pc_mishkin_ppt13.ppt

8/11/2019 pc_mishkin_ppt13.ppt

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Chapter 13

The ForeignExchange

Market


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Copyright 2006 Pearson Addison-Wesley. All 13-2

Chapter Preview

We develop a modern view of exchangerate determination that explains recentbehavior in the foreign exchange market.

Topics include:

Foreign Exchange Market

Exchange Rates in the ong Run

Exchange Rates in the !hort Run

Explaining "hanges in Exchange Rates


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Most countries of the world have their owncurrencies: the #.!.$ France$ %ra&il$ and'ndia$ (ust to name a few.

The trading of currencies and banksdeposits is what makes up the foreign

exchange market.


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The next slide shows exchange rates forfour currencies from )**+,-++.

/ote the difference in rate fluctuationsduring the period. Which appears mostvolatile0 The least0


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Foreign Exchange Market:

Historical Exchange Rates

"urrent foreign exchange rateshttp:11www.federalreserve.gov1releases12)+1hist

Figure 13.1:Exchange Rates$ )**+3-++
http://www.federalreserve.gov/releases/H10/histhttp://www.federalreserve.gov/releases/H10/histhttp://www.federalreserve.gov/releases/H10/hist


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The Foreign Exchange Market

4efinitions

). !pot exchange rate

-. Forward exchange rate

5. 6ppreciation

. 4epreciation


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h! "re Exchange Rates #$portant%

When the currenc7 of 7our countr7appreciates relative to another countr7$7our countr78s goods prices abroad andforeign goods prices in 7our countr7.

). Makes domestic businesses less competitive

-. %enefits domestic consumers 97ou


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Copyright 2006 Pearson Addison-Wesley. All 13-


How is Foreign Exchange Tra&e&%

F; traded in over,the,counter market

). Most trades involve bu7ing and selling bankdeposits denominated in different currencies.

-. Trades in the foreign exchange marketinvolve transactions in excess of


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Copyright 2006 Pearson Addison-Wesley. All 13-!

Exchange Rates in the 'ong Run

Exchange rates are determined in marketsb7 the interaction of suppl7 and demand.

6n important concept that drives theforces of suppl7 and demand is the awof =ne >rice.


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Exchange Rates in the 'ong Run:

'aw o( )ne Price

The aw of =ne >rice states that the priceof an identical good will be the samethroughout the world$ regardless of whichcountr7 produces it.

Example: 6merican steel


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"# $ % 50 yen&' then pri(e are)

American Steel Japanese Steel

"n *.+. '100 '200

"n ,apan 5000 yen 10-000 yen

Exchange Rates in the 'ong Run:

'aw o( )ne Price

aw of one price E@ )++ 7en1rinciple: 'f a factor increasesdemand for domestic goods relative toforeign goods$ the exchange rate

The four ma(or factors are relative pricelevels$ tariffs and Duotas$ preferences fordomestic v. foreign goods$ and productivit7.


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Exchange Rates in the 'ong Run: Factors

"((ecting Exchange Rates in 'ong Run

Relative price levels: a rise in relativeprice levels cause a countr7s currenc7to depreciate.

Tariffs and Duotas: increasing trade barrierscauses a countr7s currenc7 to appreciate.


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>references for domestic v. foreign goods:increased demand for a countr7s goodcauses its currenc7 to appreciateincreased demand for imports causes thedomestic currenc7 to depreciate.

>roductivit7: if a countr7 is more productiverelative to another$ its currenc7appreciates.


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The following table summari&es theserelationships. %7 convention$ we areDuoting$ for example$ the exchange rate$ E$as units of foreign currenc7 1 ) #! dollar.


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Copyright 2006 Pearson Addison-Wesley. All 13-1!




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Exchange Rates in the -hort Run

'n the short run$ it is ke7 to recogni&e thatan exchange rate is nothing more than theprice of domestic bank deposits in terms offoreign bank deposits.

%ecause of this$ we will rel7 on the tools

developed in "hapter for thedeterminants of asset demand.


