Chapter 13

The Foreign
Exchange
Market

Foreign Exchange Market

Most countries of the world have their own
currencies: the U.S dollar., the euro in
Europe, the Brazilian real, and the Chinese
yuan, just to name a few.
The trading of currencies and banks
deposits is what makes up the foreign
exchange market.

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13-2

What are Foreign Exchange Rates?

Two kinds of exchange rate transactions
make up the foreign exchange market:
Spot transactions involve the near-immediate
exchange of bank deposits, completed at the
spot rate.
Forward transactions involve exchanges at
some future date, completed at the forward
rate.
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13-3

Why Are Exchange Rates Important?

When the currency of your country
appreciates relative to another country,
your country's goods prices abroad and
foreign goods prices in your country.
1. Makes domestic businesses less competitive
2. Benefits domestic consumers (you)

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13-5

Why Are Exchange Rates Important?

For example, in 1999, the euro was valued
at $1.18. On April 26, 2006, it was valued
at $1.36.
Euro appreciated 15% (1.36-1.18) / 1.18
Dollar depreciated 13% (0.75-0.85) / 0.85
Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18

We can see exchange rates in the WSJ.

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13-6

Foreign
Exchange
Market:
Exchange
Rates

Current foreign exchange rates

http://www.federalreserve.gov/releases/H10/hist

How is Foreign Exchange Traded?

FX traded in over-the-counter market
1. Most trades involve buying and selling bank
deposits denominated in different currencies.
2. Trades in the foreign exchange market
involve transactions in excess of $1 million.
3. Typical consumers buy foreign currencies
from retail dealers, such as American
Express.

FX volume exceeds $3 trillion per day.

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13-8

Exchange Rates in the Long Run: Law of

One Price
The Law of One Price states that the price
of an identical good will be the same
throughout the world, regardless of which
country produces it.
Example: American steel costs $100 per
ton, while Japanese steel costs 10,000 yen
per ton.

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13-9

Exchange Rates in the Long Run: Law of

One Price
If E = 50 yen/$ then price are:
In U.S.
In Japan

American Steel

Japanese Steel

$100
5000 yen

$200
10,000 yen

If E = 100 yen/$ then price are:

In U.S.
In Japan

American Steel

Japanese Steel

$100
10,000 yen

$100
10,000 yen

Law of one price E = 100 yen/$

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13-10

Exchange Rates in the Long Run: Theory of

Purchasing Power Parity (PPP)

The theory of PPP states that exchange

rates between two currencies will adjust to
reflect changes in price levels.
PPP Domestic price level 10%,
domestic currency 10%
Application of law of one price to price levels
Works in long run, not short run
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13-11

Exchange Rates in the Long Run: Theory of

Purchasing Power Parity (PPP)

Problems with PPP

1. All goods are not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded
(e.g., haircuts, land, etc.)

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13-12

Exchange Rates in the Long Run: PPP

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13-13

Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

Basic Principle: If a factor increases

demand for domestic goods relative to
foreign goods, the exchange rate
The four major factors are relative price
levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.

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13-14

Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

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13-15

Exchange Rates in the Short Run

In the short run, it is key to recognize that
an exchange rate is nothing more than the
price of domestic bank deposits in terms of
foreign bank deposits.
Because of this, we will rely on the tools
developed in Chapter 4 for the
determinants of asset demand.

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13-16

Exchange Rates in the Short Run: Expected

Returns on Domestic and Foreign Assets

We will illustrate this with a simple example

Franois the Foreigner can deposit excess
euros locally, or he can convert them to
U.S. dollars and deposit them in a U.S.
bank. The difference in expected returns
depends on two things: local interest rates
and expected future exchange rates.

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13-17

Exchange Rates in the Short Run: Expected

Returns on Domestic and Foreign Assets

Al the American has a similar problem. He

can deposit excess dollars locally, or he
can convert them to euros and deposit
them in a foreign bank. The difference in
expected returns depends on two things:
local interest rates and expected future
exchange rates.

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13-18

Exchange Rates in the Short Run:

Expected Returns and Interest Parity
Re for Franois
i

$ Deposits

e
t 1

Relative R

Et

iD

Et
F

F Deposits
e

Re for Al

i
D

i i

e
t 1

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Et

Et

i i

Et

e
t 1

Et

e
t 1

Et

Et

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Exchange Rates in the Short Run: Expected

Returns on Domestic and Foreign Assets

What this shows is simple. As the relative

expected return on dollar assets increases
(decreases), both Franois and Al respond
by holding more (fewer) dollar assets and
fewer (more) foreign assets.
This leads us to our formal title for what is
going on here: Interest Parity

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13-20

Exchange Rates in the Short Run:

Expected Returns and Interest Parity
Interest Parity Condition
$ and F deposits perfect substitutes
e
E
D
F
t 1 Et
i i
Et

(2)

Example: if iD = 6% (US interest rate) and iF = 3%

(foreign currency interest rate), what is the expected
appreciation of the foreign currency?

Ete1 Et
6% 3% 3%
Et
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13-21

Exchange Rates in the Short Run:

Equilibrium

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13-22

Explaining Changes in Exchange Rates:

Increase in iD
1. Demand curve
shifts right when
iD : because
people want to
hold more dollars

2. This causes
domestic currency
to appreciate.

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13-23

Explaining Changes in Exchange Rates:

Increase in iF
1. Demand curve
shifts left when
iF : because
people want to
hold fewer dollars

2. This causes
domestic currency
to depreciate.

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13-24

Explaining Changes in Exchange Rates:

Increase in Expected Future FX Rates
1. Demand curve
shifts right when
E te1 : because
people want to
hold more dollars

2. This causes
domestic currency
to appreciate.

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13-25

Explaining Changes in Exchanges Rates

Explaining Changes
in Exchanges Rates (cont.)

Explaining Changes in Exchange Rates:

Changes in the Money Supply
1. Ms , P , Eet+1 ,
shifting demand
curve from D1 to D2.
2. In long run, iD returns
to old level, and
demand shifts from
D2 to D3 (exchange
rate overshooting)

Exchange rate volatility

Exchange rate overshooting is important
because it helps explain why foreign
exchange rates are so volatile.
Another explanation deals with changes in
the expected appreciation of exchange
rates. As anything changes our
expectations (price levels, productivity,
inflation, etc.), exchange rates will change
immediately.
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13-29