1/38 FOREIGN EXCHANGE MARKET TOPIC 13

Chapter Preview We develop a modern view of exchange rate determination that explains the behavior of exchange rate in the foreign exchange market. Topics include: 1. Foreign Exchange Market 2. Exchange Rate Determination 3. Explaining Changes in Exchange Rates

1. The Foreign Exchange Market

4/34 Foreign Exchange Market What is forex market? Countries have their own currencies. When trades happen between them, domestic currencies will be exchanged with foreign currencies Forex market is where trading of currencies and banks deposits denominated–currency takes place Nominal exchange rate is the price of one country’s exchange rate in terms of another’s. Real exchange rate is the purchasing power of a currency relative to the purchasing power of other currencies.

Foreign Exchange Market: Historical Exchange Rates Figure 13.1: Exchange Rates, 1990–2004

6/34 Forex Market What is forex rate? 1.Price of a currency in terms of another 2.Determined by transactions conducted in forex market 3.These rates determine the cost of purchasing foreign goods and financial assets Types of forex rate: 1.Spot ER: ER for the current transaction; immediate (2 day) exchange of bank deposits. OTC; bid-ask spread 2.Forward ER: ER for forward transaction; exchange of bank deposits at some specified future dates. Contract to buy/sell FX at a specified price and future date; hedging instrument Changes in forex rate: 1.Appreciation 2.Depreciation 3.Devaluation?

7/34 Foreign Exchange Market Why ERs are important? They affect the relative price of domestic goods and foreign goods When currency appreciates, country’s goods become more expensive abroad and foreign goods become cheaper in the country Currency appreciation - good or bad? 1.To business: Makes domestic businesses less competitive. Difficult for domestic manufacturer to sell their goods abroad and increase competition at home as foreign goods become cheaper 2.To consumer: Benefits as foreign goods become cheaper. 3.Others: Government, students, tourists/tourism industry

8/34 How is Forex Traded? No physical place but a network of telephones, s and other telecommunication facilities connecting all large banks in the world In organized OTC market in which many dealers stand ready to buy and sell deposits denominated in specific currencies. Market very competitive since dealers are in constant telephone and computer contact Operates 24-hours a day Trades involve buying and selling bank deposits denominated in different currencies, no buying of notes Trades in the foreign exchange market involve transactions in excess of $1 million

9/34 How is Forex Traded? Participants: Commercial banks (interbank market, retail) Corporates with international operations (current transactions and hedging) Non-bank financial institutions Central banks (forex intervention) Typical consumers buy foreign currencies from retail dealers such as American Express

2. Exchange Rate Determination

11/34 Determination of Exchange Rates ERs are determined by interaction of supply and demand of currency in forex market. Behavior of ER is different in long run compared to short run In long run, behavior of ER can be explained by theory of Purchasing Power Parity (PPP) ER between two currencies will adjust to reflect changes in price levels ER is determined by changes in relative price because PPP is based on Law of One Price 1. Price level in an important concept that drives the forces of supply and demand 2. Price of an identical good should be the same throughout the world, regardless of which country produces it

12/34 Exchange Rates in the Long Run: Law of One Price Law of One Price: If 2 countries produce an identical good, price of the good should be the same throughout the world no matter which country produces it Suppose: US steel costs $100 per ton & Jap steel costs 10,000 yen per ton According to Law of One Price, the ER has to be: $100/ton=10,000 yen/ton = 100 yen/$ or $0.01/yen

13/34 Exchange Rates in the Long Run: Law of One Price At this ER 100 yen/$: US steel costs 10,000 yen per ton in Japan ($100/ton x 100 yen/$) Jap steel costs $100 per ton in US (10,000 yen/ton x $0.01/yen) If price in US increase as reflected by yen/USD ER goes to 200 yen/$: US steel costs 20,000 yen per ton in Japan ($100/ton x 200 yen/$) Jap steel costs $50 per ton in US (10,000 yen/ton x $0.005/yen) DD for US steel goes to zero resulting in excess supply of US steel. US price has to decline to increase demand for US steel US ER must depreciate so that the yen-$ ER will go to 100 yen/$ (from 200 yen/$)

14/34 Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP) Theory of PPP states:  Application of law of one price to price levels  Inflation rate differences cause changes in the nominal exchange rate.  Domestic price level increases by 10%, domestic currency would depreciate by 10%  Works in long run, not short run Complications with PPP 1.All goods are not identical in both countries (i.e., Toyota versus Chevy) 2.Many goods and services are not tradable across borders (e.g., haircuts, land, etc.)

