9 the Foreign Exchange Market

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Notes on

The Foreign Exchange Market

The foreign exchange market is the market, where not only foreign exchange but

also assets denominated in foreign currencies, such as goods and services, and allfinancial assets such as deposits, bonds, shares and properties are traded.

It is estimated that transactions in the US foreign exchange market are about $1trillion per day. It is also estimated that it is about 25 times higher than the value oftotal exports and imports.

The exchange rate is defined as the price of one currency for another. In thischapter as well as in all chapters, we use the same definition; it is the price ofdomestic currency in terms of a foreign currency. It is denoted as:

Units of foreign currency/one unit of domestic currency or simply

E = FC/DC

Some Terms

Currency Appreciation.

If domestic currency goes up in value in terms of another currency, it meansdomestic currency appreciates.

In 1998, E= NZ$ 0.90 / F$1; and in 1999, E = NZ$ 0.98/ F$1.It means Fiji dollar has appreciated in 1999 over one year period

Currency Depreciation:

In 1999, E = NZ$ 0.98 / F$ 1; and in 2000. E = NZ 0.96 / F$1,It means Fiji dollar depreciated in 2000 compared to what it was in 1999.

Carefully work out the example (French wine and American consumer; the Americancomputer and French buyer) in the textbook (page 153).

We will get a good picture of the impact of appreciation and depreciation.

When domestic currency appreciates (increases in value relative to othercurrencies), the countrys goods become more expensive and foreign goodsbecome cheaper (holding domestic prices constant in the two countries).Conversely, when a countrys currency depreciates, its goods abroad becomecheaper to foreigners and foreign goods become more expensive.

Law of one price

If two countries produce an identical good and if we ignore transportation costs and

trade barriers, the price of the good should be the same no matter which country

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produces. For example, steel per ton sells at Yen 10,000 in Japan and at $100. InUSA,

The exchange rate then is: US$ 1 = Yen 100. Or it is Yen 1 = US$ 0.01

If the exchange rate is artificially fixed at US $ 1 = Yen 200, Japanese steel will sell

in US market at US $ 50, or half the American price. The American steel will sell atYen 20,000 in Japan. Thus there will be an excess supply of American steel, whichcan be eliminated only if the American exchange rate falls to US $ 1 = Yen 100.

Theory of Purchasing Power Parity (PPP)

If we apply the law of one price to countries price levels, we derive PPP theory. Itstates that if a country s price level rises relative to another, its currency shoulddepreciate.

For example, if Japans price level rises by 10%, its price of steel per ton will rise toYen 11,000 and if US price level is unchanged, we get the new exchange rate, US$1 = Yen 110. That is, US dollar has appreciated by 10 percent.

Japanese Yen has depreciated from Yen 1 = US$0.01 to Yen 1 = US$ 0.00909

PPP theory is not able to adequately explain changes in exchange rate becausegoods produced in various countries are not of the same quality and hence notidentical. Further, there are some goods which do not get traded between countriessuch as land, housing, services such as shoe-shining, hotel meals, hair cuts, or golflessons, although they are taken into account in the calculation of price level

changes.

However, the thumb rule is that changes in price level do affect the exchange rate ofa given country. If a country experiences a rise in its price level, its currency shouldlose its value or depreciate in relation to others, depending upon the other countriesprice level changes.

Burgernomics: An interesting index has been developed by The Economist ofLondon on the basis of Macburger prices in various countries. The assumption ofidentical quality is very much in use. By comparing the prices of a given product,movements in the exchange rate are evaluated, whether a given countrys exchange

rate is overvalued or undervalued.

Factors Affecting Exchange Rate in the Long Run

Four factors affect the exchange rate: relative price levels, tariffs and quotas,preferences for domestic vs. foreign goods and productivity (Table 1).

Anything that increases the demand for domestic goods relative to foreign goodstends to appreciate domestic currency because domestic goods will continue to sellwell even when the value of domestic currency is higher. Factors such as fall in

domestic price level relative to other countries, peoples increased preferences fordomestic goods over foreign goods, imposition of restrictions on importation of

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foreign goods through tariff/quota protection or improvements in domestic labourproductivity will increase the demand for domestic goods relative to foreign goods,thereby contributing to currency appreciation.

