Exchange Rates

An exchange rate is the price of one currency in terms of another. –It indicates how many units of one currency can be bought with a single unit of another currency. Exchange rates are important because exports, imports and all international financial transactions are affected by the prices at which currencies exchange for one another.

Exchange Rates and Trade Currency Appreciation –Increase in the value of the currency When a country’s currency appreciates, its exports become more expensive and its imports become less expensive. Currency Depreciation –Decrease in the value of the currency When a country’s currency depreciates, its exports become less expensive and its imports become more expensive.

Exchange Rates and Capital Mobility Currency appreciation –Increase in the value of the currency When the dollar appreciates, U.S. assets become more attractive relative to foreign assets. Currency depreciation –Decrease in the value of the currency When the dollar depreciates, U.S. assets become less attractive relative to foreign assets.

Exchange Rates: Long Run Factors that affect exchange rates in the long run include: –Relative Price Levels –Trade Barriers –Preferences for Domestic Versus Foreign Goods –Productivity

Purchasing power parity (PPP) says that when the prices charged for essentially the same goods in different countries diverge, exchange rates will move in the opposite direction and equalize the effective prices between the two countries. Relative Price Levels and Exchange Rates

Determination of Exchange Rates: PPP Purchasing power parity says that in the long run exchange rates adjust to reflect changes in the price levels of two countries. –If one country’s price level rises relative to another, its currency tends to depreciate. –If one country’s price level falls relative to another, its currency tends to appreciate.

PPP: Simple Example Assume that the USA and Canada produce identical bushels of wheat and that the exchange rate is $1 Canadian for $1 U.S. Let the price of wheat in Canada rise to $3/bushel while the price of wheat in the U.S. remains $2.50/bushel. What will happen?

Purchasing Power Parity: Example Canadians will buy U.S. wheat. In order to do this, they must first buy U.S. dollars. –The supply of Canadian dollars in the global marketplace increases. –The demand for U.S. dollars in the global marketplace increases The Canadian dollar depreciates and the U.S dollar appreciates.

Purchasing Power Parity: Example The price of U.S. wheat increases for Canadians for two reasons. –The dollar has appreciated. –The increase in demand for U.S. wheat pushes its price towards $3.00. The decrease in demand for Canadian wheat pushes down its price down from $3.00 towards $2.50.

PPP: Simple Example Over time these effects combine to bring about a single price for U.S. and Canadian wheat. Conclusion: –A rise in the price level puts downward pressure on a currency. –A fall in the price level puts upward pressure on a currency.

Why PPP Works Poorly in the Short Run Assumptions: –All goods are identical in both countries. –All goods and services are traded across borders. –Both countries have similar levels of productivity. –Consumers do not prefer one country’s goods over another’s. –No tariffs or quotas.

Trade Barriers and Exchange Rates Barriers to free trade, increase the demand for domestic goods, causing the domestic currency to tend to appreciate. If the rising value of the currency does not decrease foreign demand, the domestic currency appreciates because the supply of that currency decreases in world markets.

Preferences and Exchange Rates Increased demand for a country’s exports causes its currency to appreciate. If the rising value of the currency does not decrease foreign demand, the demand for the domestic currency in world markets increases and its value rises.

Preferences and Exchange Rates Decreased demand for a country’s exports causes its currency to depreciate. If the falling value of the currency does not increase foreign demand, the demand for the domestic currency in world markets decreases and its value falls.

Productivity and Exchange Rates As a country becomes more productive than other countries, costs fall, permitting that country to sell at lower prices. The decrease in price increases demand for the country’s goods and services, causing the value of the country’s currency to rise.

Productivity and Exchange Rates As a country becomes less productive than other countries, costs rise, forcing that country to sell at higher prices. The increase in price decreases demand for the country’s goods and services, causing the value of the country’s currency to fall.

Exchange Rates: Short Run The modern asset market approach to explain exchange rate determination emphasizes financial flows. –Financial transactions in the U.S. are over 25 times greater than the amount of exports and imports. In the short run, decisions to hold domestic or foreign assets play a more important role than trade.

