1. © 2012 Pearson Education, Inc. Publishing as Prentice Hall R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System

2. © 2012 Pearson Education, Inc. Publishing as Prentice Hall The Market for Foreign Exchange C H A P T E R 8 LEARNING OBJECTIVES After studying this chapter, you should be able to: 8.1 8.2 8.3 Explain the difference between nominal and real exchange rates Explain how markets for foreign exchange operate Explain how exchange rates are determined in the long run 8.4 Use a demand and supply model to explain how exchange rates are determined in the short run

3. © 2012 Pearson Education, Inc. Publishing as Prentice Hall WHY WOULD THE U.S. FEDERAL RESERVE LEND DOLLARS TO FOREIGN CENTRAL BANKS? The world of international finance has become highly interconnected. The Federal Reserve can no longer ignore how its policies affect other countries or how events in other countries affect the U.S. economy. During the financial crisis of 2007–2009, the Federal Reserve established dollar liquidity swap lines with foreign central banks, which facilitated the exchange of dollars for an equivalent amount of foreign currency and allowed foreign banks to make dollar loans. The increased volume of transactions across countries makes fluctuations in exchange rates an important concern of policymakers. An Inside Look at Policy on page 244 discusses the impact of the European debt crisis of 2010 on the demand for the U.S. dollar. C H A P T E R 8 The Market for Foreign Exchange

4. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 4 of 39 Key Issue and Question Issue: During the 2007–2009 financial crisis, exchange rates proved to be particularly volatile, and the Federal Reserve and other central banks took coordinated policy actions to help stabilize the international financial system. Question: Why did the value of the U.S. dollar soar during the height of the financial crisis?

5. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 5 of 39 8.1 Learning Objective Explain the difference between nominal and real exchange rates.

6. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 6 of 39 Nominal exchange rate The price of one currency in terms of another currency; also called the exchange rate. Appreciation An increase in the value of a currency in exchange for another currency. Depreciation A decrease in the value of a currency in exchange for another currency. When individuals or firms in the United States import or export goods or make investments in other countries, they need to convert dollars into foreign currencies. Fluctuations in the exchange rate between the dollar and foreign currencies affect the prices that U.S. consumers pay for foreign imports. Exchange Rates and Trade

7. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 7 of 39 Making the Connection What’s the Most Important Factor in Determining Sony’s Profits? In the long run, Sony’s profitability depends on its ability to develop innovative new products, produce them at a low cost, and market them well to consumers. In the short run, Sony’s profits depend on the prices it charges relative to the prices its competitors charge for comparable products. Since Sony sells most of its goods outside of Japan, fluctuations in exchange rates will affect its foreign currency prices. Sony estimates that an appreciation of the yen from ¥95 = $1 to ¥85 = $1 reduces the firm’s profits by about ¥10 billion. Not surprisingly, Sony CEO Howard Stringer and the top managers of other Japanese firms continue to explore ways of cushioning the impact of fluctuations in the value of the yen on the profitability of their firms. Exchange Rates and Trade

8. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 8 of 39 Figure 8.1 Foreign-Exchange Cross Rates Foreign-exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as units of foreign currency per U.S. dollar. Reading across the rows, we have the direct quotations, while reading down the columns, we have the indirect quotations. For example, the second entry in the U.S. row shows that the exchange rate on this day was $1.2927 per euro (€). The last entry in the U.S. Dollar column shows that the exchange rate can also be expressed as €0.7736 per dollar. Exchange Rates and Trade

9. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 9 of 39 Is It Dollars per Yen or Yen per Dollar? Exchange rates quoted as units of domestic currency per unit of foreign currency are referred to as direct quotations. Indirect quotations express exchange rates as units of foreign currency per unit of domestic currency. Figure 8.2 Fluctuations in Exchange Rates, 2000–2010 The panels show fluctuations in the exchange rates between the United States dollar and the yen, the Canadian dollar, and the euro. Because we are measuring the exchange rate on the vertical axis as dollars per unit of foreign currency, an increase in the exchange rate represents a depreciation of the dollar and an appreciation of the other currency. Exchange Rates and Trade

10. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 10 of 39 Nominal Exchange Rates versus Real Exchange Rates Real exchange rate The rate at which goods and services in one country can be exchanged for goods and services in another country. We use the real exchange rate when we are interested in knowing how much of another country’s goods and services you can buy with a U.S. dollar. For example, the real exchange rate between the dollar and the pound in terms of Big Macs is: Similarly, we can derive the real exchange rate between the dollar and the pound using the nominal exchange rate and the price levels in each country: Exchange Rates and Trade

11. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 11 of 39 8.2 Learning Objective Explain how markets for foreign exchange operate.

12. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 12 of 39 Foreign-Exchange Markets Foreign-exchange market An over-the-counter market where international currencies are traded. If you want to buy foreign stocks or bonds, you must convert U.S. dollars into the appropriate currency. The large commercial banks are called market makers because they are willing to buy and sell the major currencies at any time. Most foreign-exchange trading takes place among commercial banks located in London, New York, and Tokyo, with secondary centers in Hong Kong, Singapore, and Zurich. With daily trading in the trillions of dollars, the foreign-exchange market is one of the largest financial markets in the world. Participants include investment portfolio managers and central banks.

13. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 13 of 39 Forward and Futures Contracts in Foreign Exchange In the foreign-exchange market, spot market transactions involve an exchange of currencies or bank deposits immediately (subject to a two-day settlement period) at the current exchange rate. In forward transactions, traders agree today to a forward contract to exchange currencies or bank deposits on a specific future date at an exchange rate known as the forward rate. Futures contracts in foreign exchange also exist. They are traded on exchanges, such as the CBOT, and are standardized in terms of quantity and settlement date. The exchange reduces counterparty risk, which in turn reduces default risk. In foreign exchange markets, the amount of trading in forward contracts is at least 10 times greater than the amount of trading in futures contracts. Call and put options contracts are also available on foreign exchange. Foreign-Exchange Markets

14. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 14 of 39 Exchange-Rate Risk, Hedging, and Speculating Exchange-rate risk The risk that a firm will suffer losses because of fluctuations in exchange rates. The forward rate reflects what traders in the forward market expect the spot exchange rate between the dollar and pound to be in 90 days, so it may not equal the current spot rate. To hedge against a fall in the value of the pound, a firm sells pounds in the forward market; to hedge against a rise in the value of the pound, a firm buys pounds in the forward market. A hedger uses derivatives markets to reduce risk, while a speculator uses derivatives markets to place a bet on the future value of a currency. Firms and investors can also use options contracts to hedge or to speculate. The disadvantage of speculating with options contracts is that their prices are higher than are the prices of forward contracts. Foreign-Exchange Markets

15. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 15 of 39 Making the Connection Can Speculators Drive Down the Value of a Currency? In early 2010, a controversy erupted over whether the managers of hedge funds were conspiring to earn billions of dollars by driving down the price of the euro. In February 2010, the managers of four hedge funds met in New York City to discuss whether it would be profitable to use derivatives to bet that the value of the euro would fall. The U.S. Department of Justice thought that their actions might be illegal and opened an investigation. The fund managers claimed that they were just exchanging ideas on an investment opportunity rather than conspiring to take actions that were intended to drive down the value of the euro in exchange for the dollar. But, as we will see, exchange rates among major currencies such as the euro and the dollar are determined by factors that a few hedge fund managers probably can’t affect, however large those funds. Foreign-Exchange Markets

16. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 16 of 39 8.3 Learning Objective Explain how exchange rates are determined in the long run.

17. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 17 of 39 Exchange Rates in the Long Run Law of one price The fundamental economic idea that identical products should sell for the same price everywhere. The Law of One Price and the Theory of Purchasing Power Parity Theory of purchasing power parity (PPP) The theory that exchange rates move to equalize the purchasing power of different currencies. In the context of international trade, the law of one price is the basis for the theory of purchasing power parity (PPP). In other words, in the long run, exchange rates should be at a level that makes it possible to buy the same amount of goods and services with the equivalent amount of any country’s currency.

18. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 18 of 39 The Law of One Price and the Theory of Purchasing Power Parity Once the exchange rate reflects the purchasing power of the two currencies, the opportunity for arbitrage profits is eliminated. This mechanism appears to guarantee that exchange rates will be at their PPP levels. PPP makes an important prediction about movements in exchange rates in the long run: If one country has a higher inflation rate than another country, the currency of the high-inflation country will depreciate relative to the currency of the low-inflation country. Real exchange rate between the dollar and the pound = Exchange Rates in the Long Run

19. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 19 of 39 The Law of One Price and the Theory of Purchasing Power Parity We can rearrange terms to arrive at an expression for the nominal exchange rate in terms of the real exchange rate and the price levels in the two countries: If prices in the United States increase on average faster than prices in Great Britain, then to maintain PPP, the value of the dollar will have to depreciate relative to the value of the pound. Exchange Rates in the Long Run

20. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 20 of 39 Is PPP a Complete Theory of Exchange Rates? 1. Not all products can be traded internationally. 2. Products are differentiated. 3. Governments impose barriers to trade. Tariff A tax a government imposes on imports. Quota A limit a government imposes on the quantity of a good that can be imported. Three real-world complications keep purchasing power parity from being a complete explanation of exchange rates: Exchange Rates in the Long Run

21. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 21 of 39 Solved Problem 8.3 Should Big Macs Have the Same Price Everywhere? The Economist magazine tracks the prices of the McDonald’s Big Mac hamburger in countries around the world. The following table shows the price of Big Macs in the United States and in six other countries, along with the exchange rate between that country’s currency and the U.S. dollar. a. Explain whether the statistics in the table are consistent with the theory of purchasing power parity. b. Explain whether your results in part (a) mean that arbitrage profits exist in the market for Big Macs. Exchange Rates in the Long Run

22. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 22 of 39 Solved Problem 8.3 Should Big Macs Have the Same Price Everywhere? Solving the Problem Step 1Review the chapter material. Step 2Answer part (a) by determining whether the theory of purchasing power parity applies to Big Macs. We can convert the price of a Big Mac in a given country to its price in dollars. For example, in the case of Japan: ¥330/(¥93.2/$) = $3.54. Exchange Rates in the Long Run

23. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 23 of 39 Solved Problem 8.3 Should Big Macs Have the Same Price Everywhere? Solving the Problem Step 3Answer part (b) by explaining whether arbitrage profits exist in the market for Big Macs. Exchange Rates in the Long Run It is not possible to make arbitrage profits by buying low-price Big Macs in one country and selling them in another. The theory of purchasing power parity does not provide a complete explanation of exchange rates because many goods—such as Big Macs—cannot be traded internationally.

24. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 24 of 39 8.4 Learning Objective Use a demand and supply model to explain how exchange rates are determined in the short run.

25. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 25 of 39 A Demand and Supply Model of Short-Run Movements in Exchange Rates A Demand and Supply Model of Exchange Rates By assuming that price levels are constant, our model will determine both the equilibrium nominal exchange rate and the equilibrium real exchange rate. The demand for U.S. dollars represents the demand by households and firms outside the United States for U.S. goods and U.S. financial assets. The supply of dollars in exchange for yen is determined by the willingness of households and firms that own dollars to exchange them for yen.

26. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 26 of 39 A Demand and Supply Model of Exchange Rates Figure 8.3 The Demand and Supply of Foreign Exchange The lower the exchange rate, the cheaper it is to convert a foreign currency into dollars and the larger the quantity of dollars demanded. So, the demand curve for dollars in exchange for yen is downward sloping. The higher the exchange rate, the more yen households or firms will receive in exchange for dollars and the larger the quantity of dollars supplied. The supply curve of dollars in exchange for yen is upward sloping because the quantity of dollars supplied will increase as the exchange rate increases. A Demand and Supply Model of Short-Run Movements in Exchange Rates

27. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 27 of 39 Shifts in the Demand and Supply for Foreign Exchange Figure 8.4 (1 of 2) The Effect of Changes in the Demand and Supply for Dollars Panel (a) illustrates the effect of an increase in the demand for dollars in exchange for yen. The demand curve for dollars shifts to the right, causing the equilibrium exchange rate to increase from ¥80 = $1 to ¥85 = $1 and the equilibrium quantity of dollars traded to increase from Dollars 1 to Dollars 2. A Demand and Supply Model of Short-Run Movements in Exchange Rates

28. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 28 of 39 Shifts in the Demand and Supply for Foreign Exchange Figure 8.4 (2 of 2) The Effect of Changes in the Demand and Supply for Dollars Panel (b) illustrates the effect of an increase in the supply of dollars in exchange for yen. The supply curve for dollars in exchange for yen shifts to the right, causing the equilibrium exchange rate to decrease from ¥80 = $1 to ¥75 = $1 and the equilibrium quantity of dollars traded to increase from Dollars 1 to Dollars 2. A Demand and Supply Model of Short-Run Movements in Exchange Rates

29. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 29 of 39 The “Flight to Quality” during the Financial Crisis Figure 8.5 Movements in the Trade-Weighted Exchange Rate of the U.S. Dollar The increase in the value of the dollar during the late 1990s, as shown in the figure, was driven by strong demand from foreign investors for U.S. stocks and bonds, particularly U.S. Treasury securities. Something similar happened during the financial crisis of 2007– 2009: As many foreign investors sought a safe haven in U.S. Treasury securities, the demand for dollars increased. A Demand and Supply Model of Short-Run Movements in Exchange Rates

30. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 30 of 39 The Interest-Rate Parity Condition In this section, we explore the implications of international capital mobility for the determination of exchange rates. To purchase Japanese bonds, you have to exchange your dollars for yen, thereby assuming some exchange-rate risk: While your funds are invested in Japanese bonds, the value of the yen might decline relative to the dollar. To eliminate the possibility of arbitrage profits, the difference between the interest rates on a Japanese bond and a U.S. bond must equal the expected change in the exchange rate between the yen and the dollar. A Demand and Supply Model of Short-Run Movements in Exchange Rates

31. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 31 of 39 The Interest-Rate Parity Condition Interest-rate parity condition The proposition that differences in interest rates on similar bonds in different countries reflect expectations of future changes in exchange rates. We can state this condition generally as: Interest rate on domestic bond = Interest rate on foreign bond – Expected appreciation of the domestic currency. If the expected return from owning a foreign asset—including expected changes in the exchange rate—isn’t the same as the return from owning a domestic asset, then investors can make arbitrage profits because one asset or the other will be underpriced relative to its expected return. A Demand and Supply Model of Short-Run Movements in Exchange Rates

32. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 32 of 39 The Interest-Rate Parity Condition Differences in interest rates on similar bonds in different countries do not always reflect expectations of future changes in exchange rates for several reasons: 1. Differences in default risk and liquidity. 2. Transactions costs. 3. Exchange-rate risk. To account for the additional risk of investing in a foreign asset we can include a currency premium in the interest-rate parity equation: Interest rate on the domestic bond = Interest rate on the foreign bond – Expected appreciation of the domestic currency – Currency premium. A Demand and Supply Model of Short-Run Movements in Exchange Rates

33. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 33 of 39 Solved Problem 8.4 An investor wrote the following to the financial advice column of an online magazine: It says in the papers that interest rates in Japan are under 1%. U.S. Treasury bills currently pay almost 5%. Why isn’t everybody borrowing money in Japan and investing it in the United States? It seems like a sure thing. Is it a sure thing? Can You Make Money from Interest Rate Differences across Countries? A Demand and Supply Model of Short-Run Movements in Exchange Rates

34. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 34 of 39 Solved Problem 8.4 Solving the Problem Step 1Review the chapter material. Step 2Answer the question by using the interest-rate parity condition to explain the relationship between expected changes in exchange rates and differences in interest rates across countries. Can You Make Money from Interest Rate Differences across Countries? A Demand and Supply Model of Short-Run Movements in Exchange Rates If the interest-rate parity condition holds, then a 4-percentage-point gap between the interest rate on a U.S. bond and the interest rate on a similar Japanese bond means that investors must be expecting that the value of the dollar will depreciate against the yen by 4%: 5% = 1 – (– 4%). Therefore, the expected return on a U.S. investment and a Japanese investment should be the same. A U.S. investor who borrows money at 1% in Japan and invests it at 5% in the United States will not gain anything if the dollar depreciates by 4% because the true cost of the investor’s yen loan will be 5% rather than 1%. In addition, the investor will be taking on exchange-rate risk because the dollar could depreciate by more than 4%.

35. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 35 of 39 Making the Connection Why Did the Fed Lend Dollars to Foreign Central Banks during the Financial Crisis? Before the financial crisis of 2007–2009, many economists and policymakers had been unaware of the extent to which foreign banks, particularly in Europe, had been buying dollar-denominated assets, especially securitized debt, such as mortgage-backed securities. Banks began to actively buy and sell securities, while securitization—the transformation of mortgage loans and other business and consumer debt into marketable bonds—increased the volume of dollar-denominated securities available for European banks to invest in. Banks financed their investments by borrowing dollars from other banks, from central banks, and by engaging in foreign-exchange swaps. Banks faced considerable funding risk because the maturities of these funding sources were very short compared with the maturities of the dollar- denominated assets. A Demand and Supply Model of Short-Run Movements in Exchange Rates

36. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 36 of 39 Making the Connection Why Did the Fed Lend Dollars to Foreign Central Banks during the Financial Crisis? European banks had difficulty selling their dollar-denominated assets because the markets for many of these assets, particularly mortgage-backed and similar securities, were rapidly declining, which made many of the assets illiquid. To deal with the resulting dollar shortage, in December 2007, the Federal Reserve, in conjunction with 14 foreign central banks, established the dollar liquidity swap lines. At the peak of the financial crisis in late 2008, the volume of dollar swaps was about $600 billion. As the financial crisis eased, so did foreign central banks’ use of the swap lines. We conclude that banks and other financial firms have significant investments in securities denominated in foreign currencies, and central banks are willing to cooperate to deal with financial crises. (continued) A Demand and Supply Model of Short-Run Movements in Exchange Rates

37. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 37 of 39 Answering the Key Question At the beginning of this chapter, we asked the question: “Why did the value of the U.S. dollar soar during the height of the financial crisis?” We have seen that a desire by foreign investors to buy U.S. stocks and bonds will increase the demand for dollars in exchange for other currencies. An increase in the demand for dollars increases the exchange rate. During the peak of the financial crisis from the summer of 2008 to the fall of 2009, many foreign investors saw buying U.S. Treasuries as a safer investment than many alternatives. As a result, the value of the dollar soared by more than 20%.

38. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 38 of 39 AN INSIDE LOOK AT POLICY Investors Buy Dollars and Sell Euros as Europe Faces a Debt Crisis ASSOCIATED PRESS, Growth, Rate Worries Drive Euro Near 4-Year Low In May 2010, the exchange rate of the euro against the U.S. dollar approached its lowest level in four years. The euro’s slide was the result of a nearly $1 trillion attempt to address debt problems at a time when European countries were facing weak economic growth. Interest rates in the United States were expected to fall as foreign investors shifted from European debt to U.S. bonds. Analysts were concerned that the emergency funding deal could constrain Europe if investors feared for the stability of the banking sector. Investors worried about the debts of Greece and other European countries, such as Portugal and Spain. These events caused a decline in the demand for euros and euro-denominated debt. Key Points in the Article

39. © 2012 Pearson Education, Inc. Publishing as Prentice Hall 39 of 39 AN INSIDE LOOK AT POLICY The figure below illustrates the impact on the value of the dollar and the euro after a decline in the demand for euros and euro-denominated debt.