The same reasoning, in the opposite direction, will apply for depreciation of

domestic currency. A rise in the domestic price level relative to other countries, ashift in peoples preferences against domestic goods in favour of foreign goods,relaxation or removal of restrictions on importation of foreign goods such asreduction in tariff rates and/or increase in quotas, or fall in domestic labourproductivity will all contribute to currency appreciation.

Short-run Behaviour of Exchange Rate

The asset - market approach using the theory portfolio choice is used to explain theshort - run behaviour of exchange rate. Accordingly, the exchange rate is the price

of bank deposits denominated in domestic currency in terms of depositsdenominated in a foreign currency.

The most important factor affecting the demand for both domestic and foreigndeposits is the expected return of these assets relative one another.

Interest Parity Condition

Assume here the domestic currency is US dollar and foreign currency is Euro.Francois is a French citizen living in France and Al is an American living in the US.

Both indulge in foreign exchange transactions.The exchange rate (FC/DC) presently (Et ) is units of Euro/US $1.The expected exchange rate next year (t+1) is denoted as Et+1

If Francois has his money in dollar denominated deposits for one year in the US,he earns iD (rate of interest in percent on dollar deposits) and at the end of the yearhe converts his total proceeds of interest and principal in euro. In that process, hehas to get his US dollar proceeds converted into euro at the new exchange rate.His return in terms of euros will be the rate of interest and the gain arising from theappreciation of US$, both in percent.

His RETD

in terms of euros will be = iD

+ (Et+1 -Et) / Et

His relative return has to be determined by comparing what he would have earnedhad he not put his money in US$ denominated deposits but kept in his own countryin interest earning euro deposits (iF).

Relative Return for Francois is: iD + (Et+1 - Et) / Et - iF

If Al keeps his deposits in France in Euro deposits, and takes back after oneyear, he will have to convert euro proceeds into US Dollars by converting at thesame prevailing rate as Francois.

His RETF in terms of dollars is iF - (Et+1 - Et) / Et

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His relative return is calculated in the same way, by comparing with what he wouldhave earned had he not put his money in France but in domestic American depositsearning iD

Relative Return for Al is: iD

- {iF

- (Et+1 - Et) / Et }

The interest parity condition is then derived under conditions of capital mobilitybetween countries and perfect substitutability (desirability also) of both dollar andeuro deposits.

For existing supplies of both US$ deposits and foreign deposits to be held, thereshould be no difference in their expected returns: that is the relative return mustequal zero.

Make the relative return equal to zero.

If we set relative return of Francois equal to zero,

iD + (Et+1 - Et) / Et - iF = 0

or

iD = iF - (Et+1 -Et) / Et

Similarly if we set the relative return of Al to zero, we get

iD

- {iF

- (Et+1 -Et) / Et } =0

or

iD = iF - (Et+1 -Et) / EtThis is known as interest parity condition.

The following Table summarises the position:

Al Francois

Euro Deposits iF

American $ Deposits iD

RET iF - (Et+1 - Et) /Et iD + (Et+1 - Et) / Et

Relative RET iD - {iF - (Et+1 - Et) /Et} iD + (Et+1 - Et) / Et - iF

Interest Parity condition iD = iF - (Et+1 - Et) /Et iD = iF - (Et+1 - Et)/Et

by setting relativeRETs to zero

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Thus, it may be seen that interest parity condition is identical, whether observedfrom Als or Francois point of view.

Equilibrium in the Foreign Exchange Market (Figure 4)

Given the assumption that domestic and foreign bank deposits are perfect as well asdesirable substitutes and there is perfect capital mobility, the interest paritycondition is an equilibrium condition for the foreign exchange market.

We now draw the returns curves from the US investor (Al)s point of view in US$terms

Derivation of RETFcurve

Vertical axis: Exchange Rate (FC/DC) = Euro/US$1Horizontal axis: ID in percent.Assume iF = 10%Expected E in t+1 period = Ee t+1 = Euro 1/US $ 1

At point A, if E t = Euro 0.95 / US$ 1, using the equationRETF is = iF - (Et+1 -Et) / Et

Substituting the values given above we get

at point A where Et = Euro 0 95 / US$ 1,

RETF = 0.10 - (1- 0.95) / 0.95 = 0.1 - 0.052 = 0.048 or 4.8%

At point B where Et = Euro 1.00 / US$ 1,RETF = 0.10- (1-1) / 1 = 0.1 - 0 = 0.1 or 10%

At point C, where Et = Euro 1.05 / US$ 1,RETF = 0.10- (1-1.05) / 1.05 = 0.1 - (-0.048) = 0.148 or 14.8%

RETF curve is with a positive slope as it is connecting points A, B and C.