Expected Return Demand for dollar deposits vis a vis foreign deposits depends on the relative expected return on the deposits. –A higher expected return on dollar deposits relative to foreign deposits results in a higher demand for dollar deposits. –A higher expected return on foreign deposits relative to dollar deposits results in a higher demand for foreign deposits.

Expected Return: Foreign Perspective The return on dollar deposits received by a foreigner depends on the interest rate and the exchange rate between dollars and the foreign currency because…. –Interest earned on U.S. deposits is denominated in dollars and must be converted into the foreign currency.

Expected Return: Stable Currencies Assume you are French and you have bought a U.S. asset that pays 10% interest. –If the exchange rate between the U.S. and France does not change, you receive the full 10%.

Expected Return: Changing Currency Values Assume you are French and you have bought a U.S. asset that pays 10% interest. Also assume that the exchange rate between France and the U.S. changes. You will not receive 10%. –You may receive more than 10% or less than 10%.

Expected Return: Dollar Appreciation Assume you are French and you own a U.S. asset that pays 10%. Assume also that the dollar has appreciated relative to the euro. –This means that the dollar buys euros. –This means that you earn than 10%.

Expected Return: Dollar Depreciation Assume you are French and you own a U.S. asset that pays 10%. Assume also that the dollar has depreciated relative to the euro. –This means that the dollar buys euros. –This means that you earn than 10%.

Expected Return: The Math The formula for the expected return on dollar deposits (RET$) in terms of euros is: RET$ = i $ + (E $ t+1 – E $ t )/E $ t The expected return equals the interest return denominated in dollars (i $ ) plus the expected dollar appreciation. –E $ t+1 is the expected value of the dollar in the next period. –E $ t is the expected value of the dollar today.

Expected Return: French Assets If you are French, the expected return on French deposits is the French interest rate. There is no exchange rate exposure.

Relative Expected Return If you are French, the relative expected return on dollar deposits is the difference between the expected return on dollar deposits and the expected return on euro deposits. To invest profitably, we must compare the two.

Relative Expected Return: The Math The relative expected return on dollar deposits equals: Relative RET$ = i $ – i f + (E $ t+1 – E $ t )/E $ t The relative expected return equals the interest return denominated in dollars minus the interest on French deposits plus the dollar appreciation.

Expected Return: American Perspective The return on euro deposits received by an American depends on the French interest rate and the exchange rate between dollars and the euro because…. –Interest earned on French deposits is denominated in euros and must be converted into dollars.

Expected Return: The Math The formula for the expected return on French deposits (RETF) in terms of dollars is: RETF = i f – (E $ t+1 – E $ t )/E $ t The expected return equals the interest return denominated in euros (i f ) plus the appreciation in the euro. Euro appreciation is the negative of dollar appreciation so we subtract dollar appreciation from our return.

Expected Return: U.S. Assets The expected return on U.S. deposits for Americans is the U.S. interest rate because there is no exchange rate exposure.

Relative Expected Return If you are American, the relative expected return on dollar deposits is the difference between the expected return on dollar deposits and the expected return on euro deposits. To invest profitably, we must compare the two.

Relative Expected Return: The Math The relative expected return on dollar deposits equals: Relative RET$ = i $ – (i f – (E $ t+1 – E $ t )/E $ t ) = i $ – i f + (E $ t+1 – E $ t )/E $ t The relative expected return equals the interest return denominated in dollars minus the interest on French deposits plus the dollar appreciation.

Conclusion The relative expected return on dollar deposits is the same whether it is calculated form the foreign point of view or the domestic point of view. –When the dollar is expected to appreciate, Americans and foreigners prefer to hold dollar denominated deposits.

