1. The Foreign Exchange Market
chapter 7
The Foreign Exchange Market

2. Foreign Exchange Rates

3. The Foreign Exchange Market
Definitions:
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
Currency appreciates, country’s goods prices  abroad and foreign goods prices  in that country
1. Makes domestic businesses less competitive
2. Benefits domestic consumers
FX traded in over-the-counter market
1. Trade is in bank deposits denominated in different currencies

4. Law of One Price
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton
If E = 50 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price  E = 100 yen/$

5. Purchasing Power Parity (PPP)
PPP  Domestic price level  10%, domestic currency  10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP
1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts

6. PPP: U.S. and U.K

7. Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E 

8. Expected Returns and Interest Parity
RETe for
Francois Al
$ Deposits iD + (Eet+1 – Et)/Et iD
F Deposits iF iF – (Eet+1 – Et)/Et
Relative RETe iD – iF + (Eet+1 – Et)/Et iD – iF + (Eet+1 – Et)/Et
Interest Parity Condition:
$ and F deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example: if iD = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5%  iF = 15%

9. Deriving RETF Curve Assume iF = 10%, Eet+1 = 1 euro/$ Point
A: Et = 0.95 RETF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00 RETF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05 RETF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RETF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RETF 
Deriving RETD Curve
Points B, D, E, RETD = 10%: so curve is vertical
Equilibrium
RETD = RETF at E*
If Et > E*, RETF > RETD, sell $, Et 
If Et < E*, RETF < RETD, buy $, Et 

10. Equilibrium in the Foreign Exchange Market

11. Shifts in RETF RETF curve shifts right when
1. iF : because RETF  at each Et
2. Eet+1 : because expected appreciation of F  at each Et and RETF 
Occurs:
1) Domestic P ,
2) Tariffs and quotas 
3) Imports , 4) Exports ,
5) Productivity 

12. Shifts in RETD RETD shifts right when 1. iD ; because RETD 
at each Et
Assumes that domestic e unchanged, so domestic real rate 

13. Factors that Shift RETF and RETD

14. Response to i  Because e 
1. e , Eet+1 , expected
appreciation of F ,
RETF shifts out to
right
2. iD , RETD shifts to
However because e  > iD , real rate , Eet+1  more than iD  RETF out > RETD out and Et 

15. Response to Ms  1. Ms , P , Eet+1  expected appreciation
of F , RETF shifts
right
2. Ms , iD , RETD shifts
left
Go to point 2 and Et 
3. In the long run, iD
returns to old level,
RETD shifts back, go
to point 3 and get
Exchange Rate
Overshooting

16. Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting

17. The Dollar and Interest Rates
1. Value of $ and real rates rise and fall together, as theory predicts
2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises