Money, Banking, and Financial Markets : Econ. 212

Money and BankingMoney and Banking Prof. M. El-Sakka Prof. M. El-Sakka CBA. Kuwait University CBA. Kuwait University

Money, Banking, and Financial Money, Banking, and Financial Markets : Econ. 212Markets : Econ. 212

Stephen G. Cecchetti: Stephen G. Cecchetti: Chapter 10Chapter 10Foreign ExchangeForeign Exchange


Foreign Exchange BasicsForeign Exchange Basics

The Nominal Exchange RateThe Nominal Exchange Rate The exchange rate is the price paid in one currency to obtain The exchange rate is the price paid in one currency to obtain

an amount of another currency. Exchange rates change an amount of another currency. Exchange rates change every day.every day.

A decline in the A decline in the value of one currencyvalue of one currency relative to another is relative to another is called a called a depreciationdepreciation; an increase is called an ; an increase is called an appreciationappreciation..

When one currency goes up in value relative to another, the When one currency goes up in value relative to another, the other currency must go down.other currency must go down.

Exchange rates can be quoted in units of either currency; Exchange rates can be quoted in units of either currency; for example, as the number of dollars needed to buy one for example, as the number of dollars needed to buy one euro (direct rate in USA) or as the number of euro needed to euro (direct rate in USA) or as the number of euro needed to buy one dollar (indirect rate).buy one dollar (indirect rate).


The two prices are The two prices are equivalentequivalent (one is simply the reciprocal (one is simply the reciprocal of the other) and there is no rule for determining which way of the other) and there is no rule for determining which way a particular exchange rate should be quoted.a particular exchange rate should be quoted.

In practice, most rates tend to be quoted in the way that In practice, most rates tend to be quoted in the way that yields a number larger than one.yields a number larger than one.

The Real Exchange RateThe Real Exchange Rate The real exchange rate is the rate at which one can The real exchange rate is the rate at which one can

exchange the goods and services from one country for the exchange the goods and services from one country for the goods and services from another country.goods and services from another country.

The real exchange rate is the cost of a basket of goods in one The real exchange rate is the cost of a basket of goods in one country relative to the cost of the same basket of goods in country relative to the cost of the same basket of goods in another countryanother country..


To compute the real exchange rate we take the To compute the real exchange rate we take the dollar price of dollar price of a gooda good in the United States divide it by the dollar price of the in the United States divide it by the dollar price of the same good in another countrysame good in another country (the dollar price in the other (the dollar price in the other country is found by taking the local price and multiplying by country is found by taking the local price and multiplying by the nominal exchange rate).the nominal exchange rate).

The real exchange rate is calculated using the following The real exchange rate is calculated using the following formula:formula:

e = Pe = Phomehome / P / Pforeignforeign * R * R e = real exchange ratee = real exchange rate PPhome home = price at home= price at home PPforeign foreign = price in the foreign country= price in the foreign country R = nominal exchange rateR = nominal exchange rateExampleExample If product X price in Kuwait is KWD 16, The price of product If product X price in Kuwait is KWD 16, The price of product

X in the USA is $ 50, and R = KWD .3/$, then:X in the USA is $ 50, and R = KWD .3/$, then: e =16/(50*.3) = e =16/(50*.3) = 1.066667 1.066667 Interpretation!Interpretation!


Whenever the real exchange rate as calculated above is Whenever the real exchange rate as calculated above is greater than onegreater than one (the real exchange rate has no units), (the real exchange rate has no units), foreign products will seem foreign products will seem cheapcheap..

The real exchange rate is The real exchange rate is more importantmore important than the nominal than the nominal exchange rate because it measures the exchange rate because it measures the relative price of goodsrelative price of goods and services across countries, telling us where things are and services across countries, telling us where things are cheapcheap and where they are and where they are expensiveexpensive..

The real exchange rate is the The real exchange rate is the guiding forceguiding force behind behind international transactions (international transactions (competitivenesscompetitiveness).).