Interest Rate Parity Understanding Exchange Rates in the Short Run

Explaining Interest Rates with Interest Rate Parity Interest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

Interest Rate Parity: Assumptions Foreign and U.S. deposits have similar risk and liquidity characteristics. There are few impediments to capital mobility. –Foreigners can easily purchase American assets and Americans can easily purchase foreign assets. Therefore, foreign and American deposits are perfect substitutes.

Interest Rate Parity: Investor Behavior When capital is mobile and bank deposits are perfect substitutes…. –If the expected return on dollar deposits is above foreign deposits, everyone will want to hold dollar deposits. –If the expected return on foreign deposits is above American deposits, everyone will want to hold foreign deposits.

Interest Rate Parity Condition For existing supplies of both dollar and foreign deposits to be held, it must be true that there is no difference in their expected returns. –The relative expected return must equal zero. Relative RET$ = i $ – i f + (E t+1 – E t )/ E t = 0 or i $ = i f – (E t+1 – E t )/ E t

Interest Rate Parity Condition: Implications If the domestic rate is above the foreign interest rate, positive expected appreciation of the foreign currency is expected. –The expected appreciation compensates for the lower foreign interest rate. °i $ = i f – (E t+1 – E t )/ E t °10% = 8% – x

Interest Rate Parity Condition: Implications If the domestic rate is below the foreign interest rate, positive expected appreciation of the domestic currency is expected. –The expected appreciation compensates for the lower domestic interest rate. °i $ = i f – (E t+1 – E t )/ E t °8% = 10% – x

Foreign Exchange Market Model EtEt RET$ RET D 5% 10% 15% RET F E t is the exchange rate = euros/dollars. RET D is the return on dollar deposits in the U.S. RET F is the expected return on euro deposits in terms of dollars. RET$ is the expected return on deposits in terms of dollars. 0

Foreign Exchange Market Model: Derivation EtEt RET$ RET D 5% 10% 15% RET F Let i f = 10%, E t = 9.5 and E t+1 =10. RETF = 0.10 – (10 – 9.5)/9.5 = 0.10 – = 0.48 We plot the combination 9.5 and 4.8 at point 1. 0 

Foreign Exchange Market Model: Derivation EtEt RET$ RET D 5% 10% 15% RET F Let i f = 10%, E t = 10 and E t+1 =10. RETF = 0.10 – (10 – 10)/10 = 0.10 – 0 = 0.10 We plot the combination 10 and 10 at point

Foreign Exchange Market Model: Derivation EtEt RET$ RET D 5% 10% 15% RET F Let i f = 10%, E t = 10.5 and E t+1 = 10. RETF = 0.10 – (10 – 10.5)/10.5 = 0.10 – (– 0.048) = We plot the combination 10.5 and 14.8 at point

Foreign Exchange Market Model EtEt RET$ RET D 5% 10% 15% RET F Equilibrium occurs where the return on foreign assets equals the return on domestic assets. 0

Stability of Equilibrium At equilibrium there are either no forces causing change or there are equal off-setting forces. If the equilibrium is stable, disequilibrium positions cannot exist indefinitely. –Forces in the model will tend to eliminate either the excess supply or excess demand.

Foreign Exchange Market Model EtEt RET$ RET D 5% 10% 15% RET F Equilibrium occurs where the return on foreign assets equals the return on domestic assets. If the return on foreign assets exceeds the return on domestic assets, the currency will depreciate. 0

Equilibrium Let the exchange rate be 10.5 –The expected return on euro deposits is now greater than the return on dollar deposits. –Holders of dollar deposits now will try to sell them and buy euro deposits, but no one will want them at the exchange rate of –The excess supply of dollars will cause the dollar to fall. –The dollar falls until equilibrium is reached at the exchange rate of 10.

Foreign Exchange Market Model EtEt RET$ RET D 5% 10% 15% RET F Equilibrium occurs where the return on foreign assets equals the return on domestic assets. If the return on foreign assets is less than the return on domestic assets, the currency will appreciate. 0

Equilibrium Let the exchange rate be 9.5 –The expected return on dollar deposits is now greater than the return on euro deposits. –Holders of euro deposits now will try to sell them and buy dollar deposits, but no one will want them at the exchange rate of 9.5. –The excess demand for dollars will cause the dollar to rise. –The dollar rises until equilibrium is reached at the exchange rate of 10.

