Chapter

The Foreign Exchange Market

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Chapter Preview
In the mid-1980s, American businesses
became less competitive relative to their
foreign counterparts. By the 2000s, though,
competitiveness increased. Why?
Part of the answer can be found in
exchange rates. In the 1980s, the dollar
was strong, and US goods were expensive
to foreign buyers. (GDP components?)
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Chapter Preview
By the 1990s and 2000s, the dollar
weakened, so American goods became
cheaper and American businesses became
more competitive. (GDP up)

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Chapter Preview
In this chapter, we develop a modern view
of exchange rate determination that
explains recent behavior in the foreign
exchange market. Topics include:

Foreign Exchange Market

Exchange Rates in the Long Run
Exchange Rates in the Short Run
Explaining Changes in Exchange Rates

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Foreign Exchange Market

Most countries of the world have their own
currencies: the U.S dollar., the euro in
Europe, the Brazilian real, and the Chinese
yuan, just to name a few. (Name some?)
The trading of currencies and banks
deposits is what makes up the foreign
exchange market.

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What are Foreign

Exchange Rates?
Two kinds of exchange rate transactions
make up the foreign exchange market:
Spot transactions involve the near-immediate
exchange of bank deposits, completed at the
spot rate.
Forward transactions involve exchanges at
some future date, completed at the forward
rate.
(bank preference?)
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Foreign Exchange Market

The next slide shows exchange rates for
four currencies from 19902010.
Note the difference in rate fluctuations
during the period. Which appears most
volatile? The least? (How to read)
(Direction?) (Stronger or weaken? And
reason?) (Euro?)

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Exchange
Rates
19902010

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Why Are Exchange Rates

Important?
When the currency of your country
appreciates relative to another country,
your countrys goods prices abroad and
foreign goods prices in your country.
Makes domestic businesses less competitive
Benefits domestic consumers (you) (inflation in
UK, Singapore, Malaysia?)

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Why Are Exchange Rates

Important?
For example, in 1999, the euro was valued
at $1.18. On June 23, 2010, it was valued at
$1.23.
Euro appreciated 4.2% (1.23 1.18) / 1.18
Dollar depreciated 4.2% (0.812 0.847) / 0.847
Note: 0.812 1 / 1.23, and 0.85 1 / 1.18

We can see exchange rates in the WSJ.

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Foreign
Exchange
Market:
Exchange
Rates

Current foreign exchange rates

http://www.federalreserve.gov/releases/H10/
hist
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How is Foreign
Exchange Traded?
FX traded in over-the-counter market
1. Most trades involve buying and selling bank
deposits denominated in different currencies.
2. Trades in the foreign exchange market involve
transactions in excess of $1 million.

FX volume exceeds $3 trillion per day.

(trading vs. speculation)
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Exchange Rates
in the Long Run
Exchange rates are determined in markets
by the interaction of supply and demand.
An important concept that drives the forces
of supply and demand is the Law of One
Price.

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Exchange Rates in the Long

Run: Law of One Price
The Law of One Price states that the price
of an identical good will be the same
throughout the world, regardless of which
country produces it. (identical good?)
Example: American steel costs $100 per
ton, while Japanese steel costs 10,000 yen
per ton.

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Exchange Rates in the Long

Run: Law of One Price

Law of one price E 100 yen/$

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Exchange Rates in the Long Run: Theory

of Purchasing Power Parity (PPP)

The theory of PPP states that exchange

rates (2) between two currencies will adjust
to reflect changes in price levels (1) .
PPP Domestic price level 10%,
domestic currency 10%
Application of law of one price to price levels
Works in long run, not short run

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Exchange Rates in the Long Run: Theory

of Purchasing Power Parity (PPP)

Problems with PPP

All goods are not identical in both countries
(i.e., Toyota versus Chevy)
Many goods and services are not traded
(e.g., haircuts, land, etc.)

