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Chapter 13: Krugman and Obstfeld PowerPoint PPT Presentation

Chapter 13: Krugman and Obstfeld Introduction Exchange Rates – Descriptive Material The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the Foreign Exchange Market Interest Rates, Expectations, and Equilibrium Summary Chapter 13: Krugman and Obstfeld

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Chapter 13: Krugman and Obstfeld

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Chapter 13: Krugman and Obstfeld

  • Introduction

  • Exchange Rates – Descriptive Material

  • The Foreign Exchange Market

  • The Demand for Foreign Currency Assets

  • Equilibrium in the Foreign Exchange Market

  • Interest Rates, Expectations, and Equilibrium

  • Summary


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Chapter 13: Krugman and Obstfeld

  • Readings:

    • Krugman and Obstfeld Chapter 13

    • Economic Report of the President 2007 – Ch 7

    • The Basics of Foreign Trade and Exchange


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Introduction

  • The exchange rate is a price

    • It lets us covert different currencies to a common unit.

  • Exchange rates are determined in the same way as other asset prices.

    • Supply

    • Demand

    • What a surprise!

  • Get into the specifics – exchange rate determination and international foreign exchange markets.


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Exchange Rates

  • An exchange rate either coverts foreign prices to dollars or dollar prices to foreign.

  • Domestic and Foreign Prices

    • If we know the exchange rate between two countries, we can compute the price of one country’s goods in terms of the other country’s money.

      • Example: The dollar price of a C$50 sweater with a dollar exchange rate of $1.05 per CAD is (1.02 $/C$) x (C$50) = $52.50

      • One year earlier: The dollar price of a C$50 sweater with a dollar exchange rate of $0.86 per CAD is (0.86 $/C$) x (C$50) = $43.50


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Exchange Rates and International Transactions


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Exchange Rates

  • Depreciation of home country’s currency

    • A rise in the home price of a foreign currency – more dollars for each Canadian dollar.

    • For fixed domestic prices, home goods become cheaper in foreign markets

      • Reduced demand?

      • Increased supply?

      • Difference between goods and money?

  • Appreciation of home country’s currency

    • A fall in the home price of a foreign currency – less dollars for each Canadian dollar.

    • For fixed domestic prices, home goods become more expensive in foreign markets

      • Same questions different sign.


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Exchange Rates

  • Import and export demands are influenced by relative prices. But, don’t forget relative prices are influenced by import and export demand.

  • Appreciation of a country’s currency:

    • Raises the relative price of its exports and lowers the relative price of its imports.

    • Will exports and imports increase or decrease?

  • Depreciation of a country’s currency:

    • Lowers the relative price of its exports and raised relative price of imports.

    • Will exports and imports increase or decrease?


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Example

  • The Canadian Dollar appreciated  the price of the Canadian sweater went up. Do we buy fewer Canadian sweaters?

  • The dollar price of Canadian sweaters increased.

    • Price effect makes us want to consumer fewer sweaters.

  • BUT! Why did the price increase?

    • The CAD might have appreciated BECAUSE we wanted to buy more Canadian sweaters (its cold there; they know a thing or two about sweaters).

      • Does it matter if we like U.S. sweaters less?

    • The CAD might have appreciated BECAUSE we love Canadian oil.


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Transition

  • Talk about the foreign exchange market itself.

    • Who trades in the foreign exchange market?

    • Where do the trades take place?

  • Discuss demand for assets driving exchange rate.

    • Does it matter if it is demand for assets or demand for goods which determines the exchange rate?

    • Why do people buy assets?

  • Interest parity.


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The Foreign Exchange Market

  • Exchange rates are determined in the foreign exchange market.

    • The market in which international currency trades take place

  • The major players in the foreign exchange market are:

    • Commercial banks

    • International corporations

    • Nonbank financial institutions

  • Most important player

    • Central banks – completely control the supply of money – at the end of the day this is the primary determinant of the value of a currency.


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Type of Transactions

  • Interbank trading

    • Foreign currency trading among banks

    • It accounts for most of the activity in the foreign exchange market.


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Type of Transactions

  • Characteristics of the Market

    • The worldwide volume of foreign exchange trading is enormous, and it has ballooned in recent years.

    • New technologies, such as Internet links, are used among the major foreign exchange trading centers (London, New York, Tokyo, Frankfurt, and Singapore).

