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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
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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
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Figure 1 Exchange Rates, 1990–
2014
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.
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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
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Factors that Affect Exchange
Rates in the Long Run
• Relative price levels
• Trade barriers
• Preferences for domestic versus foreign
goods
• Productivity
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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/.
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Summary Table 1 Factors That
Affect Exchange Rates in the Long
Run
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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
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Figure 3 Equilibrium in the
Foreign Exchange Market
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Explaining Changes in Exchange
Rates
• Shifts in the demand for domestic assets
– Domestic interest rate
– Foreign interest rate
– Expected future exchange rate
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Figure 4 Response to an Increase
in the Domestic Interest Rate, iD
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Figure 5 Response to an Increase
in the Foreign Interest Rate, iF
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Figure 6 Response to an Increase in
the Expected Future Exchange Rate,
Eet+1
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Summary Table 2
Factors That Shift
the Demand Curve
for Domestic Assets
and Affect the
Exchange Rate
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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.
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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
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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.
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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
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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.
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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
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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/.
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FIGURE 8 Effect of a Rise in the
Money Supply
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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
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