1. Chapter 8: Learning Objectives
Exchange rate definitions
Theories of Exchange Rate Behaviour:
From the Law of One Price to PPP
The real exchange rate concept
International linkages in interest rates
Hysteresis in exchange rate behaviour

2. A Selection of Exchange Rates
CAD $
1.2062
US$
.8290
.4313
.5203 €
.6086
0.7341
85.48
103.11
SFr
0.9405
1.1344

3. What’s an exchange rate?
The price of one currency in terms of another:
$CDN per $1.00US = e
$US per $1.00CDN
Cross-rate: when bilateral quotes n.a.
Appreciation vs. depreciation
Devaluation vs. revaluation
trade-weighted exchange rate
the “law” of one price [Pfe=P]

4. Managed or “dirty” float
Exchange Rate Systems
Fixed or Pegged
Flexible or Floating
Managed or “dirty” float
Target zone

5. Varieties of Exchange Rate Regimes

6. Financial Focus 8.1: German Reunification
Two very different systems merged in 1990
Political motives were strong
But an exchange rate had to found
Can the LOOP help?

7. Exchange Rate Determination
Demand for foreign exchange (foreign currency)
foreign trade and capital flows
Supply of Foreign exchange
foreign trade, capital flows and exchange rate systems
Equilibrium: Figure 8.1

8. Floating Exchange Rate Determination
E=($CAN per US$)
Dep’n
S0=supply of US$
$1.25 E0
D0=demand for US$
App’n

9. Fixed Exchange Rate Determination
E=($CAN per US$)
Dep’n
S0=supply of US$
$1.25 E0
D0=demand for US$
App’n

10. Balance of Payments
Like a balance sheet for a firm the BOP records international financial transactions
Divide into the CURRENT and CAPITAL accounts
In theory the BOP=0 since current account and capital account balances should offset each other except for a “statistical discrepancy”
The Current account reflect trade in goods and services; the capital account reflects cross-border financial flows
Figure 8.3 provides some data

11. Canada’s Balance of Payments

12. The Canadian Balance of Payments

13. Foreign Exchange Intervention
Central banks intervene in the foreign exchange market to influence the value of the currency. They believe the currency is over or under-valued (Figure 8.3)
Does it work? In the very short-run, yes. Over sustained periods, no
Some intervention is prompted by monetary policy such as the buying/selling of government bonds
In the absence of “sterilization” domestic monetary/fiscal policies can lead to unwanted or undesirable effects

14. Figure 8.3 Exchange Rate Equilibrium•
Quantity of US dollars
Exchange rate (C$ per US$) S D
$1.40 Q*
Equilibrium Exchange rate
Overvalued C$
Undervalued C$ Q0
$1.35 Q1

15. Economics Focus 8.2: Big Mac Parity
CAN US
Year P Pf
P/Pf e
Value
1986
1.89
1.60
1.18<
1.39
Under
1990
2.19
2.20
1.00<
1.16
1995
2.77
2.32
1.19<
1999
2.99
2.43
1.23<
1.51
2001
3.33
2.54
1.31<
1.56
2004
3.19
2.90
1.10<
1.37

16. The Twin Deficit (Surplus)
Deficits in the government’s budget can have consequences for the balance of payments
The “twin deficits” arises from the National Income accounting relation:
y=c+i+g+(x-im) if i=s, (t-g)=(x-im)
An excess of government spending leads to a current account deficit, but the empirical evidence is mixed
Works symmetrically in the case of a surplus

17. Loanable Funds in an Open Economy
Loanable funds and the “open” economy: Figure 8.4
Opening up the economy makes the supply of loanable funds more “elastic

18. Figure 8.4A. Loanable Funds with International Borrowing and Lending: A. Total Supply of Loanable Funds
LFs
Quantity of bonds 6 R% B0 B1
LFs + LFsf 8 B2 4

19. Figure 8.4B. Loanable Funds with International Borrowing and Lending: Equilibrium with International Lending and Borrowing R
LFs
Quantity of bonds R0 B*
LFd0
LFd1 R2
B**
LFs + LFsf R1

20. Purchasing Power Parity
Absolute version
Relative Version
floating case
fixed case
Real exchange rate:
a fall (app’n) means loss of competitiveness
a rise (dep’n) means a rise in competitiveness

21. Absolute & Relative PPP in Canada

22. The Bank of Canada Equation

23. International Linkages in Interest Rates
Capital mobility means that domestic and foreign rates will be linked via the exchange rate
For a given maturity we would expect
Return $C = Return in $C x Implicit
invested abroad forward
exchange
rate
OR R = Rf + (eexp – es)/es

24. A Numerical Case Study of IRP: Eurodeposits
3month eurodeposit
Spot e
3 month forward
R differential
Exp % change in e
US$
6.08
1.4755
1.4718
-1.15
-1.00 $C
4.93 €
3.37
1.5134
1.5198
+1.56
+1.69
0.18
69.38
68.55
+4.75
+4.86
5.87
2.3933
2.3945
-0.94
-0.80

25. Digrammatic Exposition of Interest Rate Parity
Rf0
Rf>R
eexp < es R
Rf<R
eexp >es
Rf0 e

26. Digrammatic Exposition of Interest Rate Parity
Rf0 R
Rf0 e

27. Digrammatic Exposition of Interest Rate Parity
Rf0 R0 A
Rf0 e

28. Digrammatic Exposition of Interest Rate Parity
Rf0 B R1 R0 A R e

29. Digrammatic Exposition of Interest Rate Parity
Rf0 B R1 R0 A
Rho R e

30. Digrammatic Exposition of Interest Rate Parity
Rf1 R
Rf0 C R0 A
Rf1
Rf0 e

31. Digrammatic Exposition of Interest Rate Parity
Rf1 R
Rf0 C R0
INF A
Rf1
Rf0 e

32. Hysteresis
“fundamentals” of exchange rate determination don’t explain exchange rate movements well
implication: exchange rate forecasting difficult
Hysteresis concept means that once the cause of an app’n or dep’n disappear, it can take some time for e to find its equilibrium

33. Summary
The exchange rate reflects the relative value of currencies
There exist a wide variety of exchange rate systems depending on the how unfettered the market for foreign exchange is
Purchasing Power Parity can explain inflation differentials between countries
The real exchange rate is a useful indicator of a country’s competitiveness