Chapter 19: The Foreign Exchange Market

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Chapter 19 The Foreign Exchange Market
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• 1. Foreign Exchange Market

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Foreign Exchange Market

• Types of exchange rates
• Exchange rate
• e foreign currency units per dollar.
• Spot rate
• Exchange rate today.
• Forward rate
• Exchange rate for 30, 90, 180 days in
  the future.
• Why are exchange rates important?
• Lower exchange rate raises cost of imports and
  and lowers cost of exports.

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• 2. Exchange Rates in the Long Run

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Law of One Price

• If two countries produce an identical
  good, the price should be the same
  regardless who produces it.
• Example
• Assume corn costs 10/bushel in the
  U.S. and 1,250 yen/bushel in Japan.
• e must be 125 yen/.

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Theory of Purchasing Power Parity

• Exchange rates between any two currencies will
  adjust to reflect changes in the price levels of
  the two countries.
• This is the law of one price applied to
  price levels.
• Example
• If the U.S. price level rises by 10 relative to
  Japan's price level.
• The U.S. exchange rate must fall by 10.

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Theory of Purchasing Power Parity

• Problems with purchasing power parity
• Some products are not identical.
• Not all goods are traded
• e.g. services

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Factors that Affect Exchange Rates

• Relative price levels
• ? Relative price level ? ? e.
• Tariffs and quotas
• ? Tariff/restrictive quota ? ? e.
• Preferences for domestic/foreign goods.
• ? Export demand ? ? e.
• ? Import demand ? ? e.
• Productivity
• ? Productivity ? ? e.

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• 3. Exchange Rates in the Short Run

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Comparing Domestic and Foreign Returns

• Investors compare the returns for domestic assets
  versus foreign assets.
• Domestic return iD
• Foreign return iF (Eet1- Et)/ Et
• (Eet1- Et)/ Et expected appreciation of
  dollar
• Relative rate of return (in dollars)
• Relative RETD iD iF (Eet1- Et)/ Et
• Relative rate of return is same for foreigners.

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Interest Parity Condition

• Capital is mobile so that rate of return on
  foreign assets should be the same as the rate of
  return on domestic assets.
• iD iF - (Eet1- Et)/ Et

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Equilibrium in the Foreign Exchange Market

• Diagram

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• 4. Explaining Changes in Exchange Rates

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Explaining Changes in Exchange Rates

• Shifts in the expected return schedule for
  foreign deposits
• Foreign interest rate
• ? iF ? ? RETF ?? Et
• Expected future exchange rate
• ? Eet1 ? ? RETF ?? Et
• Diagram
• Factors affecting Eet1
• Expected domestic price level
• Expected tariffs and quotas
• Expected export demand
• Expected import demand
• Expected productivity

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Explaining Changes in Exchange Rates

• Shifts in the expected return schedule for
  domestic deposits
• Domestic interest rate
• ? iD ? ? RETD ? ? Et
• Diagram

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Changes in Interest Rates

• The effect of changes in the domestic (or
  foreign) interest rate depends on cause of
  change.
• If increase is due to an increase in the real
  interest rate
• No change in expected future exchange rate
  
• Result increase in Et
• Diagram

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Changes in Interest Rates

• If increase is due to a rise in inflationary
  expectations rate
• Decrease in expected future exchange rate leading
  to ? RETF
• The expected future exchange rate
  effect dominates iD effect, thus leading
  to a lower e.
• Diagram

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Changes in Money Supply

• ? Money supply ? ? inflationary expectations ? ?
  expected future exchange rate ? ? RETF ? ? Et
• ? Money supply ? ? iD ? ? RETD ? ? Et
• Diagram

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EndChapter 19