Chapter 19

The Foreign Exchange Market

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Foreign Exchange Rates

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The Foreign Exchange Market

Definitions:1. Spot exchange rate2. Forward exchange rate3. Appreciation4. Depreciation

Currency appreciates, country’s goods prices abroad and foreign goods prices in that country

1. Makes domestic businesses less competitive2. Benefits domestic consumers

FX traded in over-the-counter market1. 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:

Canadian Steel Japanese Steel

In Canada $100 $200

In Japan 5000 yen 10,000 yen

If E = 100 yen/$ then prices are:

Canadian Steel Japanese Steel

In Canada $100 $100

In Japan 10,000 yen 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.

19-7

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

Re for

Francois Al

$ Deposits iD + (Eet+1 – Et)/Et iD

Euro Deposits iF iF – (Eet+1 – Et)/Et

Relative Re iD – iF + (Eet+1 – Et)/Et iD – iF + (Ee

t+1 – Et)/Et

Interest Parity Condition:

$ and Euro deposits perfect substitutes

iD = iF – (Eet+1 – Et)/Et

Example: if iD = 10% and expected appreciation of $, (Ee

t+1– Et)/Et, = 5% iF = 15%

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Deriving RF Curve

Assume iF = 10%, Eet+1 = 1 euro/$

Point

A: Et = 0.95, RF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%

B: Et = 1.00, RF = .10 – (1 – 1.0)/1.0 = .100 =10.0%

C: Et = 1.05, RF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%

RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF

Deriving RD CurvePoints B, D, E, RD = 10%: so curve is vertical

EquilibriumRD = RF at E*

If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et

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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

19-12

Shifts in RF

RF curve shifts right when

1. iF : because RF at each Et

2. Eet+1 : because expected

appreciation of F at each Et and RF

Occurs Eet+1 iF:

1) Domestic P ,

2) Trade Barriers 3) Imports , 4) Exports , 5) Productivity

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Shifts in RD

RD shifts right when

1. iD ; because RD at each Et

Assumes that domestic e unchanged, so domestic real rate

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Factors that Shift RF and RD

19-15

Response to i Because e

1. e , Eet+1 , expected

appreciation of F ,

RF shifts out to

right

2. iD , RD shifts to

right

However because e > iD , real rate , Ee

t+1 more than iD RF out > RD out and Et

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19-16

Response to Ms

1. Ms , P , Eet+1

expected appreciation

of F , RF shifts

right

2. Ms , iD , RD shifts

left

Go to point 2 and Et

3. In the long run, iD

returns to old level,

RD shifts back, go

to point 3 and get

Exchange Rate

Overshooting

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Why Exchange Rate Volatility?

1. Expectations of Eet+1 fluctuate

2. Exchange rate overshooting