International Economics Part International financial relations Lecture 7 BOP in Open Economy Lecture 8 Market-Determined Exchange Rates Lecture 9 The International Currency System Lecture 10 Domestic Policy to Adjust the Balance of Payments Lecture 11 Effects of Exchange Rate Adjustment on the Current Account and the Domestic Economy Feb.15,2011~Jun.10,2011

International Economics Lecture 8 Market-Determined Exchange Rates Feb.15,2011~Jun.10,2011

Exchange rate: the number of units of one currency that are exchangeable for a unit of another. (Inverse of exchange rate) Foreign exchange market: The marketplace where international currencies trades take place.( London, New York, Tokyo, Zurich) Topics: how exchange rates are determined and the causes of their fluctuations.

outlines Demand and Supply of Foreign Currencies Shifts in the Demand and Supply Curves The Foreign Exchange Market Summary

1.Demand and Supply of Foreign Currencies Figure 8-1 supply and demand curves for dollars in the EURO- Zone foreign exchange market(E.G., In frankfurt market) Floating exchange rate depreciation appreciation

A currency is fundamentally strong and its value may be pushed upward when the countrys autonomous inpayments (exports of goods and services plus inflow of capital) exceed outpayments (imports plus outflow of capital). It is weak when this situation is reversed.

2.Shifts in the Demand and Supply Curves Relative interest rate Relative price change Expectations Other factors

Figure 8-2 effect of a rise in the U.S. interest rates on the Dollar- Euro exchange rate Other things being equal, a rise in U.S. interest rate increases demand for dollars, and lifts its exchange value.

How monetary and fiscal policies affect the exchange rate? Policy Monetary expansion Monetary contraction Fiscal expansion Fiscal contraction Effect on the money market Money supply rises Money supply declines Money demand rises Money demand declines Effect on interest rate Decline Rise Decline Effect on the exchange rate Depreciates Appreciates Depreciates

Figure 8-3 effect of U.S. inflation on the Dollar-Euro exchange rate A rise in a countrys inflation relative to that in the rest of the world depreciates its currency, as its sales abroad decline and purchase abroad rise.

Monetary policy has a powerful effect on the exchange rate. It affects the rate through both the price and interest rate channels. Overshooting Purchasing power parity Changes in the balance of trade The exchange rate reflects the relative purchasing power of the two currencies. U.S. trade deficits would cause dollar to depreciates A rise in the productivity in a countys tradeable-goods would cause its currency appreciates.

Figure 8-4 exchange rate overshooting Only the exchange rate adjusts immediately. It must therefore absorb the entire impact in money supply, causing it overshoot.

summary

3.The Foreign Exchange Market vDefinition The marketplace where international currencies trades take place It need not be a collective fair for traders but always integrated by telephones,fax and internet links, each part of the market makes the sun never set(24hours a day): four major markets Huge trading volume (over 1500b per day) USD acts as vehicle currency

1.Spot transactions: immediate delivery within two business days 2.Forward transactions: dealing on value date basis more than two mature date and at an agreed upon price 3.Swap transactions: converting one currency to another currency which makes up a significant proportion of all foreign exchange trading Transaction types

Foreign Exchange Market Transaction Actors include: ØCommercial banks: interbank trading ØCorporations: across border payments and earnings ØNonbank financial institutions:Funds holders and operators ØCentral Banks:intervention/final settlement ØThe Truth is: There is a market, there exists difference A network of telephone lines and cables.

Cross rate: are exchange rates between two nondollar currencies. Arbitrage: taking advantage of price differentials between two locations. Instant communication ensures that the foreign exchange markets will be orderly: that the value of one currency in terms of another will be the same in all major financial centers. $1 It yields riskless profits. Triangular arbitrage ensures that such rates would be orderly. 100

The forward exchange market There is a lapse of several months between the time the order is placed and the time the importer must make payment.

Hedging üForward exchange rate: is the rate that governs transactions to be consummated in the future. üSpot exchange rate: is the rate that governs transactions to be consummated within 2 days. üUnder orderly market conditions, the forward and spot exchange rates are related to each other in a way that reflects the interest-rate differential in the two financial markets.

Buy $20,000 3%4% 20,000 Spot exchange rate: 1 = $ 1 forward exchange rate: 1 = $ 1.01

The interest rate parity The interest rate parity stipulates that the relation between the spot and forward rates equals the interest rate differential between the two financial markets. It states that the forward discount or premium is equal to the interest differential. For several reasons the expected relationship may not exist.p216

Speculation Speculation does not involve the covered position, it involves risk. Short position is the forward sale of a foreign currency which the seller does not have. Long position is the forward purchase of a foreign currency which the buyer does not need.

5.Summary Supply and demand forces emanating from international transactions interact to determine the exchange rate. As a country's currency depreciates, its imports become more expensive in home currency terms and its exports cheaper in foreign currency terms. This improves their competitiveness at home and abroad. Interest rate changes have a powerful effect on exchange rates in the short run. A rise in interest rates will cause the currency to appreciate; a fall leads to depreciation.

Fiscal expansion causes a rise in interest rates which leads to appreciation of the home currency. Relative price changes are important in the long run. Sustained inflation leads to currency depreciation. As exchange rates move from one equilibrium point to the next, overshooting is likely to occur. Arbitrage and speculation are vital for orderly financial markets.

Suggested Further Reading Robert Cumby, Forecasting Exchange Rates and Relative Prices with the Hamburger Standard: Is What You Want What You Get with McParity?, NBER Working Paper 5675, July 1, Paul R. Krugman, and Maurice Obstfeld, International Economics: Theory and Policy, 7th Edition, New York: Harper Collins, R.M. Levich, "Empirical Studies of Exchange Rates: Price Behavior, Rate Determination and Market Efficiency," in R.W. Jones and Peter Kenen, eds., Handbook of International Economics, Vol. II, New York: North Holland, 1985.