1. The Foreign Exchange Market

3. Asian Currencies vs. U.S. Dollar

4. 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

5. The Foreign Exchange MarketD S
Exchange rate
Peso/$
Supply of Dollars by
people who want pesos
Demand for Dollars by
people who have pesos
Foreign exchange (dollars)

6. Currency Depreciation and Appreciation
Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange
Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange

7. Changes in the Equilibrium Exchange Rate
Supply of Dollars by people who want pesos D
Exchange rate
Peso/$ S S’
$ -depreciation
Peso- appreciation
Demand for Dollars by
people who have pesos
Foreign exchange (dollars)

8. Exchange Rate Regimes Flexible (Floating) exchange rates.
Fixed exchange rates.
Currency Board
Monetary Union
Managed Float (Dirty Float) exchange rates.

9. The Central Bank Can Intervene to Maintain Exchange Rates
D’’
Exchange rate
$/pound D’ S
Foreign exchange (pounds)

10. China

11. Currency Crisis D’
Exchange rate
Baht/$ D S 52 25
Foreign exchange ($)

12. Asian Currencies vs. U.S. Dollar

13. 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 $100
In Japan 10,000 yen 10,000 yen
Law of one price  E = 100 yen/$

14. 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

15. Big Mac Index

16. PPP: U.S. and U.K

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

18. Exchange Rates in the Short Run
An exchange rate is the price of domestic assets in terms of foreign assets
Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other

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

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

21. Equilibrium in the Foreign Exchange Market

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

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

24. Foreign Exchange I
Exchange rate—price of one currency in terms of another
Foreign exchange market—the financial market where exchange rates are determined
Spot transaction—immediate (two-day) exchange of bank deposits
Spot exchange rate
Forward transaction—the exchange of bank deposits at some specified future date
Forward exchange rate

25. Foreign Exchange II
Appreciation—a currency rises in value relative to another currency
Depreciation—a currency falls in value relative to another currency
When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa
Over-the-counter market mainly banks

26. Exchange Rates in the Long Run
Law of one price
Theory of Purchasing Power Parity
Assumes all goods are identical in both countries
Trade barriers and transportation costs are low
Many goods and services are not traded across borders

27. Factors that Affect Exchange Rates in the Long Run
Relative price levels
Trade barriers
Preferences for domestic versus foreign goods
Productivity

28. Factors that Shift RF and RD

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

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

31. Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
Why exchange rates fluctuate more than relative prices?

32. 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

38. The International Financial System
Chapter 18
The International Financial System

39. Unsterilized Foreign Exchange Intervention
Federal Reserve System
Assets
Liabilities
Foreign Assets
-$1B
Currency in circulation
Deposits with the Fed
(International Reserves)
(reserves)
A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base
A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base

40. Unsterilized Intervention
An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

42. Sterilized Foreign Exchange Intervention
Federal Reserve System
Assets
Liabilities
Foreign Assets
Monetary Base
(International Reserves)
-$1B
(reserves)
Government Bonds
+$1B
To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation
There is no effect on the monetary base and no effect on the exchange rate

43. Balance of Payments Current Account Trade Balance Capital Account
International transactions that involve currently produced goods and services
Trade Balance
Capital Account
Net receipts from capital transactions
Sum of these two is the official reserve transactions balance

44. Monetary Policy Strategy: The International Experience

45. Role of a Nominal Anchor
Ties Down  Expectations
Helps Avoid Time-Consistency Problem
1. Arises from pursuit of short-term goals which lead to bad long-term outcomes
2. Time-consistency resides more in political process
3. Nominal anchor limits political pressure for time-consistency

46. Exchange-Rate Targeting
Advantages
1. Fixes  for internationally traded goods
2. Anchors  expectations
3. Automatic rule, avoids time-consistency
4. Easy to understand: “sound currency” as rallying cry
5. Helps economic integration
6. Successful in reducing 
France, UK, Mexico

