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Foreign Exchange Market Abbreviation: FOREX

Over a trillion dollars

worth are traded daily. Most trading is to finance

the purchase ofassets

(e.g., bank deposits), not

goods and services. OTC (several hundred

dealers, mostly banks)

Wholesale vs. retail

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QuotesEuro-dollar quote of $1.2120

The euro is the BASE currency.

The dollar is the TERMS currency.

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www.newyorkfed.org/markets

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Purchasing

Power

Parity Theory

A method of calculating exchange rates that

attempts to value currencies at rates such

that each currency will buy an equal basket

of goods.

Creates a balance in trade. When a country

has an inflation, its currency depreciates.

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Volatility in forex market not

explained by PPPTPurchasing power changes gradually.

Exchange rates change rapidly.

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Asset Demand TheoryExchange rates adjust so that expected returns

across assets of equal risk are equalized.

So if the expected return on European assets ishigher than ones in the U.S. assets, the

value of the Euro will appreciate.

In equilibrium all expected returns are equal.

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Exchange Rate Overshooting A change in money supply causes a short-run

change in the real interest rate.

Eventually the real interest rate adjusts back to itsoriginal level and the exchange rate goes back aswell.

Purchasing power changes slowly.

Most forex trading is not to finance import/exporttraded.

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19th

Century Gold Standard1 oz of gold = $20 =

4

1 = $5

Suppose 1 = $5.25.Whats the arbitrage

opportunity?

Liberty Gold Dollar (1849-1854)

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Two types of exchange rate regimeFlexible Exchange rate determined by

supply and demand.

Characterized by volatility. Creates uncertainty in

conducting internationalbusiness.

Changes in value called

appreciation and depreciation.

Fixed Central bank buys and sells

domestic currency at a fixed

price. The gold standard was a fixed

exchange rate regime.

Bretton Woods was another.

Provides more certainty in theshort run but the system issusceptible to speculativeattacks.

Changes in value calledrevaluation and devaluation.

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B

retton Woods Agreement 1944Established a system of

fixed exchange rates.

Major architect ofagreement J.M.Keynes called gold abarbarous relic.

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Nixon Closes the Gold Window

(1971)1960s inflation in US

Accumulation of $s in

ROWGerman CB requests

gold for $s.Nixon refuses to honor

agreement signalingthe beginning of theend of fixed exchangerates.

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Exchange Rate InterventionsUnsterilized

CB enters into forex

market to influencevalue of currency.

E.g. Fed buys $ to keepvalue high.

Sterilized

CB enters into forex

market and thenconducts OMO tokeep money supplyconstant.

E.g. Fed buys $ in forexmarket and thenconductsexpansionary OMO.

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Effect of InterventionsEvidence shows sterilized interventions have

little effect.

Consider, Germany during final years ofBW.

Buying dollars, selling DM and then

buying DM to prevent inflation.No matter how many dollars they bought

they couldnt get the exchange rate at BW

levels.

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George Soros vs. Bank of

EnglandMinus $1.1 billionPlus $1.1 billion

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Common CurrencyAdvantages

Eliminates costs of

exchanging currencies.

Facilitates price

comparisons.

Creates a larger market.

Disadvantage

Loss of control over

monetary policy

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Euroland12 Member States of the European

Union are participating in thesingle currency:

Belgium

Germany

Greece

Spain

France

Ireland

Italy

Luxembourg The Netherlands

Austria

Portugal

Finland

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Dollarization A country abandons their domestic currency

and uses the dollar.