The The competitivenesscompetitiveness of Kuwait’s exports (except for oil) of Kuwait’s exports (except for oil) depends on the real exchange rate; if it depends on the real exchange rate; if it appreciatesappreciates, Kuwaiti , Kuwaiti exports (except for oil) become exports (except for oil) become less competitiveless competitive and if it and if it depreciates they become more competitivedepreciates they become more competitive..


Foreign Exchange MarketsForeign Exchange Markets The daily volume of foreign exchange transactions is The daily volume of foreign exchange transactions is

enormous. According to the Bank of International enormous. According to the Bank of International Settlements, the Settlements, the daily turnover of global foreign exchange daily turnover of global foreign exchange transactions in 2007 is 3.1 trillion US dollars. transactions in 2007 is 3.1 trillion US dollars.

Because of its liquidity, the U.S. dollar is one side of roughly Because of its liquidity, the U.S. dollar is one side of roughly 90 percent of the currency transactions that occur.90 percent of the currency transactions that occur.

The most important center for such transactions is London; The most important center for such transactions is London; other significant foreign exchange trading occurs in New other significant foreign exchange trading occurs in New York, Tokyo, Singapore, Frankfurt, and Zurich.York, Tokyo, Singapore, Frankfurt, and Zurich.


Figure 1: Daily Turnover of global foreign exchange transactions

• BIS "Triennial Central Bank Survey Foreign exchange and derivatives market activity in 2007" December 2007BIS "Triennial Central Bank Survey Foreign exchange and derivatives market activity in 2007" December 2007



Exchange Rates in the Long RunExchange Rates in the Long Run The Law of One PriceThe Law of One Price

The law of one price is the starting point for The law of one price is the starting point for understanding how long-run exchange rates are understanding how long-run exchange rates are

determineddetermined.. PPX,K X,K = P= PX,USX,US . e . ekwd/$kwd/$

The law is based on The law is based on arbitragearbitrage, the idea that identical , the idea that identical products should products should sell for the same price sell for the same price anywhere in the anywhere in the world.world.

If the same good did not sell for the same price in two places If the same good did not sell for the same price in two places there would be an opportunity for someone to profit by there would be an opportunity for someone to profit by purchasing the item where it is purchasing the item where it is cheapcheap and reselling it where and reselling it where its price is its price is higherhigher (this is known as (this is known as commodity arbitragecommodity arbitrage), but ), but by doing that, the relative supplies would change and move by doing that, the relative supplies would change and move the two prices to equality.the two prices to equality.


The law of one price The law of one price failsfails almost all the time; the same almost all the time; the same commodity or service sells for commodity or service sells for vastly different prices vastly different prices in in different countries as a result of different countries as a result of transportation coststransportation costs, , taxestaxes, , differences in technical specificationsdifferences in technical specifications, , differences in tastesdifferences in tastes, , and that fact that some things simply cannot be traded (like and that fact that some things simply cannot be traded (like haircutshaircuts).).

Purchasing Power ParityPurchasing Power Parity Even with its obvious flaws the law of one price is Even with its obvious flaws the law of one price is

extremely useful in explaining the behavior of exchange extremely useful in explaining the behavior of exchange rates over rates over long periodslong periods, like ten or twenty years., like ten or twenty years.

Extending the law from a single commodity to a Extending the law from a single commodity to a basket of basket of goodsgoods and services results in the theory of and services results in the theory of purchasing power purchasing power parityparity ( (PPPPPP), which means that one unit of Kuwait’s ), which means that one unit of Kuwait’s domestic currency will buy the same basket of domestic currency will buy the same basket of goods and goods and services anywhere in the world.services anywhere in the world.


Again the law of one price states: Again the law of one price states:

PPX,K X,K = P= PX,USX,US . e . ekwd/$kwd/$

Using the price of a basket of goods ands in Kuwait and Using the price of a basket of goods ands in Kuwait and USA, PPP impliesUSA, PPP implies

eekwd/$ kwd/$ == PPK K / P/ PUSUS

PPP implies that the PPP implies that the real exchange rate is always equal to onereal exchange rate is always equal to one..

