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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.