 Exchange Rate: S - # of domestic currency units purchased for 1 US$.  An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation. Exchange Rates

It is January 1 st, and you have D$1000 to save for 1 year. You can put it into: 1. Put it into a domestic currency bank account at an interest rate i. 2. a foreign currency bank account at interest rate i F.

 Strategy two has three parts. 1. Buy foreign exchange at spot rate S 01/01 to get {D$1000/S 01/01 } US dollars. 2. Put {S 01/01 × D$1000} into bank account. After 1 year get US$(1+i F )×{D$1000/S 01/01 } 3. Convert these funds into US at exchange rate prevailing in 1 year.

 If > 1+i, deposit funds then deposit in US$ account.  If < 1+i, deposit funds then deposit in HK$ account.  Then in equilibrium

 The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rate would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account.  Approximately

1. Future exchange rates are risky, uncovered interest parity does not account for risk. 2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons.

 Relative values of two currency determined by supply and demand by traders of the two currencies.  People trade currencies to engage in foreign trade and international investment.

Consider the spot foreign exchange market.  Price of US$: S is the price of US$ in terms of DCU.  Supply of US$: Foreign people who want to acquire DCU to buy domestic goods or assets. ◦ When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency.  Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. ◦ When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

S Demand Supply S* 1

S Supply Demand S* Demand ' S** Domestic Currency Depreciates 1 2

S Supply Demand S* Supply ' S** Domestic Currency Appreciates 1 2

S Supply Demand S* Supply ' Demand' S** Domestic Currency Depreciates 1 2

S Supply Demand S* Supply ' Demand ' S** Domestic Currency Appreciates 1 2

 The central impact of the foreign currency intervention is on domestic interest rates.  Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves.  Monetary policy that does not shift interest rates will not shift exchange rates.

 If people’s expectation of the future exchange rate indicates a future depreciation, this will reduce the expected returns on investing in the domestic economy at any given interest rate.  This will increase demand for US$ and reduce supply.  An expected depreciation leads to a current depreciation!

S Supply Demand S* Supply ' Demand ' S** Domestic Currency Depreciates 1 2

Students should be able to:  Use interest differentials to calculate expected depreciation rate under UIRP.  Use the Supply-Demand model of the forex model to explain: ◦ the effect of international trade conditions on the exchange rate. ◦ the impact of interest rates and other financial market conditions on exchange rates.