PPP implies that when prices change in one country but not PPP implies that when prices change in one country but not in in another the another the exchange rate should change as wellexchange rate should change as well..


Changes in exchange rates are therefore Changes in exchange rates are therefore tied to differences in tied to differences in inflationinflation from one country to another; the currency of a from one country to another; the currency of a country with high inflation will depreciate.country with high inflation will depreciate.

Over weeks, months, and even years, nominal exchange Over weeks, months, and even years, nominal exchange rates canrates can deviatedeviate substantially from the levels implied by substantially from the levels implied by purchasing power paritypurchasing power parity. Such short-term movements have . Such short-term movements have other explanations.other explanations.

A current market rate that deviates from purchasing power A current market rate that deviates from purchasing power parity results in a currency being considered parity results in a currency being considered undervalued or undervalued or overvalued (sometimes it is called overvalued (sometimes it is called misalignmentmisalignment).).



Exchange Rates in the Short RunExchange Rates in the Short Run

The Supply of KWDThe Supply of KWD

Someone who wants to exchange KWD for another Someone who wants to exchange KWD for another currency currency supplies them to the foreign exchange supplies them to the foreign exchange markets.markets.

The two reasons for such an exchange would be to The two reasons for such an exchange would be to purchase purchase foreign goods and servicesforeign goods and services or to or to invest in foreign assetsinvest in foreign assets..

The The more valuable more valuable the KWD, the cheaper foreign goods, the KWD, the cheaper foreign goods, services, and assets are, and the higher will be the supply of services, and assets are, and the higher will be the supply of KWDs in the foreign exchange market.KWDs in the foreign exchange market.


The Demand for KWDThe Demand for KWD

Foreigners who want to purchase Kuwaiti-made goods, Foreigners who want to purchase Kuwaiti-made goods, assets, or services need KWD to do so and so represent assets, or services need KWD to do so and so represent the demand for KWD.the demand for KWD.

The The cheapercheaper the KWD the more attractive such goods, the KWD the more attractive such goods, assets, or services are and the higher the demand for KWD assets, or services are and the higher the demand for KWD with which to buy them.with which to buy them.

Equilibrium in the Market for KWDsEquilibrium in the Market for KWDs

Equilibrium in the market for KWDs occurs where Equilibrium in the market for KWDs occurs where the supply and demand are equal.the supply and demand are equal.


Fluctuations in the values of currencies are the result of shifts Fluctuations in the values of currencies are the result of shifts in supply or demand.in supply or demand.

Shifts in the Supply and Demand for KWDsShifts in the Supply and Demand for KWDs

Shifts in supplyShifts in supply: the supply of KWDs will increase the more : the supply of KWDs will increase the more Kuwaitis want to import goods and services from abroad or Kuwaitis want to import goods and services from abroad or the higher their preference for foreign stocks and bonds. the higher their preference for foreign stocks and bonds. These can result from:These can result from:

an increase in Kuwaitis’ preference for foreign goods.an increase in Kuwaitis’ preference for foreign goods. an increase in Kuwait’s real GDP and real income.an increase in Kuwait’s real GDP and real income. an increase in the real interest rate on foreign bonds.an increase in the real interest rate on foreign bonds. an increase in Kuwaiti wealth.an increase in Kuwaiti wealth.


a decrease in the riskiness of foreign investments relative a decrease in the riskiness of foreign investments relative to Kuwaitis investments.to Kuwaitis investments.

an expected depreciation of the KWD.an expected depreciation of the KWD.

Shifts in Shifts in DemandDemand: the demand will increase if there is an : the demand will increase if there is an increased desire by foreigners to buy Kuwaiti-made goods increased desire by foreigners to buy Kuwaiti-made goods and services or to invest in Kuwaitiand services or to invest in Kuwaiti assets. This can be the assets. This can be the result of:result of: an increase in foreigners’ preference for an increase in foreigners’ preference for Kuwaiti Kuwaiti goods.goods. an increase in foreign real GDP and real income.an increase in foreign real GDP and real income. an increase in the real interest rate on an increase in the real interest rate on Kuwaiti Kuwaiti bonds.bonds. an increase in foreign wealth.an increase in foreign wealth. a decrease in the riskiness of a decrease in the riskiness of Kuwaiti Kuwaiti investments relative to investments relative to

foreign investments.foreign investments. an expected appreciation of the KWD.an expected appreciation of the KWD.






