Foreign Exchange Markets

The Foreign-Exchange Market and Exchange Rates

Why do we care about exchange rate markets?

• Countries have different currencies and exchange is denoted in these different currencies

• For trade to occur, you need to be able to buy and sell in the currency of your trading partner.

• Why not just one currency?

Appreciation and Depreciation

• Appreciation: when your currency becomes more expensive in terms of other currencies. (For example If 1 USD cost 1 Euro and then went up to 1.2 Euros you have an appreciation

• Depreciation: when your currency becomes less expensive in terms of other currencies. (For example if the USD cost 1 Euro and then went down to .8 Euros you have a depreciation)

Exchange Rates

• The nominal exchange rate is the price of one country’s exchange rate in terms of another’s.

• Example: In India, if you want to buy a dollar, it costs 50 Rupees on the market- so, the nominal exchange for dollars is 1/50=.02 dollars per rupee in India. In the U.S, the nominal exchange rate for a rupee is 50 rupees to the dollar.

Real Exchange Rate

• The real exchange rate is the purchasing power of a currency relative to the purchasing power of other currencies.

• Things cost different amounts in each country. For example, to take the Indian case with 50 rupees to the dollar. A shirt in India may cost 250 rupees, while in the U.S it costs 10 dollars. Are you better off buying in India or in the U.S? To check, we have to calculate the real exchange rate

Real E.R

• Formula: EXr=[EX X P]/Pf

• Real E.R= (Nominal ER X Domestic Price)/Foreign Price

• = (Rs.50/$1 )*($10)/Rs.250=2 Indian Shirts/1 U.S Shirt

• So shirts are in real terms, twice as expensive in the U.S as they are in India

Price indices

• In reality, we compare not prices of any particular good, but general prices (price indices) (basket of goods containing lots of common items)

• So we compare general price levels

Relationship between Nominal and Real Exchange Rates over time

• Formula: EXr=[EX * P]/Pf

So, in percentages

EXr/EXr= EX/EX+P/P-Pf/Pf

%change in RE=% change in nominal+ percentage change in price level domestically- percentage change in price level in the foreign country

Example

EXr/EXr= EX/EX+P/P-Pf/Pf

Let us take our previous example and say that that shirts cost more in the US- (now they are $15). The RER is now

• (Rs.50/$1 )*($15)/Rs.250=3 Indian Shirts/1 U.S Shirt

• The change in EX=0, in P=50% in Pf=0

• Change in EXr=50%

Foreign-Exchange Markets

• Spot market transactions involve immediate exchanges of currency or bank deposits. Example: I exchange one dollar for 45 rupees today

• Forward transactions involve future exchanges of currencies or bank deposits. Example: I buy a contract today to exchange $1 for 45 rupees 3 months from now? Why?

• Zero sum game.

Causes of Higher Long-run Exchange Rates

• A decrease in a country’s relative price level (If U.S goods are cheaper than in India, more people will buy U.S goods, and bid up the price of the dollar)

• An increase in a country’s relative productivity• (If U.S goods are made more productively, they will be

cheaper than in India, more people will buy U.S goods, and bid up the price of the dollar)

• A decrease in a country’s demand for foreign goods or a rise in foreign demand for a country’s exports (If people think that Indian goods are not of the same quality, they will buy more U.S goods…etc)

• An increase in a country’s tariffs (foreign goods become costlier)

Rearranging our Equation

EX/EX = EXr/EXr + f-

refers to inflation

Nominal E.R change = Real E.R change+ difference in foreign and domestic inflation rates

Purchasing Power Parity/Law of One Price• Law of One Price: LOOP-if two countries produce an

identical good, if the good is tradable, if there is free trade and there are no transactions /transportation costs, then the price should be the same in both countries. In the shirt example, U.S consumers would buy Indian shirts, buy more rupees, causing an appreciation of the Indian rupee and making it relatively more costly to buy the shirt. This would go on till the RER= 1 shirt India/1 shirt US

• Purchasing power parity (PPP) theory applies the law of one price to a group of goods. Under LOOP, RER is always constant, (percentage change is zero) so according to PPP, changes in N.E.R reflect inflation rate differences cause changes in the nominal exchange rate.

EX/EX = EXr/EXr + f-underPPP EX/EX = f-

Another Determinant of Exchange Rates

• The flow of goods and services (called trade) is not the only thing that moves between countries

• Capital flows too (financial flows between countries).

• Just like with trade, borrowers need finance in their local currency and sellers need repayment in their own currency, so they need foreign exchange markets.

• How does this explain the fact that while the U.S has a constant and huge trade deficit, its currency isn’t depreciating fast?

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Determining Short-run Exchange Rates

• Investors compare the return on a domestic asset with the return on a foreign asset evaluated in terms of domestic currency.

Example in the Book

• Two assets with equal risk- Japanese Bonds and U.S Bonds each offering 5% return.

• Basic point- overall return (R) depends on both interest rate and exchange rate

• The return on a domestic asset (1 + i) should be compared with the return on a foreign asset evaluated in terms of domestic currency (1+ if – ∆EXe/EX). Note Exe= expected change

• If Japanese yen depreciates by 5% over the year the return to the U.S bond is 1+.05=1.05=5% return, while to the Japanese bond=1+.05-.05=1= 0% return

The graph shows the expected rate of return on a Japanese bond. Let the expected exchange rate one year from now be 100. If current ER is 105, then actual R=.05+5/105=.098=9.8%If current ER is 97, then actual R=.05+ (-3/97)=1.9%

Rules• Nominal interest rate parity: ceteris paribus, the

nominal returns of domestic and foreign assets must be equal.

• International capital mobility results in an exchange rate market equilibrium reflecting the nominal interest rate parity condition: When domestic and foreign assets have identical risk, liquidity, and information characteristics, their nominal returns (measured in the same currency) also must be identical (i = if – ∆EXe/EX).

• Real interest rate parity: expected real rates of interest are equal. (1 + r) = (1 + rf)(EXrr/EXre ).

Other comparative statics: 1. Effect of a Change in the Domestic Real Interest Rate

Effect of an Increase in Domestic Expected Inflation

Effect of a Change in the Foreign Interest Rate

Effect of Changes in Exchange Rate Expectations

Play ball!

• You are a currency speculator. Choose (as soon as you can) what currency, Yen or the Dollar, you would under the following bits of news…

Choices

• “Japanese productivity continues to increase”

• “U.S announces unilateral tariffs on all Japanese products”

• “U.S products seen to be of better quality”

• “Japanese raise interest rates”

• “Higher expected inflation in the U.S”

• “Moody’s downgrades Japanese bonds”

• “U.S trade deficit continues to rise”