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International Finance Foreign Exchange Markets In the US, we use the US dollar as currency, and most countries have their own currencies. To exchange one currency for another, a price for one currency in terms of the other is needed -- hence “foreign exchange markets.” Ex: Japan Ex: Japan

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International Finance

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International Finance


Foreign Exchange Markets

  • In the US, we use the US dollar as currency, and most countries have their own currencies.

  • To exchange one currency for another, a price for one currency in terms of the other is needed -- hence “foreign exchange markets.”


Ex: Japan

Ex: Japan

12/1/99

12/1/99

Perdollarquotes

Foreign currency

Yen

=

=

=

US Dollar

US Dollar

Perforeign currencyquotes

US Dollar

US Dollar

=

=

=

Foreign currency

Yen

Exchange Rate Measures

  • The foreign exchange rate is the nominal price for which one currency is exchanged for another.

102.10

.00979


Wall Street Journal 9/98


An Example:

  • Suppose you can buy a CD in France or in the US, where should you buy it?

    • PUS= US $ 15.00

    • PFR = 60 FF


PerFrench francquotes

PerUS dollarquotes

(

(

)

)

=

=

French franc

US Dollar

e

e

=

=

5.0

US Dollar

French franc

.20

Exchange Rate Measures (cont.)

PUS= $ 15.00 PFR = 60 FF


*

PFR

(

)

$?

$1

e

US Dollar

=

FF 5

FF 60

FR franc

Price of FrenchCD in US$

=

  • In order to make a decision, you must convert the French CD to US dollars:

e(US Dollar) = 1

FR franc 5

We want the $ equivalent of 60 FF.

FF 60 * 1 = $12

5


FF 60 * 1 = $12

5

  • Recall the price of the same CD in the U.S. was US $15.00.

Where would you prefer to buy the CD?


Reality Check

  • This ignores transaction costs

  • Transaction costs on LARGE exchanges -- millions of $s -- are small, fractions of a %

  • Transaction costs on small exchanges -- for tourists or travelers -- can be large; in North America and Western Europe, a fixed fee (say $5) per exchange plus commission of 1 or 2 per cent, or more. Travelers be warned!


When currencies change value….

  • Currency depreciation:- a currency depreciates if its value in terms of foreign currency goes down.

  • That automatically means it costs more of the depreciated currency to buy a unit of the foreign currency.


  • Example: Say that currently one US dollar is worth 2 DM (German currency),

    or ,

  • If the new exchange rate isthen one US dollar buys 1 DM.

  • Currency depreciation: (an example)

  • The US dollar buys less and has thus depreciated.

The DM appreciated, the $ depreciated.


What determines an exchange rate?

Under a flexible (floating) exchange rate system, the

value of currencies is determined by market forces.

  • The foreign exchange market is the market in which

  • the currency of one country is exchanged for the

  • currency of another.

  • This market is widely dispersed and highly organized.


The Demand for Dollarsis a derived demand -- it comes from holders of other currencies wanting US dollars to make payments in dollars -- e.g. to buy US goods, services, or assets.

  • What determines the quantity of dollars demanded in the foreign exchange market?

  • The exchange rate.


  • Suppose the current exchange rate is - - - This means that 100 yen(Japanese currency) will buy you $1.00.

  • Suppose the exchange rate increases to 200 yen. Now someone in Japan hasto give up twice as many yen to get $1.00.

  • Quantity demanded for dollars (an example)

  • The price of a dollar has gone up, so less willbe demanded.


Other things remaining

the same, a rise in the

exchange rate decreases

the quantity of dollars

demanded...

100

D

1.3

The Demand for Dollars

ExchangeRate(Yen for $)

150

100

50

0

1.1

1.2

1.4

1.5

1.3

Quantity (trillions of $ per day)


Other determinants cause the demand for dollars curve to shift

1) Interest rates in the US and other countries.

Example: Suppose US interest rates go up. What will happen to the demand for the dollar?

  • At the same exchange rate, Japanese investors will want to take advantage of the higher returns by investing more in the US.

  • This means more US dollars will be purchased and the demand for dollars will shift to the right.


Other determinants cause the demand for dollar curve to shift (cont.)

2) relative prices in the United States and other countries.

3) GDP in the foreign country

4) the expected future exchange rate


Increase in the

demand for dollars

Decrease

in the

demand for

dollars

D1

D2

Changes in the Demand for Dollars

150

Exchange rate (yen per dollar)

100

50

D0

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


The U.S interest rate differential increases

Japanese prices rise, relative to US prices.

Japanese GDP rises.