Explaining exchange rate movementsExplaining exchange rate movements: : The supply and demand model helps to explain The supply and demand model helps to explain short-run short-run

movements in currency values.movements in currency values. Shifts in supply and demand can both occur at the same time, Shifts in supply and demand can both occur at the same time,

and the movement of the exchange rate will depend on which and the movement of the exchange rate will depend on which effect is stronger.effect is stronger.

Government Policy and Foreign Exchange InterventionGovernment Policy and Foreign Exchange Intervention Government officials can intervene in foreign exchange markets in Government officials can intervene in foreign exchange markets in

several ways.several ways. Some countries adopt a Some countries adopt a fixed exchangefixed exchange rate and act to maintain it rate and act to maintain it

at a level of their choosing.at a level of their choosing. Large industrialized countries generally allow markets to Large industrialized countries generally allow markets to

determine the exchange rate but may intervene at times to determine the exchange rate but may intervene at times to influence the value (influence the value (managed floatingmanaged floating).).

When policymakers buy or sell currency to affect demand or When policymakers buy or sell currency to affect demand or supply it is called foreign exchange supply it is called foreign exchange interventionintervention..


Appendix:Appendix: Interest Rate Parity and Short‑Run Exchange Interest Rate Parity and Short‑Run Exchange Rate DeterminationRate Determination

Another way to think about the determinants of exchange Another way to think about the determinants of exchange rates over the short term is to focus on them from an rates over the short term is to focus on them from an investor’s point of view.investor’s point of view.

If the bonds issued in different countries are If the bonds issued in different countries are perfectperfect substitutessubstitutes for each other, then for each other, then arbitragearbitrage will equalize their will equalize their returns. Since investing abroad means exchanging returns. Since investing abroad means exchanging currencies, currencies, the result is a relationship among domestic the result is a relationship among domestic interest rates, foreign interest rates, and the exchange rate.interest rates, foreign interest rates, and the exchange rate.

The interest parity condition (derived in this appendix) tells The interest parity condition (derived in this appendix) tells us that the us that the Kuwaiti interest rate equals the rate on a foreign Kuwaiti interest rate equals the rate on a foreign bond minus the KWD’s expected appreciationbond minus the KWD’s expected appreciation..


If the interest parity condition If the interest parity condition did not holddid not hold, people would , people would have an incentive to shift their investments until it did.have an incentive to shift their investments until it did.

Knowing current Kuwaiti and foreign interest rates allows Knowing current Kuwaiti and foreign interest rates allows us to calculate us to calculate what the exchange rate should be.what the exchange rate should be.

The current value of the KWD will be higher the higher The current value of the KWD will be higher the higher Kuwaiti interest rates are, the lower foreign interest rates Kuwaiti interest rates are, the lower foreign interest rates are, and the higher the expected future value of the KWD isare, and the higher the expected future value of the KWD is..


Lessons of Chapter 10Lessons of Chapter 10 Different areas and countries of the world use different currencies in their Different areas and countries of the world use different currencies in their

transactions.transactions. The nominal exchange rate is the rate at which the currency of one country can The nominal exchange rate is the rate at which the currency of one country can

be exchanged for the currency of another.be exchanged for the currency of another. A decline in the value of one currency relative to another is called depreciation.A decline in the value of one currency relative to another is called depreciation. An increase in the value of one currency relative to another is called An increase in the value of one currency relative to another is called

appreciation.appreciation. If the dollar appreciates relative to the euro, the euro will have depreciated If the dollar appreciates relative to the euro, the euro will have depreciated

relative to the dollar.relative to the dollar. The real exchange rate is the rate at which the goods and services of one country The real exchange rate is the rate at which the goods and services of one country