47. Exchange-Rate Targeting
Disadvantages
1. Loss of independent monetary policy
Problems after German reunification: UK, French monetary policy too tight
2. Open to speculative attacks
Europe, Sept. 1992; Mexico: 1994; Asia: 1997
3. Successful speculative attack disastrous for emerging market countries because it leads to financial crisis
4. Weakened accountability: lose exchange-rate signal

48. Currency Boards vs. Dollarization
1. Domestic currency exchanged at fixed rate for foreign currency automatically
2. Fixed exchange rate with very strong commitment mechanism and no discretion
3. Usual disadvantages of fixed exchange rate
4. Still subject to speculative attack
5. Lose ability to have lender of last resort
Dollarization
1. Even stronger commitment mechanism
2. No possibility of speculative attack
3. Usual disadvantages of fixed exchange rtae
4. Lose seignorage

49. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies

50. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies

51. Monetary Targeting Canada 1. Targets M1 till 1982, then abandons it
: declining  targets, M2 as guide
United Kingdom
1. Targets M3 and later M0
2. Problems of M as monetary indicator
Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful as monetary indicator
3. High money growth : “bubble economy,” then tight money policy
Germany and Switzerland
1. Not monetarist rigid rule
2. Targets using M0 and M3: changes over time
3. Allows growth outside target for 2-3 years, but then reverses overshoots
4. Key elements: flexibility, transparency, and accountability

52. Monetary Targeting Advantages Disadvantages
1. Able to cope with domestic considerations
2. Signals are immediate
3. Immediate accountability of central bank
Disadvantages
1. Big if: all advantages require reliable relationship between goal and targeted aggregate
2. In many countries, weak relationship between goal and M-aggregate
Poor communications device and accountability

53. Inflation Targeting Five Elements
1. Public announcement of medium-term š-target
2. Institutional commitment to price stability
3. Information inclusive strategy
4. Increased transparency through public communication
5. Increased accountability

54. Inflation Targeting in New Zealand, Canada, and the UK

55. Inflation Targeting Advantages
1. Allows focus on domestic considerations
2. Not dependent on reliable relationship between M-aggregate and inflation
3. Readily understood by public
4. Reduce political pressures for time-consistent policy
5. Focus on transparency and communication
6. Increased accountability of central bank
7. Performance good:  and e  , and stays low in business cycle upturn

56. Inflation Targeting Disadvantages Nominal GDP Targeting
1. Delayed signalling
2. Too much rigidity
3. Potential for increased output fluctuations
4. Low economic growth
Nominal GDP Targeting
1. Close to inflation targeting with concern about output fluctuations
2. Problem of announcing specific target for real GDP growth
3. Harder for public to understand

57. Monetary Policy with an Implicit Nominal Anchor
Forward-Looking and Preemptive to Deal With Long Lags
Advantages
1. Focus on domestic considerations
2. Has worked very well in the U.S.
3. If It Ain’t Broke Why Fix It?
Disadvantages
1. Lack of transparency and accountability
2. Dependence on personalities
3. Inconsistent with democratic principles

58. Comparing Expected Returns I

59. Comparing Expected Returns II

60. Comparing Expected Returns III

61. Interest Parity Condition
Capital mobility with similar risk and liquidity  the assets are perfect substitutes
The domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency
Expected returns are the same on both domestic and foreign assets
An equilibrium condition

62. Demand and Supply for Domestic Assets
Relative expected return
At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher
Supply
The amount of bank deposits, bonds, and equities in the U.S.
Vertical supply curve

67. Exchange Rate Overshooting
Monetary Neutrality
In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level
The exchange rate falls by more in the short run than in the long run
Helps to explain why exchange rates exhibit so much volatility

69. The Dollar and Interest Rates
While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced

71. Exchange Rate Regimes Fixed exchange rate regime
Value of a currency is pegged relative to the value of one other currency (anchor currency)
Floating exchange rate regime
Value of a currency is allowed to fluctuate against all other currencies
Managed float regime (dirty float)
Attempt to influence exchange rates by buying and selling currencies

