Determination of Exchange Rates and Interest Parity

1
Determination of Exchange Rates and Interest
Parity
2
Demand and Supply in Foreign Exchange Markets

• Demand for foreign exchange
• Relationship between the quantity demanded of
  foreign exchange and the spot exchange rate
  (expressed as the domestic currency price of a
  unit of foreign currency) is a negative one.
• As the exchange rate rises, the quantity of
  foreign exchange demanded falls.

3
Demand for Foreign Exchange
e /
e
1
e
2
_
)
(



D
i

,i
,e
e
,e
f
0
Quantity Demanded of

-Denominated Deposits
4
Supply of Foreign Exchange
e /

S
0
Quantity Supplied of

-Denominated Deposits
5
Shifts in the Demand for Foreign Ex.
e /
i

?

e
e
?

e
f
?

i

S
e
1
e
0
D
e
2
1
D
0
D
2
0
Quantity of

-Denominated Deposits
6
Types of Exchange Rate Regimes

• Exchange rate regime in each country, the
  government decides the type of policy to follow
  regarding the exchange rate.
• Four types of regime
• Flexible or floating exchange rates
• Fixed or pegged exchange rates
• Managed floating (a mixture of flexible and
  fixed) and
• Exchange controls.

7
Equilibrium under Flexible Exchange Rates
e /
S
Surplus
of
e
1
e
3
e
2
D
Shortage
of
0
Quantity of

-Denominated Deposits
8
Pegged Exchange Rate above the Equilibrium Rate
e /
S
Intervention
e
p
1
D
0
Quantity of

-Denominated Deposits
9
Pegged Exchange Rate below the Equilibrium Rate
e /
S
e
p
2
Intervention
D
0
Quantity of

-Denominated Deposits
10
Demand for Foreign Currency Assets

• Example
• R 3.24
• R 4.47
• E/ 1.83 /
• Ee/ 1.79 /
• Imagine you have 1,000 that you want to invest
  for one year. Should you hold them in or
  British Pound?

11
Demand for Foreign Currency Assets

• Holding in , your investment will yield 1032.4
  a year from now.
• Transferring to Pounds and changing back at the
  end of the year, your investment will yield
  1021.87 a year from now.
• Invest the money in the US.

12
Demand for Foreign Currency Assets

• The expected rate of return difference between
  dollar and pound deposits is
• R - R (Ee/ - E/ )/ E/ R - R -
  (Ee/ - E/ )/ E/
• where
• R interest rate on one-year dollar
  deposits
• R todays interest rate on one-year euro
  dep.
• E/ todays dollar/euro exchange rate
• Ee/ dollar/euro exchange rate expected to
• prevail a year from today

13
Demand for Foreign Currency Assets

• When the previous equation is positive, dollar
  deposits yield the higher expected rate of
  return. When it is negative, pound deposits yield
  the higher expected rate of return.
• R - R - (Ee/ - E/ )/ E/ gt lt 0 ?
• In our example R - R - (Ee/ - E/ )/ E/
• 0.0324-0.0447-(1.78-1.83)/1.83 0.015gt0
• Therefore you should hold you money in .

14
Equilibrium in the Foreign Exchange Market

• Interest Parity The Basic Equilibrium Condition
• The foreign exchange market is in equilibrium
  when deposits of all currencies offer the same
  expected rate of return.
• Interest parity condition
• The expected returns on deposits of any two
  currencies are equal when measured in the same
  currency.
• It implies that potential holders of foreign
  currency deposits view them all as equally
  desirable assets.
• The expected rates of return are equal when
• R R (Ee/ - E/ )/ E/