19-1 foreign exchange rates. 19-2 the foreign exchange market definitions: 1.spot exchange rate...
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19-2
The Foreign Exchange MarketDefinitions:1. Spot exchange rate2. Forward exchange rate3. Appreciation4. Depreciation
Currency appreciates, country’s goods prices abroad and foreign goods prices in that country
1. Makes domestic businesses less competitive2. Benefits domestic consumers
FX traded in over-the-counter market1.Trade is in bank deposits denominated in different currencies
(Note: Exchange rates are always quoted in foreign currency per dollar, i.e. euro/ $)
19-3
Law of One Price
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton
If E = 50 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price E = 100 yen/$
19-4
Purchasing Power Parity (PPP)
PPP Domestic price level 10%, domestic currency 10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP
1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts
19-6
Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E
19-7
Expected Returns and Interest Parity
Re for
Francois Al
$ Deposits iD + (Eet+1 – Et)/Et iD
Euro Deposits iF iF – (Eet+1 – Et)/Et
Relative Re iD – iF + (Eet+1 – Et)/Et iD – iF + (Ee
t+1 – Et)/Et
Interest Parity Condition:
$ and Euro deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example: if iD = 10% and expected appreciation of $, (Ee
t+1– Et)/Et, = 5% iF = 15%
19-8
Deriving RF Curve
Assume iF = 10%, Eet+1 = 1 euro/$ (fixed)
Point
A: Et = 0.95, RF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00, RF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05, RF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF
Deriving RD CurvePoints B, D, E, RD = 10%: so curve is vertical
EquilibriumRD = RF at E*
If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et
19-10
Shifts in RF
RF curve shifts right when
1. iF : because RF at each Et
2. Eet+1 : because expected
appreciation of F at each Et and RF
Occurs Eet+1 iF:
1) Domestic P ,
2) Trade Barriers 3) Imports , 4) Exports , 5) Productivity
19-11
Shifts in RD
RD shifts right when
1. iD ; because RD at each Et
Assumes that domestic e unchanged, so domestic real rate
19-13
Response to i Because e
1. e , Eet+1 , expected
appreciation of F ,
RF shifts out to
right
2. iD , RD shifts to
right
However because e > iD , real rate , Ee
t+1 more than iD RF out > RD out and Et Note: if only real interest rate => only RD shifts to the
right and Et
19-14
Response to Ms
1. Ms , P , Eet+1
expected appreciation
of F , RF shifts
right
2. Ms , iD , RD shifts
left
Go to point 2 and Et
3. In the long run, iD
returns to old level,
RD shifts back, go
to point 3 and get
Exchange Rate
Overshooting
19-15
Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate (influenced by expectations of many variables)
2. Exchange rate overshooting