Chapter 20

The Foreign Exchange Market

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Foreign Exchange Market

• 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

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Foreign Exchange Market (cont’d)

• 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

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Figure 1 Exchange Rates, 1990–2011

Source: Federal Reserve; www.federalreserve.gov/releases/h10/hist.

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Exchange Rates in the Long Run

• Law of one price

• Theory of Purchasing Power Parity assumptions:– All goods are identical in both countries– Trade barriers and transportation costs are low– Many goods and services are not traded across

borders

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Figure 2 Purchasing Power Parity, United States/United Kingdom, 1973–2011 (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

• Relative price levels

• Trade barriers

• Preferences for domestic versus foreign goods

• Productivity

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Summary Table 1 Factors That Affect Exchange Rates in the Long Run

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Exchange Rates in the Short Run: A Supply and Demand Analysis

• An exchange rate is the price of domestic assets in terms of foreign assets

• Supply curve for domestic assets– Assume amount of domestic assets is fixed

(supply curve is vertical)

• Demand curve for domestic assets– Most important determinant is the relative

expected return of domestic assets– At lower current values of the dollar (everything

else equal), the quantity demanded of dollar assets is higher

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Figure 3 Equilibrium in the Foreign Exchange Market

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Explaining Changes in Exchange Rates

• Shifts in the demand for domestic assets

– Domestic interest rate

– Foreign interest rate

– Expected future exchange rate

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Figure 4 Response to an Increase in the Domestic Interest Rate, iD

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Figure 5 Response to an Increase in the Foreign Interest Rate, iF

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Figure 6 Response to an Increase in the Expected Future Exchange Rate, Ee

t+1

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Summary Table 2 Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate

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APPLICATION Effects of Changes in Interest Rates on the Equilibrium Exchange Rate

• 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.

• Changes in the Money Supply– A higher domestic money supply causes the

domestic currency to depreciate.

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Figure 7 Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected Inflation

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Application: The Dollar and Interest Rates

• The value of the dollar and the measure of real interest rates tend to rise and fall together

• Our model of exchange rate determination helps explain the rise in the dollar in the early 1980s and fall thereafter– a rise in the U.S. real interest rate raises the relative

expected return on dollar assets, which leads to purchases of dollar assets that raise the exchange rate

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Figure 8 Value of the Dollar and Interest Rates, 1973–2010

Sources: Federal Reserve; www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4.

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Application: The Global Financial Crisis and the Dollar

• 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”

• The dollar appreciated