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chapter 7
The Foreign Exchange Market
Copyright © 2001 Addison Wesley Longman TM 7- 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. Makes domestic businesses less competitive
2. 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- 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 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price E = 100 yen/$
Copyright © 2001 Addison Wesley Longman TM 7- 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
Copyright © 2001 Addison Wesley Longman TM 7- 5
PPP: U.S. and U.K
Copyright © 2001 Addison Wesley Longman TM 7- 6
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- 7
Expected Returns and Interest Parity
RETe for
Francois Al
$ Deposits iD + (Eet+1 – Et)/Et iD
F Deposits iF iF – (Eet+1 – Et)/Et
Relative RETe iD – iF + (Eet+1 – Et)/Et iD – iF + (Ee
t+1 – Et)/Et
Interest Parity Condition:
$ and F deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example: if iD = 10% and expected appreciation of $, (Ee
t+1– Et)/Et, = 5% iF = 15%
Copyright © 2001 Addison Wesley Longman TM 7- 8
Deriving RETF Curve
Assume iF = 10%, Eet+1 = 1 euro/$
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- 9
Equilibrium in the Foreign Exchange Market
Copyright © 2001 Addison Wesley Longman TM 7- 10
Shifts in RETF
RETF curve shifts right when
1. iF : 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- 11
Shifts in RETD
RETD shifts right when
1. iD ; because RETD at each Et
Assumes that domestic e unchanged, so domestic real rate
Copyright © 2001 Addison Wesley Longman TM 7- 12
Factors that Shift RETF and RETD
Copyright © 2001 Addison Wesley Longman TM 7- 13
Response to i Because e
1. e , Eet+1 , expected
appreciation of F ,
RETF shifts out to
right
2. iD , RETD shifts to
right
However because e > iD , real rate , Ee
t+1 more than iD RETF out > RETD out and Et
Copyright © 2001 Addison Wesley Longman TM 7- 14
Response to Ms
1. Ms , P , Eet+1
expected appreciation
of F , RETF shifts
right
2. Ms , iD , RETD shifts
left
Go to point 2 and Et
3. In the long run, iD
returns to old level,
RETD shifts back, go
to point 3 and get
Exchange Rate
Overshooting
Copyright © 2001 Addison Wesley Longman TM 7- 15
Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
Copyright © 2001 Addison Wesley Longman TM 7- 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 70s as nominal rate rises
