1 of 12 Exchange Rate Determination in the Short Run Advanced International Economics Rameshwar Patel

2 of 12 Agenda develop basic demand/supply model for foreign exchange define effective rate of return, and show how to compare returns on assets priced in different currencies equilibrium: define and explore the Covered Interest Parity condition see how money demand and monetary policy influence rates of return and exchange rates

3 of 12 Basics: Demand Demand for foreign exchange  to buy things denominated in it (goods, services, or assets)  to hold interest-bearing accounts in that currency  greater quantity demanded at lower price/exchange rate Non-price Determinants of Demand.  increased (decreased) demand for foreign G&S  increased (decreased) domestic income  lower (higher) relative price levels for G&S denominated in currency  increased (decreased) relative return on assets denominated in foreign currency

4 of 12 Basics: Supply Supply of foreign exchange: wanting to sell a currency  greater quantity supplied at higher price/exchange rate People wanting to sell more (less) of a currency at any given XR is an increase (decrease) in supply  change in foreign income  change in relative price levels  change in relative rate of return on domestic assets

5 of 12 Equilibrium Equilibrium XR where Q D = Q S Shifts in D or S change XR  what happens if foreign goods get more costly?  what happens if US income falls? Will $ prices of foreign goods fully reflect changes in XR? i.e., how complete is passthru?

6 of 12 The Assets Approach to Exchange Rates FX turnover far more than necessary for purchasing output  FX mostly to purchase assets, incl. foreign currency! Process of interest arbitrage. What determines demand for foreign currency deposits? Effective Rate of Return!  rate of return on the deposit  expected change in domestic currency value of foreign currency  simple interest rates insufficient ~ may be higher UK interest rate on £, but what if £ loses value against $?  uncertainties in predicting future value of any asset  risk and liquidity premiums

7 of 12 Determining Interest Rates: The Market for Money Exchange Rate is a Relative Price of Monies! Money  medium of exchange; unit of account; store of value  Supply ~ assume Central Bank controls M S  Demand (M D ) ~ money only held for liquidity!  R = opportunity cost of money, i.e., the interest rate  P = price level of output (hold fixed for SR)  Y = real nat’l income  L(R,Y) = real aggregate money demand  L(R,Y) = M D /P

8 of 12 Comparing ERR across currencies Nomenclature  R = rate of return on home currency  R* = rate of return on foreign currency  E = current spot rate (units home currency per unit foreign currency)  F = expected future spot rate (hold fixed for SR) Leave out risk, liquidity factors (for now) Return on home currency deposit $1 = $(1+R) ~ ERR $ = R Return on foreign currency deposit of initial value of $1  get 1/E units foreign currency  foreign currency return of (1+R*)/E  convert to home currency, get F(1+R*)/E dollars  ERR* = R* + (F-E)/E + R*·(F-E)/E  last term likely small for economies with stable currencies, low interest rates

9 of 12 Covered Interest Parity (CIP) ERR $ = R; ERR* = R* + (F-E)/E = R* + expected %  E  intuition: ERR on foreign deposit is the rate of change in the foreign currency value of the deposit (R*), plus the forward premium on the foreign currency [(F-E)/E ] (or expected rate of depreciation of $)  Example: R $ =.06, R* =.03, (E e -E)/E =.04  $ pays higher interest rate than FX, but the forward premium on foreign currency more than compensates for the lower foreign rate. Equilibrium E: all deposits offer same ERR Covered Interest Parity  CIP condition: R = R* + (F-E)/E  no incentive to buy or sell deposits of any currency ~ no change in demand or supply of currencies!  R* = R - (E e -E)/E or R – R* = (F-E)/E Uncovered Interest Parity (UIP)

10 of 12 Using CIP Domestic and foreign money markets jointly determined XR! Relevant Variables  domestic and foreign income  domestic and foreign price levels  domestic and foreign money supplies  expected future exchange rates/forward rate

11 of 12 Using CIP, cont. What happens if foreign income falls?  foreign money demand , R* , need larger fwd prem. on FX…E  ($ appr, FX depr)  spot rates tend to change with interest rates! What happens if fwd rate increases?  no change in R or R*, so fwd prem must be unchanged…spot rate changes same amount  changes in expectations tend to manifest now! If US R = 0.045, foreign R* = 0.07, what is fwd prem on FX?  FX is at fwd discount of (2.5% expected depr)

12 of 12 Agenda develop basic demand/supply model for foreign exchange define effective rate of return, and show how to compare returns on assets priced in different currencies equilibrium: define and explore the Covered Interest Parity condition see how money demand and monetary policy influence rates of return and exchange rates on to Module 2A – Exchange Rates in the Long Run