72. Past Exchange Rate Regimes
Gold standard
Fixed exchange rates
No control over monetary policy
Influenced heavily by production of gold and gold discoveries
Bretton Woods System
Fixed exchange rates using U.S. dollar as reserve currency
International Monetary Fund (IMF)

73. Past Exchange Rate Regimes (cont’d)
Bretton Woods System (cont’d)
World Bank
General Agreement on Tariffs and Trade (GATT)
World Trade Organization
European Monetary System
Exchange rate mechanism

76. How a Fixed Exchange Rate Regime Works
When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result, it loses international reserves
When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves

77. How Bretton Woods Worked
Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)
Loans from IMF to cover loss in international reserves
IMF encourages contractionary monetary policies
Devaluation only if IMF loans are not sufficient
No tools for surplus countries
U.S. could not devalue currency

78. Managed Float Hybrid of fixed and flexible
Small daily changes in response to market
Interventions to prevent large fluctuations
Appreciation hurts exporters and employment
Depreciation hurts imports and stimulates inflation
Special drawing rights as substitute for gold

79. European Monetary System
8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar
ECU value was tied to a basket of specified amounts of European currencies
Fluctuated within limits
Led to foreign exchange crises involving speculative attack

80. Capital Controls Outflows Inflows
Promote financial instability by forcing a devaluation
Controls are seldom effective and may increase capital flight
Lead to corruption
Lose opportunity to improve the economy
Inflows
Lead to a lending boom and excessive risk taking by financial intermediaries

81. Capital Controls (cont’d)
Inflows (cont’d)
Controls may block funds for productions uses
Produce substantial distortion and misallocation
Lead to corruption
Strong case for improving bank regulation and supervision

82. The IMF: Lender of Last Resort
Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in this function
May be able to prevent contagion
The safety net may lead to excessive risk taking (moral hazard problem)

83. How Should the IMF Operate?
May not be tough enough
Austerity programs focus on tight macroeconomic policies rather than financial reform
Too slow, which worsens crisis and increases costs

84. Direct Effects of the Foreign Exchange Market on the Money Supply
Intervention in the foreign exchange market affects the monetary base
U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market

85. Balance-of-Payments Considerations
Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong
U.S. deficits mean surpluses in other countries large increases in their international reserve holdings world inflation

86. Exchange Rate Considerations
A contractionary monetary policy will raise the domestic interest rate and strengthen the currency
An expansionary monetary policy will lower interest rates and weaken currency

87. Advantages of Exchange-Rate Targeting
Contributes to keeping inflation under control
Automatic rule for conduct of monetary policy
Simplicity and clarity

88. Disadvantages of Exchange-Rate Targeting
Cannot respond to domestic shocks and shocks to anchor country are transmitted
Open to speculative attacks on currency
Weakens the accountability of policymakers as the exchange rate loses value as signal

89. Exchange-Rate Targeting for Industrialized Countries
Domestic monetary and political institutions are not conducive to good policy making
Other important benefits such as integration

90. Exchange-Rate Targeting for Emerging Market Countries
Political and monetary institutions are weak
Stabilization policy of last resort

91. Currency Boards
Solution to lack of transparency and commitment to target
Domestic currency is backed 100% by a foreign currency
Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate
Money supply can expand only when foreign currency is exchanged for domestic currency
List of currency boards

92. Currency Boards (cont’d)
Stronger commitment by central bank
Loss of independent monetary policy and increased exposure to shock from anchor country
Loss of ability to create money and act as lender of last resort

93. Dollarization Another solution to lack of transparency and commitment
Adoption of another country’s money
Even stronger commitment mechanism
Completely avoids possibility of speculative attack on domestic currency
Lost of independent monetary policy and increased exposure to shocks from anchor country

94. Dollarization (cont’d)
Inability to create money and act as lender of last resort
Loss of seignorage
List of countries

95. Appendix
Slides after this point will most likely not be covered in class. However they may contain useful definitions, or further elaborate on important concepts, particularly materials covered in the text book.
They may contain examples I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.