can be exchanged for the goods and services of another.can be exchanged for the goods and services of another. Enormous quantities of currency are traded every day in markets run by Enormous quantities of currency are traded every day in markets run by

brokers and foreign exchange dealers.brokers and foreign exchange dealers. In the long run, the value of a country’s currency is tied to the price of goods and In the long run, the value of a country’s currency is tied to the price of goods and

services in that country.services in that country. The law of one price states that two identical goods should sell for the same The law of one price states that two identical goods should sell for the same

price, regardless of location.price, regardless of location. The law of one price fails because of transportation costs, differences in taxation The law of one price fails because of transportation costs, differences in taxation

and technical specifications, and the fact that some goods cannot be moved.and technical specifications, and the fact that some goods cannot be moved. The theory of purchasing power parity applies the law of one price to The theory of purchasing power parity applies the law of one price to

international transactions; it states that the real exchange rate always equals international transactions; it states that the real exchange rate always equals one.one.

Purchasing power parity implies that countries with higher inflation than other Purchasing power parity implies that countries with higher inflation than other countries will experience exchange rate depreciation.countries will experience exchange rate depreciation.


Over decades, exchange rate changes are approximately equal to differences in Over decades, exchange rate changes are approximately equal to differences in inflation, implying that purchasing power parity holds.inflation, implying that purchasing power parity holds.

In the short run, the value of a country’s currency depends on supply and demand In the short run, the value of a country’s currency depends on supply and demand for the currency in foreign exchange markets.for the currency in foreign exchange markets. When people in the United States wish to purchase foreign goods and services or When people in the United States wish to purchase foreign goods and services or

invest in foreign assets, they must supply dollars to the foreign exchange market.invest in foreign assets, they must supply dollars to the foreign exchange market. The more foreign currency that can be exchanged for one dollar, the greater The more foreign currency that can be exchanged for one dollar, the greater

will the supply of dollars will be; that is, the supply curve for dollars is upward will the supply of dollars will be; that is, the supply curve for dollars is upward sloping.sloping.

Foreigners who wish to purchase American‑made goods and services or invest Foreigners who wish to purchase American‑made goods and services or invest in U.S. assets will demand dollars in the foreign exchange market.in U.S. assets will demand dollars in the foreign exchange market.

The fewer units of foreign currency needed to buy one dollar, the higher the The fewer units of foreign currency needed to buy one dollar, the higher the demand for dollars – that is, the demand curve for dollars is downward sloping.demand for dollars – that is, the demand curve for dollars is downward sloping.

Anything that increases the desire of Americans to buy foreign-made goods and Anything that increases the desire of Americans to buy foreign-made goods and services or invest in foreign assets will increase the supply of dollars (shift the services or invest in foreign assets will increase the supply of dollars (shift the supply curve for dollars to the right), causing the dollar to depreciate.supply curve for dollars to the right), causing the dollar to depreciate.

Anything that increases the desire of foreigners to buy American-made goods Anything that increases the desire of foreigners to buy American-made goods and services or invest in U.S. assets will increase the demand for dollars (shift and services or invest in U.S. assets will increase the demand for dollars (shift the demand curve of dollars to the right), causing the dollar to appreciate.the demand curve of dollars to the right), causing the dollar to appreciate.

Some governments buy and sell their own currency in an effort to affect the Some governments buy and sell their own currency in an effort to affect the exchange rate. Such foreign exchange interventions are usually ineffective.exchange rate. Such foreign exchange interventions are usually ineffective.


Key Terms








Key Terms

Appreciation Big Mac index

capital account capital account deficit/surplus

current account current account deficit/surplus

demand for KWDs depreciation

foreign exchange intervention Law of One Price

nominal exchange rate overvalued currency

purchasing power parity (PPP) real exchange rate

supply of KWDsundervalued currency

Date post:	11-Jan-2016
Category:	Documents
Upload:	orien
View:	44 times
Download:	0 times

Money, Banking, and Financial Markets : Econ. 212

Documents