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Exchange Rates in the -hort Run: Expecte&

Returns on o$estic an& Foreign eposits

We will illustrate this with a simple example

Francois the Foreigner can deposit excess

euros locall7$ or he can convert them to#.!. dollars and deposit them in a #.!.bank. The difference in expected returns

depends on two things: local interest ratesand expected future exchange rates.


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Exchange Rates in the -hort Run:

Expecte& Returns an& #nterest Parit!


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iD = iF

Et+1

e

Et

Et

Et+1e Et

Et

= 5% iF

= 15%

Example: if iD@ )+A and expected appreciation of


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Expecte& Returns an& #nterest Parit!

To determine the eDuilibrium condition$ wemust first determine the expected return interms of dollars on foreign deposits$ RF.

/ext$ we must determine the expectedreturn in terms of dollars on dollar

deposits$ R4.


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eriving RFCurve

RFcurve connects these points and is upward slopingbecause when Etis higher$ expected appreciation

of Fhigher$ RF


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eriving RDCurve

4eriving RD"urve

>oints %$ 4$ E$ RD@ )+A$ so curve

is vertical


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E/uili0riu$

EDuilibrium

RD@ RFat EG

'f EtH EG$ RFH RD$ sell


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Figure 13.3 EDuilibrium in the Foreign Exchange Market


E/uili0riu$

C


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Copyright 2006 Pearson Addison-Wesley. All 13-2!

Explaining Changes

in Exchange Rates

To understand how exchange rates shift intime$ we need to understand the factorsthat shift expected returns for domestic andforeign deposits.

We will examine these separatel7$ as well

as changes in the mone7 suppl7 andexchange rate overshooting.

E l i i Ch i E h


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Figure 13. !hifts in the !chedulefor the Expected Return on Foreign 4eposits RF

Explaining Changes in Exchange

Rates: -hi(ts in RF

1. RFcurve shifts rightwhen

iF: because RFateach Et

Eet+1: becauseexpected appreciationof Fat each Etand RF

-. =ccurs: ). 4omestic P

-. Restrictions ontrade 5. 'mports . Exports J. >roductivit7

E l i i Ch i E h


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Figure 13.2 !hifts in the !chedulefor the Expected Return on 4omestic 4eposits R4


Rates: -hi(ts in RD

1.RDshifts right when

iD$ because RDat each Et

6ssumes thatdomestic eunchanged$ sodomestic real

rate

E l i i Ch i E h


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Rates: Factors that -hi(t RFan& RD


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Explaining Changes in Exchange Rates:

Factors that -hi(t RFan& RD*cont.+

E l i i Ch i E h


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Figure 13. Effect of a Rise in the 4omestic/ominal 'nterest Rate as a Result of an 'ncrease in Expected 'nflation


Rates: Response to i 4ecause e

1. e$ EetK)$ expected

appreciation of F$RFshifts out to right

2. iD$ RDshifts to right

5. 2owever because eH iD$ real rate $EetK)more than iD

RFshifts out H RD

shifts out and Et

E l i i Ch i E h


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Figure 13.5 Effect of a Rise in the Mone7 !uppl7


Rates: Changes in the Mone! -uppl!

1. Ms$ P$ EetK)$expected appreciationof F$ RFshifts right

2. Ms

$i D

$RD

shiftsleftLgo to point -and Et

5. 'n long run$ i Dreturnsto old level$ RDshiftsback$ go to point 5and get exchangerate overshooting

C h E h R t


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Case: h! are Exchange Rates

-o 6olatile

Expectations of EetK)fluctuate

Exchange rate overshooting


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C i h 2006 P Addi W l All 13 40

Chapter -u$$ar! *cont.+

Exchange Rates in the !hort Run: short,run rates are determined b7 the demandfor assets denominated in both domesticand foreign currencies.

Explaining "hanges in Exchange Rates:

factors leading to shifts in the RF and R4schedules were explored.

pc_mishkin_ppt13.ppt

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