15/34 Factors Affecting Exchange Rates in Long Run Basic Principle: Any factor contributing to increased demand for domestic goods relative to foreign goods, domestic currency will appreciate 1. Relative price levels: When price of dom goods , the dd for domestic goods decrease Dom curr must depreciate so that the domestic goods can still sell In LR, a rise in relative price levels cause a country’s currency to depreciate 2. Tariffs and quotas : Impact: reduces the availability of foreign goods in dom market  the dd for domestic goods and the dom curr will appreciate In the LR,  trade barriers causes a country’s currency to appreciate

16/34 Factors Affecting Exchange Rates in Long Run 3. Preferences for domestic vs foreign goods Increased demand for a country’s good causes its currency to appreciate Increased demand for imports causes the domestic currency to depreciate 4. Productivity  productivity, dom business can lower the prices of dom goods,  the dd for dom goods, dom curr appreciates In the LR, if a country is more productive relative to another, its currency appreciates

17/34 Factors Affecting Exchange Rates in Long Run

18/34 ER in the Short Run ER shows larger fluctuations in the SR than in the LR In the SR, an ER is the price of domestic bank deposits in terms of foreign bank deposits Thus, ER can be determined by analyzing the dd for domestic asset holding and foreign asset holdings (the determinants of asset demand) The most important factor affecting this demand is the expected return on these assets relative to each other

19/34 Exchange Rates in the Short Run: Expected Returns and Interest Parity According to the interest parity condition: The interest parity condition states that the domestic interest rate is equal to foreign interest rate minus the expected appreciation of the domestic currency. Example: if i D = 10% and expected appreciation of $ is 5%,

Exchange Rates in the Short Run The usual approach to supply-demand analysis focused on import/export demand Here, we emphasize stocks rather than flows, because flows are small relative to the domestic and foreign asset stocks.

Exchange Rates in the Short Run: Supply Curve Analysis We will use the US as the “home country,” so domestic assets are denominated in US dollars. We will use “euros” the generically represent any foreign country's currency. Dollar assets supplied is primarily the quantity of bank deposits, bonds, and equities in the United States. This is fairly fixed in the short- run. The quantity supplied at any exchange rate does not change, so the supply curve, S, is vertical.

Exchange Rates in the Short Run: Demand Curve Analysis The demand curve traces out the quantity demanded at each current exchange rate The current exchange rate and the expected future exchange rate are held constant in this analysis. Let’s see a specific example that illustrates this point.

Exchange Rates in the Short Run: Supply and Demand Curves

Deriving the Demand Curve The demand curve connects these points and is downward sloping because when E t is higher, expected appreciation of the dollar is higher.

Exchange Rates in the Short Run: Equilibrium Equilibrium Supply = Demand at E* If E t  E*, Demand  Supply, buy $, E t  If E t  E*, Demand  Supply, sell $, E t 

3. Explaining Changes in Exchange Rates

Explaining Changes in Exchange Rates To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits. We will examine these separately, as well as changes in the money supply and exchange rate overshooting.

Explaining Changes in Exchange Rates: Increase in i D Demand curve shifts right when i D  : because people want to hold more dollars This causes domestic currency to appreciate.

Explaining Changes in Exchange Rates: Increase in i F Demand curve shifts left when i F  : because people want to hold fewer dollars This causes domestic currency to depreciate.

Explaining Changes in Exchange Rates: Increase in Expected Future FX Rates Demand curve shifts left whe  : because people want to hold more dollars This causes domestic currency to appreciate.

Explaining Changes in Exchanges Rates Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing Expected fall in relative U.S. price levels Expected increase in relative U.S. trade barriers Expected lower U.S. import demand Expected higher foreign demand for U.S. exports Expected higher relative U.S. productivity These are summarized in the following slides.

Explaining Changes in Exchanges Rates (a)

Explaining Changes in Exchanges Rates (b)