Changes in Exchange Rates To explain how exchange rates change over time, we have to understand the factors that shift the expected-return schedules for domestic dollar deposits and foreign deposits.

Shifting the Expected-Return Schedule for Foreign Deposits The RETF schedule shifts when there is a change in the foreign interest rate. –An increase in the foreign interest rate shifts the RETF schedule to the right and causes the domestic currency to depreciate. –A decrease in the foreign interest rate shifts the RETF schedule to the left and causes the domestic currency to appreciate.

Shifting the Expected-Return Schedule for Foreign Deposits EtEt RET$ RET D 1 RET F 1 Other things remaining the same, a change in i f changes the expected return on foreign deposits. If i f rises, at any given exchange rate, RETF is higher so we shift the RETF schedule to the right. If i f falls, at any given exchange rate, RETF is lower so we shift the RETF schedule to the left. RET F 2 RET F 3 0

Foreign Interest Rate Rises EtEt RET$ RET D RET F 1 RET F 2 An increase in the expected return on foreign deposits causes the domestic currency to depreciate. The higher rates of return on foreign financial assets attract U.S. buyers. In order to buy foreign financial assets, U.S. investors must first buy foreign currency. The supply of dollars increases in the global marketplace and the dollar depreciates. E1E2E1E

Shifting the Expected-Return Schedule for Foreign Deposits The RETF schedule shifts when there is a change in the expected future exchange rate. –A rise in the expected future exchange rate shifts the RETF schedule to the left and causes the domestic currency to appreciate. –A fall in the expected future exchange rate shifts the RETF schedule to the right and causes the domestic currency to depreciate.

Shifting the Expected-Return Schedule for Foreign Deposits EtEt RET$ RET D 1 RET F 1 Other things remaining the same, a change in E t+1 changes the expected appreciation of the dollar. If E t+1 rises, the euro is expected to fall and RETF will be lower. We shift the RETF schedule to the left. If E t+1 falls, the euro is expected to rise and RETF will be higher. We shift the RETF schedule to the right. RET F 2 RET F 3 0

Shifting the Expected-Return Schedule for Domestic Deposits EtEt RET$ RET D 2 RET F A rise in the domestic interest rate shifts RET D to the right and causes an appreciation of the domestic currency. A fall in the domestic interest rate shifts RET D to the left and causes a depreciation of the domestic currency. RET D 3 RET D 1 0

Real Rate of Interest Rises EtEt RET$ RET D 1 RET F RET D 2 A rise in the real domestic rate of interest causes the currency to appreciate. The higher rates of return on U.S. financial assets attract foreign buyers. In order to buy U.S. financial assets, foreigners must first buy dollars. The demand for dollars increases in the global marketplace and the dollar appreciates. E2E1E2E

Inflation and the Exchange Rate EtEt RET$ RET D RET F 1 RET F 2 An increase in inflation causes the currency to depreciate. If nominal interest rates rise because of an increase in the inflation premium, the rise in expected domestic inflation leads to a decline in the expected appreciation of the dollar. E1E2E1E2 1 2 RET D 2 0

Money Supply and the Exchange Rate EtEt RET$ RET D 1 RET F 1 RET F 2 RET D 2 An increase in the money supply can cause the domestic currency to depreciate, if it causes an increase in the domestic price level that leads to a lower expected future exchange rate. The decline in the expected appreciation of the dollar raises the expected return of foreign deposits. In the short run, domestic interest rates fall E1E1 E2E2 E3E3

Volatility of Exchange Rates Exchange rates are volatile because –Exchange rates are determined by expectations about domestic interest rates, foreign interest rates, inflation, and many other variables. –When expectations change about any of these variables, exchange rates are affected.