That is when Et the domestic exchange rate is higher and given Et+1, the expectedexchange rate, expected appreciation of F higher, RETF is higher

Derivation of RETD curve

If the domestic interest rate on dollar deposits is fixed and if Al puts his money onlyin US deposits, he can get his return only at 10% and nothing else. At all points it isthe same 10%So it is vertical.

The equilibrium is obtained when two curves, RETD and RETF intersect at E*.

RETD

= RETF

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At other points, there is disequilibrium.

So we will have the following:

If Et is greater than E*, RETF is greater than RETD. The holders of dollar deposits

would like to switch to Euro deposits and will download $ or sell $ deposits to buyeuro deposits. So US $ will depreciate.

The opposite will be the case.

Shifts in RETF (Figure 2)

Shifts in RETF take place

(i) when iF is increased on euro deposits, because RETF will be higher at each Et.

(ii) any factors affecting exchange rate (Table 1) change such as when:

(a) domestic price level in US rises relative to other countries, expectedEt+1 depreciates, which means euro is expected to appreciate andRETF shifts to right.

(b) when tariffs/and other restrictions such as quotas are reduced/relaxed,there is a rise in import volume; there will be expectations of fall inEt+1; which means euro is expected to appreciate and RETF shifts toright.

(c) when imports rise, there will be expectations of fall in expected Et+1which means which means euro is expected to appreciate and RET F

shifts to right

(d) When exports decrease, there will be expectations of fall in expectedEt+1 which means which means euro is expected to appreciate andRETF shifts to right

(e) When domestic productivity declines relative to other countries, therewill be expectations of fall in expected Et+1 which means euro is

expected to appreciate and RETF

shifts to right

Shifts in RETD curve take place if iD changes. If iD increases say from 10% to 15%,we see RETD shifts to right and vice versa (Figure 3).

Factors that shift RETF and RETD are summarised in Figure 4.

If there is a rise in domestic interest rate relative to foreign interest rate, it can resultin either an appreciation or depreciation of domestic currency. If the rise is due to arise in expected inflation, the domestic currency would depreciate. This is very

much in accordance with what we saw under PPP theory. (Figure 5).

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However, if interest rate rises due to a rise in real interest rate, the domesticcurrency would appreciate. This actually happened in the USA in the 1980s.

Volatility in exchange rate

It was thought that floating or flexible exchange rate regimes by allowing thedetermination of exchange rates by free market forces, would bring in stability. Onthe contrary, we now find there is greater volatility. The theory of asset demandexplains the volatility as a result of changing expectations, which themselves arevolatile. For example, fears of a military coup, civil disorder or after impact ofterrorist attack, expectations undergo rapid and unexpected changes. They makethe RETF shift to the right and the result is a decline in exchange rate.

Exchange Rate Overshooting (Figure 6)

An important theoretical contribution is in regard to exchange rate overshooting.This is in connection with a rise in domestic money supply leading to fall in domesticinterest rate. A fall in domestic interest rate following an increase in money supplyand results in RETD curve shifting to the left. However, a rise in money supply itselfimpacts expectations: price level will increase and so the domestic exchange woulddepreciate. Returns on foreign deposits become more attractive and RETF curveshifts to right. We find exchange rate falls because of the new equilibrium point at2. This is a short run reaction.

In the long run, of course if there is no further rise in money supply, things will settle

down. General price level will rise by the same proportion as rise in money supply.This will result in real values all unchanged. This is known as money neutrality. A10% rise in money supply will lead to a 10% rise in price level, leaving real variablesunchanged. So we will now see, ID will go back to old level and the curve shiftsback to original position. The new equilibrium point will be 3. The exchange ratewould rise. The rise is much less than we saw earlier.

This phenomenon that exchange rate falls by more in the short run than in the longrun when money supply rises is called exchange rate overshooting.

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9 the Foreign Exchange Market