    • The integration of financial centers implies that there can be no significant arbitrage.

      • The process of buying a currency cheap and selling it dear.


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Type of Transactions

Vehicle currency

  • A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency.

    • Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.


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Type of Transactions

  • Spot Rates and Forward Rates

    • Spot exchange rates

      • Apply to exchange currencies today.

    • Forward exchange rates

      • Apply to exchange currencies on some future date at a prenegotiated exchange rate.

    • Forward and spot exchange rates, while not necessarily equal, almost always move closely together.


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Forward vs. Spot Rates


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Type of Transactions

  • Foreign Exchange Swaps

    • Spot sales of a currency combined with a forward repurchase of the currency.

    • They make up a significant proportion of all foreign exchange trading.

    • Why would you want a foreign exchange swap?

    • What is the difference between a foreign exchange swap and simply purchasing a foreign exchange forward contract?


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Type of Transactions

  • Futures and Options

    • Futures contract

      • The buyer buys a promise that a specified amount of foreign currency will be delivered on a specified date in the future.

    • Foreign exchange option

      • The owner has the right to buy or sell a specified amount of foreign currency at a specified price at any time up to a specified expiration date.

    • For what purpose would you use a foreign exchange option?

    • Why would you prefer an option to a futures contract or to an outright forward purchase?


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Type of Transactions

  • Hedging versus transaction derived demand.

  • Hedging: Offsetting the risk of a specific foreign currency exposure.

  • Transaction derived demand: I need a specific amount of foreign currency at a specific future date.


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Type of Transactions

  • Almost all foreign exchange transactions are conducted as a swap.


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The Demand for Currency

  • Demand for foreign currency exactly the same as the demand for IBM stock.

    • You don’t care about IBM you only want more goods tomorrow.

    • Increase in return buy more. Decrease buy less.

  • Assets and Asset Returns

    • Defining Asset Returns

      • Nominal return – how much money do I have tomorrow for investing money today.

    • The Real Rate of Return

      • The amount of goods you can buy with the money you make. Wheat today versus wheat tomorrow. Inflation really matters.


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The Demand for Currency

  • Risk and Liquidity

    • Risk

      • An asset that pays off either 100 or 0 tomorrow with equal probability is not the same asset as one which pays off 50 with certainty.

    • Liquidity

      • The ease with which it can be sold or exchanged for goods. Cash is the most liquid asset. A high (notional) rate of return is useless if I can’t sell the asset.


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The Demand for Currency

  • Choosing an investment currency.

    • All things equal, choose the currency with the highest interest rate.

    • All things equal, choose the currency with the largest expected appreciation.

  • Hmm? Do you expect to make money (excess return) by investing in foreign money markets?


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Carry Trade

  • Borrow in a low interest rate economy (Japan) and invest in a high interest rate economy (New Zealand).

    • Seems like a great way to get rich.

  • Questions which must be asked

    • Is this a risk free investment?

    • What keeps other people from making the investment?


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Get rich quick – especially after 2000


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Get a lot richer in Stock Market


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The Demand for Currency

  • Exchange Rates and Asset Returns

    • The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.

    • In order to decide whether to buy a euro or a dollar deposit, one must calculate the dollar return on a euro deposit.


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The Demand for Currency

  • A Simple Rule

    • The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro.

      • Therate of depreciationof thedollar against the euro is the percentage increase in the dollar/euro exchange rate over a year.


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The Demand for Currency

  • What is the return on investing in euros?

    • Take $100 dollars, convert into euros today.

      • $100 * €/$ = €70.9 (if exchange rate is 1.41 $/€)

    • Deposit €70.9 in a euro-area bank

      • €70.9 * (1+r) = €73.96 (if interest rate is 3.86%)

    • Convert €73.96 into dollars.

      • Which exchange rate to use? Use the interest rate prevailing one year from now.

