1 ECON 671 – International Economics Foreign Exchange Markets

2 Model of the FX Market

3 Exchange Rates F Bilateral Exchange Rate is the price of one currency in terms of another currency. F This exchange rate can be quoted in two ways: –Direct or "European" –Direct or "European" = Domestic Currency per Foreign Currency Units, or –Indirect or "American" –Indirect or "American" = Foreign Currency per Domestic Currency Units. F How an exchange rate is quoted depends on the currency and the convention. –We generally use Direct method in what follows. –There is a Bilateral exchange rate for home currency against each foreign currency.

4 Changes in Exchange Rates F Depreciation F Depreciation of the Home currency –value of home currency falls relative to the foreign currency. depreciates appreciating –If the home currency exchange rate depreciates then the foreign currency is appreciating. F Appreciation F Appreciation of the Home currency –value of home currency rises relative to the foreign currency. appreciates depreciating –If the home currency exchange rate appreciates then the foreign currency is depreciating. F Changes in the value of one currency vis a vis another are determined by the workings of the FX market. –Be careful! What happens to the exchange rate depends on how it is being quoted!!! For Direct Method, Depreciation implies EXR rises!!

5 Demand and Supply for FX F Demand for Foreign Currency –Home country citizens and firms demand foreign currency for use in the following transactions: u Purchase foreign goods and services. u Send gifts or pay investment income to foreign citizens. u Purchase foreign financial or real assets. u Speculate or Hedge changes in future value of foreign currency. F Supply of Foreign Currency –Foreign country citizens and firms sell foreign currency (& buy domestic currency) to use in transactions: u Purchase foreign goods and services. u Send gifts or pay investment income to foreign citizens. u Purchase foreign financial or real assets. u Speculate or Hedge changes in future value of foreign currency.

6 Diagram of the FX Market # of Euros e ($/Euro) D 0 Euro S 0 Euro e0e0 S 1 Euro e” D 1 Euro e’ Make sure you understand why the curves slope as they do given the way EXR is quoted!!!

7 FX Market & Balance of Payments # of Euros e ($/Euro) S G&S S Total D G&S D Total Q1Q1 Q2Q2 e0e0 Q eq CAB Surplus Capital Acc’t

8 Exchange Rate Regimes  Flexible Exchange Rate System: Demand and supply for foreign currency determine exchange rate (value of foreign currency in terms of domestic currency). –No intervention by government or central bank in FX markets.  Fixed Exchange Rate System: Gov’t sets exchange rate and then fixes this level by intervening to buy or sell foreign currency depending on demand and supply at the fixed rate. –Intervention by government through central bank in FX markets to maintain EXR at desired level.

9 Market for Foreign Exchange Exchange Rate Supply of FX (from Foreign Citizens) Demand for FX (from Domestic Citizens) Quantity of Foreign Currency Exchanged $/Foreign Currency Flexible EXR FX* Fixed EXR 1  FX Reserves > 0 Fixed EXR 2  FX Reserves < 0

10 Types of Fixed Exchange Rate Regimes Fixed Fixed Exchange Rate System: F When a nation absolutely fixes its exchange rate between its own currency and the currency of another country or region. –Example: Countries such as Hong Kong or Argentina that have a currency board that exchanges HK$ for US$ at a fixed rate. Pegged Fixed Exchange Rate System: F When a nation sets a desired level and bands around that level for the exchange rate between its currency and the currency of another country or region. –Example: Many European countries prior to the euro belonged to the Exchange Rate Mechanism (ERM). Each nation in the ERM set its exchange rate with the Deutschemark (DM) but allowed their exchange with DM to fluctuate within established bands. F Key difference between a fixed exchange rate regime and a pegged exchange rate regime is that in a pegged system the nation’s exchange rate can vary within the bands without central bank intervention.

11 Other Exchange Rate Regimes Monetary Union: F When a nation converts all of its currency into the currency of another country or region at a fixed exchange rate. –Example: Countries such as Ecuador that replaced their currency, the sucre, with the US$ or EU countries that joined the Euro zone by replacing their currencies with a new regional currency, the euro. “Dirty Float” Exchange Rate System: F When a nation allows its exchange rate to be determined by market forces most of the time. Exception is if the exchange rate changes “too much” or too rapidly” the central bank will intervene to moderate the change. This is like a discretionary pegged exchange rate system. –Example: Japan tends to allow their exchange rate with the US$ to be determined by market forces except when the Yen strengthens “too much”, making Japanese exports expensive and threatening their competitive position.

12 Multiple EXR Systems Market for buy & sell FX is controlled by the gov’t (central broker) More than 2 EXR’s at which sell or buy a given foreign currency EXR levels are tiered by gov’t to achieve “economic objectives” 1.Preferential 2.Necessity 3.Auction and/or free market rate Dutch auction - EXR is rate each bids, until D = S. Marginal price auction – same EXR for all so that D = S.

13 Administered EXR with more than one EXR implicitly provide a subsidy or tax to groups Depends on the EXR’s they face in buying and selling. Can measure level of this “protection” by looking at overall average EXR versus each EXR. Protection & Administered EXR Distorts economic decisions in the entire economy. Gov’t could do better with explicit tax/subsidy scheme and flexible EXR system instead.

14 Exchange Rate Measures

15 Real Exchange Rate  Bilateral Real Exchange Rate, . output outputRate at which can exchange output of one country for output of another country.  = Nominal Exchange Rate x Foreign Price Level Domestic Price Level or  = e x [P*/P] Real exchange rate gives # of units of domestic output per unit of foreign output. Depreciation of Real Exchange Rate increases NX. u makes U.S. output cheaper, increasing U.S. exports while decreasing U.S. imports.

16 Effective Exchange Rates F Each country transacts with many others, so need index of exchange rates to measure overall price of domestic goods against rest of the world. F Effective Nominal Exchange Rates –bilateral trade-weighted index of exchange rates in which the weight given to each currency is assigned on the basis of its bilateral trade with the domestic country. –multilateral exchange rate model index (MERM) of the effective exchange rate weights each country’s exchange rate based on the currency’s importance in world trade. –use effective exchange rates to measure the effects of exchange rate changes on a country’s international competitiveness. F Real Effective Exchange Rates –use bilateral real exchange rates to construct effective real exchange rates as for nominal rates above.

17 Determinants of Nominal EXR e =  [P/P*]  Relationship between nominal and real exchange rates.  = e [P*/P] or e =  [P/P*] where P = Domestic Price Level, etc.  Changes (  )in nominal exchange rate expressed as: %  e = %  + %  P - %  P* But %  P = Inflation rate =  etc so %  e = %  + (  –  ) Percent change nominal exchange rate should equal the percent change in the real exchange rate plus the difference between the two countries’ inflation rates.

18 Purchasing Power Parity, PPP F Absolute Purchasing Power Parity –Simplest theory of how exchange rates are determined. “Law of One Price”:“Law of One Price”: A good should not sell for different prices in different places at same time. In long run should have: P H = e x P F F Relative Purchasing Power Parity If PPP holds in terms of percent changes then:  %P H =  %e +  %P F And so nominal exchange rate change approximated as:  %e =  H -  F