Expected Future Exchange Rate, Eet+1 14-14 © 2013 Pearson Education, Inc. All rights reserved. Summary Table 2 Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate 14-15 © 2013 Pearson Education, Inc. All rights reserved. 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. 14-16 © 2013 Pearson Education, Inc. All rights reserved. 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 • The exchange rate falls by more in the short run than in the long run – Helps to explain why exchange rates exhibit so much volatility 14-17 © 2013 Pearson Education, Inc. All rights reserved. Application: Effects of Changes in Interest Rates on 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. 14-18 © 2013 Pearson Education, Inc. All rights reserved. Figure 7 Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected Inflation Exchange Rate, Et (euros/$) S Step 1. A rise in the domestic real interest as a result of an increase in expected inflation shifts the demand curve to the left . . . Step 2. leading to a fall in the exchange rate. 1 E1 E2 2 D2 D1 Quantity of Dollar Assets 14-19 © 2013 Pearson Education, Inc. All rights reserved. Application: Why are Exchange Rates So Volatile? • The volatility of exchange rates is due, in part, to the fact that they are based on unstable expectations regarding an uncertain future. 14-20 © 2013 Pearson Education, Inc. All rights reserved. Application: The Dollar and Interest Rates • The value of the dollar and the measure of real interest rates tend to rise and fall together. • Our model of exchange rate determination helps explain the rise in the dollar in the early 1980s and fall thereafter. – a rise in the U.S. real interest rate raises the relative expected return on dollar assets, which leads to purchases of dollar assets that raise the exchange rate 14-21 © 2013 Pearson Education, Inc. All rights reserved. Figure 8 Value of the Dollar and Interest Rates, 1973–2014 Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/. 14-22 © 2013 Pearson Education, Inc. All rights reserved. FIGURE 8 Effect of a Rise in the Money Supply 14-23 © 2013 Pearson Education, Inc. All rights reserved. Application: The Dollar and Interest Rates • 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 14-24 © 2013 Pearson Education, Inc. All rights reserved.