chapter 7 The Foreign Exchange Market The Foreign

chapter 7 The Foreign Exchange Market

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 Copyright © 2001 Addison Wesley Longman TM 7 - 2

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 $100 10, 000 yen Law of one price E = 100 yen/$ Copyright © 2001 Addison Wesley Longman TM 7 - 3

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 Copyright © 2001 Addison Wesley Longman TM 7 - 4

PPP: U. S. and U. K Copyright © 2001 Addison Wesley Longman TM 7 - 5

Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E Copyright © 2001 Addison Wesley Longman TM 7 - 6

Expected Returns and Interest Parity RETe for Francois Al $ Deposits i. D + (Eet+1 – Et)/Et i. D F Deposits i. F – (Eet+1 – Et)/Et Relative RETe i. D – i. F + (Eet+1 – Et)/Et Interest Parity Condition: $ and F 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% Copyright © 2001 Addison Wesley Longman TM 7 - 7

Deriving RETF Curve Assume i. F = 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 Copyright © 2001 Addison Wesley Longman TM 7 - 8

Equilibrium in the Foreign Exchange Market Copyright © 2001 Addison Wesley Longman TM 7 - 9

Shifts in RETF curve shifts right when 1. i. F : because RETF at each Et 2. Eet+1 : because expected appreciation of F at each Et and RETF Occurs: 1) Domestic P , 2) Tariffs and quotas 3) Imports , 4) Exports , 5) Productivity Copyright © 2001 Addison Wesley Longman TM 7 - 10

Shifts in RETD shifts right when 1. i. D ; because RETD at each Et Assumes that domestic e unchanged, so domestic real rate Copyright © 2001 Addison Wesley Longman TM 7 - 11

Factors that Shift RETF and RETD Copyright © 2001 Addison Wesley Longman TM 7 - 12

Response to i Because e 1. e , Eet+1 , expected appreciation of F , RETF shifts out to right 2. i. D , RETD shifts to right However because e > i. D , real rate , Eet+1 more than i. D RETF out > RETD out and Et Copyright © 2001 Addison Wesley Longman TM 7 - 13

Response to Ms 1. Ms , P , Eet+1 expected appreciation of F , RETF shifts right 2. Ms , i. D , RETD shifts left Go to point 2 and Et 3. In the long run, i. D returns to old level, RETD shifts back, go to point 3 and get Exchange Rate Overshooting Copyright © 2001 Addison Wesley Longman TM 7 - 14

Why Exchange Rate Volatility? 1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting Copyright © 2001 Addison Wesley Longman TM 7 - 15

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 Copyright © 2001 Addison Wesley Longman TM 7 - 16