Transcript Financial Crises: A sharp increase in asymmetric

The Foreign
Exchange
Market
Chapter 17
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Foreign Exchange Definitions



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
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Spot exchange rate
Forward transaction: the exchange of bank
deposits at some specified future date

Forward exchange rate
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Foreign Exchange

Appreciation: a currency rises in value
relative to another currency
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Depreciation: a currency falls in value
relative to another currency
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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
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Exchange Rates
Feb. 2, 2009
1 USD = .7786 EUR
1 USD = .7002 GBP
1 USD = 89.61 JPY
Mar. 28, 2010
1 USD = .7471 EUR
1 USD = .6711 GBP
1 USD = 92.4700 JPY
Calculate the appreciation and depreciation of each currency.
Find the values for today and calculate the appreciation/depreciation.
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Exchange Rates, 1990–2008
Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist.
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Factors that Affect Exchange
Rates in the Long Run
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Relative price levels
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Trade barriers
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Preferences for domestic versus foreign
goods
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Productivity
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Price Changes
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Law of one price: for identical products
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Theory of Purchasing Power Parity
Expanding the law of one price to all products
 All goods are identical in both countries
 Trade barriers and transportation costs are
low
 Many goods and services are not traded
across borders, undermining PPP

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Purchasing Power Parity, United
States/United Kingdom, 1973–2008
(Index: March 1973 = 100.)
Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt.
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Factors That Affect Exchange
Rates in the Long Run
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Demand and Supply in the SR
EUR/USD
USD denominated assets
In the short run,
demand for USD is low
when USD is strong
because there is a high
likelihood that USD will
depreciate in the future.
Holding an asset that
will lose its value is very
risky.
In the short run the
supply of USD in the
FX market is fixed by
the available bank
deposits, bonds and
stocks.
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Equilibrium in the Foreign
Exchange Market
At E2 there is excess
supply of dollar
denominated assets.
The foreign price of
these assets fall to
bring the market into
equilibrium.
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Domestic Currency Appreciation
EUR/USD
The foreign price of USD
denominated assets
increases.
USD denominated assets
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Domestic Currency Depreciation
EUR/USD
USD denominated assets
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Explaining Changes in SR
Exchange Rates

Shifts in the demand for domestic assets
 Domestic
 Foreign
interest rate
interest rate
 Expected
future exchange rate
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Increase in the Domestic
Interest Rate, iD
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Increase in the Foreign
Interest Rate, iF
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Increase in the Expected Future
Exchange Rate, Eet+1
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Factors That Shift the Demand
Curve for Domestic Assets
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Increase in Expected Inflation
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Interest Rates and FX

Changes in Interest Rates
When domestic real interest rates raise, the
domestic currency appreciates.
 When domestic interest rates rise due to an
expected increase in inflation, the domestic
currency depreciates.
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Changes in the Money Supply
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A higher domestic money supply causes the
domestic currency to depreciate.
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Exchange Rate Overshooting
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Monetary Neutrality
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In the long run, a one-time percentage rise in
the money supply is matched by the same onetime percentage rise in the price level
The exchange rate falls by more in the short
run than in the long run because interest
rates fall in the short run in response to
monetary expansion
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Rise in the Money Supply
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Which Interest Rate?

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
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Value of the Dollar and
Interest Rates, 1973–2008
Sources: Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 127in
Chapter 4.
USD and the Subprime Crisis
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During 2007 interest rates fell in the United
States and remained unchanged in Europe.
 The
dollar depreciated
Starting in the summer of 2008 interest rated
fell in Europe.
 Increased demand for U.S. Treasuries “flight
to quality”
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 The
dollar appreciated
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