Exchange Rates

Exchange Rate: S - # of domestic currency units purchased for 1 US$.

An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation.

Exchange Rates

Exchange Rates are Volatile

Interest Parity

Saving It is January 1st, and you have D$1000 to save

for 1 year. You can put it into:1. Put it into a domestic currency bank

account at an interest rate i.2. a foreign currency bank account at

interest rate iF.

Payoff to strategy #2 Strategy two has three parts.1. Buy foreign exchange at spot rate S01/01 to get

{D$1000/S01/01} US dollars. 2. Put {S01/01 × D$1000} into bank account. After 1

year get US$(1+iF)×{D$1000/S01/01 }3. Convert these funds into US at exchange rate

prevailing in 1 year.

12/31

01/01

(1 )$1000

Fi SD

S

Uncovered Interest Parity

If > 1+i, deposit funds

then deposit in US$ account. If < 1+i, deposit

funds

then deposit in HK$ account. Then in equilibrium

12/31

01/01

(1 )Fi SS

12/31

01/01

(1 )Fi SS

01/01

12/31

(1 ) 1F Si i

S

Interest Rate Parity The only reason people would be willing to

hold a US$ account when US interest rates were lower than domestic interest rate would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account.

Approximately

12/31 01/01

01/01

F S Si i

S

Why the failure?Two Reasons1. Future exchange rates are risky,

uncovered interest parity does not account for risk.

2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons.

Supply and Demand Model

Relative values of two currency determined by supply and demand by traders of the two currencies.

People trade currencies to engage in foreign trade and international investment.

Why do exchange rates change?

Consider the spot foreign exchange market. Price of US$: S is the price of US$ in terms of

DCU. Supply of US$: Foreign people who want to

acquire DCU to buy domestic goods or assets.◦ When US$ becomes expensive, domestic goods or

assets get cheap and foreign investors are attracted to domestic currency.

Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment.◦ When US$ get cheap, US$ goods or assets get cheap

and demand for US$ rises

Equilibrium in Forex MarketSupply Equals Demand

S

Demand

Supply

S*1

Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods

S

Supply Demand

S*

Demand '

S** Domestic Currency Depreciates1

2

Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods

S Supply

Demand

S*

Supply'

S**

Domestic Currency Appreciates

1

2

US Monetary Policy Causes US$ Interest Rates Go UpRelative Demand for US$ Goes Up

S

Supply Demand

S*

Supply'

Demand'

S**Domestic Currency Depreciates1

2

Domestic Monetary Policy CausesD.C. Interest Rates Go UpRelative Demand for US$ Goes Down

S Supply

Demand

S*

Supply'

Demand '

S**

Domestic Currency Appreciates

1

2

Monetary Policy & Exchange Rates

The central impact of the foreign currency intervention is on domestic interest rates.

Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves.

Monetary policy that does not shift interest rates will not shift exchange rates.

Future Exchange Rate Level If people’s expectation of the future

exchange rate indicates a future depreciation, this will reduce the expected returns on investing in the domestic economy at any given interest rate.

This will increase demand for US$ and reduce supply.

An expected depreciation leads to a current depreciation!

Expectation of St+1 Increases

S

Supply Demand

S*

Supply'

Demand '

S**Domestic Currency Depreciates1

2

Learning Outcomes Students should be able to: Use interest differentials to calculate

expected depreciation rate under UIRP. Use the Supply-Demand model of the forex

model to explain:◦ the effect of international trade conditions on the

exchange rate.◦ the impact of interest rates and other financial

market conditions on exchange rates.