      • €73.96*$/ € F= $103.86 (if forward rate is 1.41 $/€)

    • If U.S. interest rate is 4.14%, which currency should we invest in. But then, what does that mean for the exchange rate?  Euro is expected to appreciate to 1.43 $/€


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The Book Gives this Interest Parity Eq

  • If interest parity holds, the following equation must also hold:

    R$ = R€- (Ef$/€-E$/€)/E$/€

    where:

    R$ = interest rate on one-year dollar deposits

    R€= today’s interest rate on one-year euro deposits

    E$/€= today’s dollar/euro exchange rate (number of dollars per euro)

    Ee$/€ = dollar/euro exchange rate (number ofdollars per euro) expected to prevail a year from today


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We can use the easier and correct Interest Parity Eq

  • If interest parity holds, the following must also hold:

    R$= (1+r€ )Ef$/€/E$/€

    where:

    R$ = interest rate on one-year dollar deposits

    R€= today’s interest rate on one-year euro deposits

    E$/€= today’s dollar/euro exchange rate (number of dollars per euro)

    Ef$/€ = dollar/euro exchange rate (number ofdollars per euro) expected to prevail a year from today


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The Demand for Currency

  • Return, Risk, and Liquidity in the Foreign Exchange Market

    • The demand for foreign currency assets depends not only on returns but on risk and liquidity.

      • There is no consensus among economists about the importance of risk in the foreign exchange market.

      • Most of the market participants that are influenced by liquidity factors are involved in international trade.

        • Payments connected with international trade make up a very small fraction of total foreign exchange transactions.

        • But they may be the marginal demanders of a currency.

    • We will for the most part ignore the risk and liquidity motives for holding foreign currencies.

      • But, it likely really matters.


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Equilibrium in the Foreign Exchange Market

  • Interest Parity: The Basic Equilibrium Condition

    • The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return.

    • What about our Carry Trade example.

    • Interest parity condition

      • The expected return is the same no matter where you deposit your money.

        R$= (1+r€ )Ef$/€/E$/€


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Equilibrium in the Foreign Exchange Market

  • According to the text:

    • Depreciation of a country’s currency today lowers the expected domestic currency return on foreign currency deposits.

    • Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits.

  • Do you expect that this is true?


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What happens when Spot Rate Changes?


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Equilibrium in the Foreign Exchange Market

  • The Equilibrium Exchange Rate

    • Exchange rates (or interest rates) always adjust to maintain interest parity.

    • Assume that the dollar interest rate R$, the euro interest rate R€, and the expected future dollar/euro exchange rate Ee$/€, are all given.


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Equilibrium in the Foreign Exchange Market

Exchange rate, E$/€

Return on

dollar deposits

2

E2$/€

1

E1$/€

3

E3$/€

Expected return

on euro deposits

R$

Rates of return

(in dollar terms)

Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate


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Interest Rates, Expectations, and Equilibrium

  • The Effect of Changing Interest Rates on the Current Exchange Rate

    • An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies.

      • A rise in dollar interest rates causes the dollar to appreciate against the euro.

      • A rise in euro interest rates causes the dollar to depreciate against the euro.


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Interest Rates, Expectations, and Equilibrium

Exchange rate, E$/€

Dollar return

1

1'

E1$/€

E2$/€

2

Expected

euro return

R1$

R2$

Rates of return

(in dollar terms)

Figure 13-5: Effect of a Rise in the Dollar Interest Rate


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Interest Rates, Expectations, and Equilibrium

Exchange rate, E$/€

Dollar return

Rise in euro

interest rate

2

E2$/€

E1$/€

1

Expected

euro return

R$

Rates of return

(in dollar terms)

Figure 13-6: Effect of a Rise in the Euro Interest Rate


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Interest Rates, Expectations, and Equilibrium

  • The Effect of Changing Expectations on the Current Exchange Rate

    • A rise in the expected future exchange rate causes a rise in the current exchange rate.

    • A fall in the expected future exchange rate causes a fall in the current exchange rate.


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Summary

  • Exchange rates play a role in spending decisions because they enable us to translate different countries’ prices into comparable terms.

  • A depreciation (appreciation) of a country’s currency against foreign currencies makes its exports cheaper (more expensive) and its imports more expensive (cheaper).

  • Exchange rates are determined in the foreign exchange market.


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Summary

  • An important category of foreign exchange trading is forward trading.

  • The exchange rate is most appropriately thought of as being an asset price itself.

  • The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes.


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Summary

  • Equilibrium in the foreign exchange market requires interest parity.

    • For given interest rates and a given expectation of the future exchange rate, the interest parity condition tells us the current equilibrium exchange rate.

  • A rise in dollar (euro) interest rates causes the dollar to appreciate (depreciate) against the euro.

  • Today’s exchange rate is altered by changes in its expected future level.


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