chapter 17 the foreign exchange market. © 2013 pearson education, inc. all rights reserved.14-2...
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© 2013 Pearson Education, Inc. All rights reserved.14-3 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 banksTRANSCRIPT
Chapter 17
The Foreign Exchange Market
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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, Ee
t+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
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.
Exchange Rate, Et
(euros/$)
E1
1
S
D2 D1
Quantity of Dollar Assets
E22
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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