Exchange Rates

MBMM Lecture 11.2.

Petar Stankov

petar.stankov@cerge-ei.cz

09 Dec. 2008

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 1 / 11

Outline

1 What Are Foreign Exchange Rates?

2 How Is the Foreign Exchange Rate Determined?

3 Equilibrium: The Interest Rate Parity Condition

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 2 / 11

The Foreign Exchange Market

What is a foreign exchange market?

De�nition: A foreign exchange market

A market where funds are converted from one currency to another

Why do �rms and citizen need this conversion?

to transfer funds from one country to another

for safety reasons

De�nition: A foreign exchange rate

A price of one currency in terms of another

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 3 / 11

The Foreign Exchange Market - Graphs

What is the Euro-Dollar exchange rate for 2000-2008?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 4 / 11

The Foreign Exchange Market - Graphs

How is the US dollar moving in terms of other currencies?

Why do we care? What do these graphs mean?

What happens when the Euro becomes expensive? For citizens, andfor �rms...

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 5 / 11

How Does the Foreign Exchange Market Work?An over-the-counter market

How does the exchange market work:

If you want 20 e, go to the exchange o�ce.

If you want 20 mln. e, go to the bank, open an account in CZK, andask the bank to trade for you. The bank trades over-the-counter withother banks, and buys the 20 mln for you.

You go to Italy and buy furniture, invest in real estate, buy a factory,etc.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 6 / 11

How Does the Foreign Exchange Market Work?An over-the-counter market

How does the exchange market work:

If you want 20 e, go to the exchange o�ce.

If you want 20 mln. e, go to the bank, open an account in CZK,

andask the bank to trade for you. The bank trades over-the-counter withother banks, and buys the 20 mln for you.

You go to Italy and buy furniture, invest in real estate, buy a factory,etc.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 6 / 11

How Does the Foreign Exchange Market Work?An over-the-counter market

How does the exchange market work:

If you want 20 e, go to the exchange o�ce.

If you want 20 mln. e, go to the bank, open an account in CZK, andask the bank to trade for you.

The bank trades over-the-counter withother banks, and buys the 20 mln for you.

You go to Italy and buy furniture, invest in real estate, buy a factory,etc.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 6 / 11

How Does the Foreign Exchange Market Work?An over-the-counter market

How does the exchange market work:

If you want 20 e, go to the exchange o�ce.

If you want 20 mln. e, go to the bank, open an account in CZK, andask the bank to trade for you. The bank trades over-the-counter withother banks, and buys the 20 mln for you.

You go to Italy and buy furniture, invest in real estate, buy a factory,etc.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 6 / 11

How Does the Foreign Exchange Market Work?An over-the-counter market

How does the exchange market work:

If you want 20 e, go to the exchange o�ce.

If you want 20 mln. e, go to the bank, open an account in CZK, andask the bank to trade for you. The bank trades over-the-counter withother banks, and buys the 20 mln for you.

You go to Italy and buy furniture, invest in real estate, buy a factory,etc.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 6 / 11

How Is the Foreign Exchange Rate Determined?Four main factors for demand shifts

What shifts demand for domestic/foreign goods?

1 Price levels in CR (or US) and in EU

2 Home bias in consumption

3 Productivity (cost) improvement

4 Tari�s and quotas

Common factor: demand for domestic/foreign goods

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 7 / 11

How Is the Foreign Exchange Rate Determined?Four main factors for demand shifts

What shifts demand for domestic/foreign goods?

1 Price levels in CR (or US) and in EU

2 Home bias in consumption

3 Productivity (cost) improvement

4 Tari�s and quotas

Common factor: demand for domestic/foreign goods

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 7 / 11

Factors Determining the Changes in Exchange RatesThe long-run perspective

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 8 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in Europe

Suppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .

Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.

Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?

Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU +

Et+1 − EtEt

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

Factors Determining the Changes in Exchange RatesSpecial attention to expected returns on assets

Recall the exchange rate transmission channel of monetary policy:

Ms ↑⇒ ir ↓⇒ E ↓⇒ NX ↑⇒ Y ↑

Example: Assets in US Vs. Assets in EuropeSuppose Assets in US yield iUS , and Assets in Europe yield iEU .Suppose further iUS = 7%, iEU = 5%.Is this information enough to make a decision which assets to buy?Suppose US $ is expected to depreciate by 3%.EReturn

US = ?Formally:

EReturnUS = iUS − iEU + Et+1 − Et

Et

What happens when EReturnUS ↑?

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 9 / 11

The Interest Rate Parity Condition

Recall:

EReturnUS = iUS − iEU +

Et+1 − EtEt

Set EReturnUS = 0. ⇒

The Interest Rate Parity Condition

iUS = iEU − Et+1 − Et

Et

This condition determines equilibrium on the foreign exchange market.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 10 / 11

The Interest Rate Parity Condition

Recall:

EReturnUS = iUS − iEU + Et+1 − Et

Et

Set EReturnUS = 0. ⇒

The Interest Rate Parity Condition

iUS = iEU − Et+1 − Et

Et

This condition determines equilibrium on the foreign exchange market.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 10 / 11

The Interest Rate Parity Condition

Recall:

EReturnUS = iUS − iEU + Et+1 − Et

Et

Set EReturnUS = 0. ⇒

The Interest Rate Parity Condition

iUS = iEU − Et+1 − Et

Et

This condition determines equilibrium on the foreign exchange market.

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 10 / 11

Equilibrium on the Foreign Exchange MarketA graphical illustration

P. Stankov (CERGE-EI) Lecture 11.2 09 Dec. 2008 11 / 11

What Are Foreign Exchange Rates?How Is the Foreign Exchange Rate Determined?Equilibrium: The Interest Rate Parity Condition