The expected future exchange rate rises

The U.S. interest rate differential decreases

Japanese prices fall, relative to US prices.

Japanese GDP falls.

The expected future exchange rate falls

The demand for dollars

increases if:

The demand for dollars

decreases if:

Summary: Changes in the Demand for Dollars

I

P

G

E


The Supply of Dollarsis derived -- it arises from holders of dollars wanting foreign currency to make payments in foreign currency -- e.g. to buy goods, services, or assets abroad.

  • What determines the quantity of dollars supplied in the foreign exchange market?

    • The exchange rate


  • Suppose the current exchange rate is - - - And, further, suppose that 1.3 trillion dollars are supplied.

  • If the exchange rate increases to 200 yen. One dollar buys more yen.

  • Quantity supplied of dollars (an example)

  • Japanese goods are cheaper so you will supply more dollars in order to get the yen needed to purchase the cheaper Japanese goods.


S

100

Other things remaining

the same, a rise in the

exchange rate increases

the quantity of dollars

supplied...

1.3

The Supply of Dollars

ExchangeRate(Yen for $)

150

100

50

0

1.1

1.2

1.4

1.5

1.3

Quantity (trillions of $ per day)


Other determinants cause the supply of dollars curve to shift

1) Interest rates in the US and other countries.

2) relative prices in the United States and other countries.

3) GDP in the US

4) the expected future exchange rate


S1

S2

Decrease in the

supply of dollars

Increase in the

supply of dollars

The Supply of Dollars

S0

150

Exchange rate (yen per dollar)

100

50

0

1.1

1.2

1.3

1.4

1.5

Quantity (trillions of dollars per day)


The U.S interest rate differential decreases

Japanese price level falls relative to the US price level.

U.S. GDP increases.

The expected future exchange rate falls

The U.S. interest rate differential increases

Japanese price level increases, relative to the US price level.

US GDP decreases.

The expected future exchange rate rises

The supply of dollars

increases if:

The supply of dollars

decreases if:

Summary: Changes in the Supply of Dollars

I

P

G

E


Equilibrium Exchange Rate:

  • The equilibrium exchange rate occurs where the quantity of dollars demanded is just equal to the quantity of dollars supplied.


Surplus at

150 yen per dollar

S

Equilibrium at

100 yen per dollar

100

D

Shortage at

50 yen per dollar

1.3

Equilibrium Exchange Rate

ExchangeRate(Yen for $)

150

100

50

0

1.1

1.2

1.4

1.5

1.3

Quantity (trillions of $ per day)


How volatile are exchange rates?


Suppose that Americans export cell phones to the

French, and the French export wine to the U.S…..

Suppose a French bottle of wine sells for 100 FF, and an

American cell phone sells for $80.

If the exchange rate is $1 = 5 francs, how much is

A bottle of wine in $?

$20


If exchange rate = $1/5 FF, a bottle of French wine costs $20.

What quantity of French francs will be demanded?

50m * 100 FF = 5000mFrench francs are demanded

What quantity of American dollars will be supplied?

$20 * 50m = $1000mAmerican dollars are supplied


Suppose a French bottle of wine sells for 100 FF, and an

American cell phone sells for $80.

If the exchange rate is $1 = 5 francs, how much is

A cell phone in FF?

400FF


If exchange rate = $1/5 FF, a cell phone costs 400 FF.

What quantity of American dollars will be demanded?

80m * $80 = 6400mAmerican dollars are demanded

What quantity of French francs will be supplied?

400FF * 80m = 32000mFrench francs are supplied


Balance of Payments

  • The U.S. accounts will have a balance of

  • payments when the value of exports equals

  • the balance of imports.


The Twin Deficits


  • Balance of Payments Accounts

  • Is there any reason to be concerned that the US is a debtor country?

    - No, if the borrowing is financing investment that is generating economic growth and higher income.

    - Yes, if the money is being used to finance consumption.

    • This could result in higher interest payments to foreigners and lower consumption sometime in the future.


Borrowing for what?

Is the U.S. Borrowing for Consumption or Investment?

  • Net exports were –$99 billion in 1996

  • Governments in the US buy structures (e.g. highways, schools, dams) worth more than $200 billion/year.

  • Governments also spend on education and health care—increases human capital.

  • Looks like investment, not consumption.


The International Exchange Market and the Aggregate Demand/Supply Market are connected by….

  • higher interest rates attract investments at home

  • and abroad, and thus effect the demand for dollars

  • Growth in export demand (foreigners demanding

  • more U.S. goods) leads to increases in AE, then

  • GDP, then DI.


S2

D2

An Application: Interest rates fluctuate up.

