Chapter 19 The Foreign Exchange Market Foreign Exchange

Chapter 19 The Foreign Exchange Market

Foreign Exchange Rates © 2004 Pearson Addison-Wesley. All rights reserved 2

The Foreign Exchange Market Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation Currency appreciates, country’s goods prices abroad and foreign goods prices in that country 1. 2. Makes domestic businesses less competitive Benefits domestic consumers FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies © 2004 Pearson Addison-Wesley. All rights reserved 3

Law of One Price Example: American steel $100 per ton, Japanese steel 10, 000 yen per ton If E = 50 yen/$ then prices are: American Steel Japanese Steel In U. S. $100 In Japan $200 5000 yen 10, 000 yen If E = 100 yen/$ then prices are: American Steel Japanese Steel In U. S. $100 In Japan $100 10, 000 yen Law of one price E = 100 yen/$ 4

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 © 2004 Pearson Addison-Wesley. All rights reserved 5

PPP: U. S. and U. K © 2004 Pearson Addison-Wesley. All rights reserved 6

Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 7

Expected Returns and Interest Parity Re for Francois Al $ Deposits i. D + (Eet+1 – Et)/Et i. D Euro Deposits i. F – (Eet+1 – Et)/Et Relative Re i. D – i. F + (Eet+1 – Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes i. D = i. F – (Eet+1 – Et)/Et Example: if i. D = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5% i. F = 15% © 2004 Pearson Addison-Wesley. All rights reserved 8

Deriving RF Curve Assume i. F = 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 Curve Points B, D, E, RD = 10%: so curve is vertical Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et © 2004 Pearson Addison-Wesley. All rights reserved 9

Equilibrium in the Foreign Exchange Market 10

Shifts in RF RF curve shifts right when 1. i. F : because RF at each Et 2. Eet+1 : because expected appreciation of F at each Et and RF Occurs Eet+1 i. F: 1) Domestic P , 2) Trade Barriers 3) Imports , 4) Exports , 5) Productivity 11

Shifts in RD RD shifts right when 1. i. D ; because RD at each Et Assumes that domestic e unchanged, so domestic real rate © 2004 Pearson Addison-Wesley. All rights reserved 12

Factors that Shift RF and RD © 2004 Pearson Addison-Wesley. All rights reserved 13

Response to i Because e 1. e , Eet+1 , expected appreciation of F , RF shifts out to right 2. i. D , RD shifts to right However because e > i. D , real rate , Eet+1 more than i. D RF out > RD out and Et 14

Response to Ms 1. Ms , P , Eet+1 expected appreciation of F , RF shifts right 2. Ms , i. D , RD shifts left Go to point 2 and Et 3. In the long run, i. D returns to old level, RD shifts back, go to point 3 and get Exchange Rate Overshooting 15

Why Exchange Rate Volatility? 1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting © 2004 Pearson Addison-Wesley. All rights reserved 16

The Dollar and Interest Rates 1. Value of $ and real rates rise and fall together, as theory predicts 2. No association between $ and nominal rates: $ falls in late 70 s as nominal rate rises © 2004 Pearson Addison-Wesley. All rights reserved 17