Foreign Exchange Markets, ECO Money & Banking - Dr. D. Foster Purchasing Power Parity, and Real Interest Parity

We want to buy foreign exchange. We don’t really want the “money.” We want the goods/services/financial assets We pay $ to get foreign exchange. When the $ appreciates, we can buy more... i.e. the price is lower. When the $ appreciates, the £ depreciates. When $ depreciates … price is higher. Perspective! The U.S.

Demand shows: our demand for British goods and services (our imports) We demand foreign exchange - £, Ұ, € The market for pounds (£) D £ $ (per £) Q£Q£ E = $2 E = $1 At higher prices… it takes more dollars to buy a pound, British goods are more expensive, the dollar is depreciating (and the £ is appreciating). At lower prices …

What would shift the demand for British pounds? D £ $ (per £) Q£Q£ The Fed may buy pounds! A change in our tastes and preferences for their goods. A change in our income. A change in trade restrictions. A change in monetary policy... D’ £ D” £ The market for pounds (£) Perspective! The U.S.

The market for pounds (£) S £ $ (per £) Q£Q£ E = $2 E = $1 Foreigners supply foreign exchange - £, Ұ, € Supply shows: British demand for dollars to buy our goods (our exports). To acquire $ they must supply £. At higher prices… pounds buy more dollars, American goods are cheaper, the dollar is depreciating (and the £ is appreciating). At lower prices … Perspective! The U.S.

S £ $ (per £) Q£Q£ The market for pounds (£) What would shift the supply of British pounds? their A change in their tastes and preferences for our goods. their A change in their income. A change in trade restrictions. A change in monetary policy... The Fed may sell pounds! S’ £ Perspective! The U.S.

Exchange rate changes as S & D change... D £ S £ $ (per £) Q£Q£ E $ depreciates; the price rises; we buy less $ appreciates; the price falls; we buy more Equilibrium in the market for pounds (£) Perspective! The U.S.

D £ S £ $ (per £) Q£Q£ E D £ S £ $ (per £) Q£Q£ E D £ S £ $ (per £) Q£Q£ E Q - What if our incomes rise? Q - What if Brits want more US goods? Q - What if we want less British goods? E’ D’ A - Increase Demand; E rises; $ depreciates E’ D’ A - Decrease Demand; E falls; $ appreciates E’ S’ A - Increase Supply; E falls; $ appreciates Perspective! The U.S.

They want to buy foreign exchange ($). They don’t really want the “money.” They want our goods/services/financial assets They pay £ to get $ (foreign exchange). When the £ appreciates, they can buy more... i.e. the price is lower. When the £ appreciates, the $ depreciates. When £ depreciates … price is higher. Perspective! Britain

Exchange rate changes as S & D change... D $ S $ £ (per $) Q$Q$ 1E1E £ depreciates; the price rises; we buy less £ appreciates; the price falls; we buy more $ appreciates $ depreciates Perspective! Britain

D $ S $ £ (per $) Q$Q$ 1/E Q - What if U.S. incomes rise? Q - What if we want less British goods? A - Increase Demand; 1/E rises; $ appreciates 1/E’ D’ D $ S $ £ (per $) Q$Q$ 1/E D $ S $ £ (per $) Q$Q$ 1/E 1/E’ S’ A - Increase Supply; 1/E falls; $ depreciates 1/E’ S’ A - Decrease Supply; 1/E rises; $ appreciates Q - What if Brits want more US goods? Perspective! Britain

Current Exchange Rates D £ S £ $ (per £) Q£Q£ D $ S $ £ (per $) Q$Q$

Real Exchange Rates Nominal: What we see reported. Real: Adjusted for price level changes. Can $/US $: 2013 – – CPI (Can): CPI (US): Nominal %Δ: – 5.15%; Real %Δ: – 4.17%

Real Exchange Rates Who’s perspective? Draw it out D$D$ Can $/$ S$S$ So, the $ is depreciating in value.

Purchasing Power Parity Where... transportation costs are zero. tax differentials do not exist. there are no trade restrictions. goods are homogeneous. A unit of goods in one country trades for the same price in another country. Law of One Price: A unit of goods in one country trades for the same price in another country.

Example - Apples in U.S. & Britain U.S. price = $.50; British = £.75 If exchange rate is.667 ($/£) then the apple sells for the same price in both. What if the exchange rate is.75? Sell apple in Britain for.75 (£) and convert to $: (£.75)*(.75) = $.562 for a 6.2 cent profit! What happens...?

Arbitrage results U.S. -  demand for apples -  apple prices Britain -  supply of apples -  apple prices In U.S. foreign exchange market,  S £ as arbitrageurs convert back to $ S£S£ S£1S£1 D£D£ S/ £ Q£Q£ On your own - show this from the British perspective.

Different PPP models Absolute PPP: CPI US = E  (CPI Brit ) if this can be applied to all goods, assumes goods mix the same in both. Solve for rate: E = (CPI US )/(CPI Brit ) Relative PPP: %ΔE = %Δ(CPI US ) - %Δ(CPI Brit ) differences in inflation rates explain... appreciating/depreciating exchange rates. Long-run data tends to confirm this.

Hedging your bets - Futures Market You want to buy British bonds... earning i Brit but you face the risk of changing E... So, you buy $ futures contract. Locks in your financial outcome... Buying Future Dollars

Let i US =6% and i Brit =8% with E=1.2 E aka “spot rate.” Let the forward rate be E f =1.18 With $1200, should you invest in US bonds or British bonds? British bonds... buy £1000 bond; in one year, worth £1080; $1274 converts back at (1.18)*(1080) = $1274; $1272 In US, would make $1272. What if the risk premiums differed? Wait …

British bond earns: i Brit + [(E f - E)/E] in equilibrium, this equals i us Noting relative PPP: %  E e =  e US -  e Brit where e=expected and  =inflation. Buying Future Dollars Using r to represent real interest, rewrite as: (E e - E)/E = (i us - r e US ) - ( i Brit - r e Brit )

Real Interest Rate Parity Substituting for i US i Brit + [(E f - E)/E] (E e - E)/E = ( i Brit + [(E f - E)/E] - r e US ) - ( i Brit - r e Brit ) Canceling for i Brit cancel out and if E e =E f, then: r e US = r e Brit

Revisit Bond Problem U.S. return = 6%; take the U.S. bond!!! What if the UK bond had a risk premium of +0.3% over the US bond? U.K. return = $74/1200 = 6.17% … but adjusted for risk = 5.87%

Foreign Exchange & Monetary Policy Gold Standard  $ policy Fixed X∆ rates,  K flows,  $ policy Bretton Woods System  K flows Fixed X∆ rates,  K flows,  $ policy Unmanaged free floating rates Volatile X∆ rates Volatile X∆ rates,  K flows,  $ policy Managed rates Semi-fixed X∆ rates,  K flows, ???$ policy

Foreign Exchange Markets, ECO Money & Banking - Dr. D. Foster Purchasing Power Parity, and Real Interest Parity