  • If the US interest rate goes up, what will happen to the dollar?

S1

  • With higher interest rates in the US, investors abroad demand more dollars with which to invest in the US.

e1

  • With higher interest rates in the US, investors in the US are less willing to buy foreign currency (supply dollars) and more willing to invest at higher interest rates at home.

D1

Q1

0

Quantity of $


S2

e2

D2

Q2=

An Application: Interest rates fluctuate up.

  • The equilibrium exchange rate occurs where the quantity of dollars demanded is just equal to the quantity of dollarssupplied.

S1

e1

  • The new equilibrium results in a higher exchange rate (yen for $).

  • Prediction: The dollar shouldappreciate in relation to the yen.

D1

Q1

0

Quantity of $


e2

D2

An Application: Foreign Exchange Intervention.

  • Foreign exchange intervention is when a govt. tries to maintain an exchange rate in the foreign exchange model.

S1

  • Suppose the Japanese yen is rising w/respect to the US dollar.

e1

  • The Fed could intervene in the market to “prop up” the dollar.

D1

  • Without intervention, the exchange rate will fall to e2.

Q1

0

Quantity of $


e1

D2

An Application: Foreign Exchange Intervention.

  • In order for the Fed to intervene and attempt to maintain the exchange rate between dollars and yen at e1, it would have to demand (buy) dollars to shift the demand curve back to D1

S1

e1

e2

D1

D1

Q1

0

Quantity of $


Reality Check

  • Nowadays, intervention rarely works

  • The volume of foreign exchange transactions is of the order of $2 trillion a day

  • This is massively larger than any country’s foreign exchange reserves, so in most cases intervention alone is inadequate -- it does not shift the curves enough.


Changes in the Exchange Rate

Why the Exchange Rate is Volatile

  • Supply and demand are not independent of each other.

  • A change in the expected future exchange rate or U.S. interest rate differential changes both supply and demand.

  • Day-to-day movements in exchange rates are dominated by the large amounts of internationally mobile liquid capital and changes in sentiment -- i.e. expectations about the future


S94

S95

Exchange Rate Fluctuations

1994 to 1995

Exchange rate (yen per dollar)

100

84

D94

D95

0

Q0

Quantity (trillions of dollars per day)


S97

D97

Exchange Rate Fluctuations

S95

1995 to 1997

123

Exchange rate (yen per dollar)

84

D95

0

Q0

Quantity (trillions of dollars per day)


The Exchange Rate

Exchange Rate Expectations

Two influences on expectations that affect the international value of a currency are:

1) Purchasing power parity ideas

2) Interest rate parity expectations


The Exchange Rate

Purchasing Power Parity

  • Money is worth what it will buy.

  • Purchasing power parity means equal value of money -- the idea that, ceteris paribus, $1 ought to buy the same amount of real goods anywhere.

  • PPP is misleading -- much of output is nontradable -- most services, most low value-to-mass or -to-bulk, or perishable, goods (e.g. haircuts, restaurant meals, fresh bread)


The Exchange Rate

Purchasing Power Parity

  • If prices [of traded goods] increase in Canada (for example) and other countries but remain constant in the United States, people will generally expect that the value of the U.S. dollar is too low and will expect it to rise.

  • Supply of and demand for dollars change

  • The exchange rate changes


The Exchange Rate

Interest Rate Parity

  • “Money is worth what it can earn.”

  • Interest rate parity means equal interest rates -- i.e., ceteris paribus, interest rates should be the same everywhere.

  • Again, they aren’t -- because risk differentials differ, and because possible future changes in exchange rates have to be taken into account.


The Exchange Rate

Interest Rate Parity

If the rate of return on the dollar is higher in the United States than the rate of return on local currencies in other countries, the demand for U.S. dollars rises and the exchange rate rises until interest rates are equal.

If you are the treasurer of a multinational (e.g. Ford), you will put your liquid funds (cash) in the market (and the currency) where you expect the biggest return.


Speculation and Exchange Rates

  • The problem is, small differentials in interest rates can be swamped by small changes in exchange rates

  • So expectations about likely future changes in exchange rates tend to be much more powerful influences on supply and demand to foreign exchange markets in the short run than fundamentals like relative price levels and interest rate differentials.


Real Exchange Rate:

=

X

)

(

)

(

Foreign currency

Foreign currency

Re

e

US Dollar

US Dollar

PUS

PFC

  • Exchange Rate Measures (cont.)

  • The real exchange rate is the nominal exchange rate adjusted for prices

  • That means we multiply the nominal exchange rate by the ratio of the US and foreign price indices:


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