International Economics Mordecai E. Kreinin Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Part II International Financial Relations Part II International Financial Relations

C11-2 CHAPTER 11 Market-Determined Exchange Rates

C11-3 OVERVIEW Demand and Supply of Foreign Currencies Shifts in the Demand and Supply Curves Foreign Exchange Market Demand and Supply of Foreign Currencies Shifts in the Demand and Supply Curves Foreign Exchange Market

C11-4 Important Concepts Foreign Exchange market Freely fluctuating exchange rate Appreciation Depreciation Demand for dollars Supply of dollars Exchange rate overshooting Purchasing power parity (PPP) Speculative bubble Managed float Arbitrage Vehicle currency Foreign Exchange market Freely fluctuating exchange rate Appreciation Depreciation Demand for dollars Supply of dollars Exchange rate overshooting Purchasing power parity (PPP) Speculative bubble Managed float Arbitrage Vehicle currency Cross rates Triangular arbitrage Hedging Forward exchange rate Interest rate parity Spot exchange rate Discount on forward rate Speculation Premium on forward rate Short position Long position

C11-5 Introduction Exchange rate Inverse of exchange rate Foreign exchange market Exchange rate Inverse of exchange rate Foreign exchange market

C11-6 Demand and Supply of Foreign Currencies Freely fluctuating (or floating) exchange rate Appreciation and depreciation Depreciation and competitiveness Appreciation and competitiveness Demand and supply A currency is strong when exports plus inflow of capital exceed outpayments Additional insights: Euro-Zone demand for dollars example Freely fluctuating (or floating) exchange rate Appreciation and depreciation Depreciation and competitiveness Appreciation and competitiveness Demand and supply A currency is strong when exports plus inflow of capital exceed outpayments Additional insights: Euro-Zone demand for dollars example

Supply and Demand Curves for Dollars in the Euro-Zone Foreign Exchange Market (e.g., Frankfurt Market) FIGURE 11.1 C11-7

C11-8 Shifts in the Demand and Supply Curves Relative interest rates Interest rate effect Relative price change Inflation effect Additional insights: fiscal and monetary policies Overshooting Purchasing power parity (PPP) Changes in balance of trade Expectations Other factors Relative interest rates Interest rate effect Relative price change Inflation effect Additional insights: fiscal and monetary policies Overshooting Purchasing power parity (PPP) Changes in balance of trade Expectations Other factors

Effect of a Rise in U.S. Interest Rates on the Dollar-Euro Exchange Rate FIGURE 11.2 C11-9

Effect of U.S. Inflation on the Dollar-Euro Exchange Rate FIGURE 11.3 C11-10

Exchange Rate Overshooting FIGURE 11.4 C11-11

C11-12 Shifts in the Demand and Supply Curves: Summary Domestic changes relative to world changes Several factors affecting exchange rate may change simultaneously Depreciation not necessarily bad, appreciation not necessarily good Freely fluctuating exchange rate would settle at a point that clears market (equated private inpayments and outpayments) No overall imbalance Managed float Domestic changes relative to world changes Several factors affecting exchange rate may change simultaneously Depreciation not necessarily bad, appreciation not necessarily good Freely fluctuating exchange rate would settle at a point that clears market (equated private inpayments and outpayments) No overall imbalance Managed float

Economic Events and Government Policies Influence Prices (P) and Rate of Interest (i) C11-13

C11-14 The Foreign Exchange Market Market Organization Commercial banks Corporations Nonbank financial institutions Central banks Arbitrage Cross Rates Forward Exchange Market Forward and spot rates Interest rate parity Speculation Short and long position Market Organization Commercial banks Corporations Nonbank financial institutions Central banks Arbitrage Cross Rates Forward Exchange Market Forward and spot rates Interest rate parity Speculation Short and long position

“Freak Situation” Schema C11-15

Financing Foreign Trade Example C11-16

C11-17 Summary Establishment of market exchange rates Causes for daily fluctuations Supply-and-demand forces Effects of interest rate changes on exchange rates Purchasing power parity Overshooting Foreign exchange markets Triangular arbitrage and cross rates Interest rate parity Establishment of market exchange rates Causes for daily fluctuations Supply-and-demand forces Effects of interest rate changes on exchange rates Purchasing power parity Overshooting Foreign exchange markets Triangular arbitrage and cross rates Interest rate parity

Demand for Dollars and Supply of Euros FIGURE A C1-18

Exchange Rate Determination FIGURE A11-4 C1-19