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Exchange Rates in the

Long Run: PPP

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Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

Basic Principle: If a factor increases

demand for domestic goods relative to
foreign goods, the exchange rate
The four major factors are relative price
levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.

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Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

Relative price levels: a rise in relative price

levels cause a countrys currency to
depreciate.
Tariffs and quotas: increasing trade barriers
causes a countrys currency to appreciate.
(Eu, Nafta, AP system)

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Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

Preferences for domestic v. foreign goods:

increased demand for a countrys good causes
its currency to appreciate; increased demand
for imports causes the domestic currency to
depreciate. (Uk property, France luxury
product)
Productivity: if a country is more productive
relative to another, its currency appreciates.
(Germany, USD)
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Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

The following table summarizes these

relationships. By convention, we are
quoting, for example, the exchange rate, E,
as units of foreign currency / 1 US dollar.

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Exchange Rates in the Long Run: Factors

Affecting Exchange Rates in Long Run

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Exchange Rates
in the Short Run
In the short run, it is key to recognize that
an exchange rate is nothing more than the
price of domestic bank deposits in terms of
foreign bank deposits.
Because of this, we will rely on the tools
developed in Chapter 4 for the
determinants of asset demand.

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Exchange Rates
in the Short Run
The usual approach to supply-demand
analysis focused on import/export demand
Here, we emphasize stocks rather than
flows, because flows are small relative to
the domestic and foreign asset stocks.

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Exchange Rates in the Short

Run: Supply Curve Analysis
We will use the US as the home country, so
domestic assets are denominated in US dollars.
We will use euros the generically represent any
foreign country's currency.
Dollar assets supplied is primarily the quantity of
bank deposits, bonds, and equities in the United
States. This is fairly fixed in the short-run.
The quantity supplied at any exchange rate does
not change, so the supply curve, S, is vertical.
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Exchange Rates in the Short

Run: Demand Curve Analysis
The demand curve traces out the quantity
demanded at each current exchange rate
The current exchange rate and the
expected future exchange rate are held
constant in this analysis.
Lets see a specific example that illustrates
this point.
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Exchange Rates in the Short

Run: Supply and Demand Curves

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Deriving the Demand Curve

The demand curve connects these points and is downward

sloping because when Et is higher, expected appreciation of the
dollar is higher.

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Exchange Rates in the Short

Run: Equilibrium
Equilibrium
Supply = Demand at E*
If Et E*, Demand Supply, $?,
If Et E*, Demand Supply, $?,

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Explaining Changes
in Exchange Rates
To understand how exchange rates shift in
time, we need to understand the factors
that shift expected returns for domestic and
foreign deposits.
We will examine these separately, as well
as changes in the money supply and
exchange rate overshooting.

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Explaining Changes in
Exchange Rates: Increase in iD
Demand curve
shifts right
when
iD : because
people want to
hold more
dollars
This causes
domestic
currency to
appreciate.
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Explaining Changes in
Exchange Rates: Increase in iF
Demand
curve shifts
left when iF :
because
people want
to hold fewer
dollars
This causes
domestic
currency to
depreciate.
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Explaining Changes in Exchange

Rates: Increase in Expected Future FX
Rates
Demand curve
shifts left when
:
because
people want to
hold more
dollars
This causes
domestic
currency to
appreciate.
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Explaining Changes in
Exchanges Rates
Similar to determinants of exchange rates in the
long-run, the following changes increase the
demand for foreign goods (shifting the demand
curve to the right), increasing

Expected fall in relative U.S. price levels

Expected increase in relative U.S. trade barriers
Expected lower U.S. import demand
Expected higher foreign demand for U.S. exports
Expected higher relative U.S. productivity

These are summarized in the following slides.

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Explaining Changes in
Exchanges Rates (a)

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Explaining Changes in
Exchanges Rates (b)

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Answer
1: c
3: B
4: B
5: B
8: a
9: d
11:a
14: a
63: c
60: d
44; c

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