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LECTURE 7. FOREIGN EXCHANGE RATES: MONETARY APPROACH. BEGINNING TERMS. FOREIGN EXCHANGE MARKET FOREIGN EXCHANGE RATE CURRENCY APPRECIATION CURRENCY DEPRECIATION PRICE PARITY INTEREST PARITY RATIO SPOT EXCHANGE RATE FORWARD EXCHANGE RATE REAL EXCHANGE RATE NOMINAL EXCHANGE RATE.

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lecture 7
LECTURE7

FOREIGN EXCHANGE RATES:

MONETARY APPROACH

slide4
FOREIGN EXCHANGE MARKET
  • FOREIGN EXCHANGE RATE
  • CURRENCY APPRECIATION
  • CURRENCY DEPRECIATION
  • PRICE PARITY
  • INTEREST PARITY RATIO
  • SPOT EXCHANGE RATE
  • FORWARD EXCHANGE RATE
  • REAL EXCHANGE RATE
  • NOMINAL EXCHANGE RATE
the key to understanding the global trade
The Key to Understanding the Global Trade
  • A fallacy students make in trying to understand international trade is to assume that a nation trades only goods. In fact, nations also trade financial assets such as stocks, bonds and bank loans. The United States sells its goods and assets in exchange for other nations’ goods and assets.
  • Exports are the US goods and services sold to foreigners, and imports are the foreigners’ goods and services purchased by US citizens.
the key to understanding the global trade7
The Key to Understanding the Global Trade
  • Net exports is the net of the goods and services sold by the United States and equals the value of exports minus the value of imports.
  • Equivalent to exported goods are the United States assets purchased by foreigners. Equivalent to imported goods are the foreign assets purchased by United States citizens.
  • Net foreign investment is the net of the assets purchased by United States citizens and equals purchases of foreign assets by United States citizens minus the purchase of United States assets by foreigners.
the key to understanding the global trade9
The Key to Understanding the Global Trade
  • Unless governments intervene, the total amount of goods and assets bought and sold tend to equally each other. So,
  • Imports plusforeign assets purchased by United States citizensequalExportsplus United States assets purchased by foreigners.
the key to understanding the global trade10
The Key to Understanding the Global Trade
  • When the nation buys more than its sells, it has a shortage of foreign currency and the exchange rate for that currency (foreign currency) will rise until the market clears.
  • When a nation sells more than it buys, it has a surplus of foreign currency and the exchange rate for that currency will fall until imports plus foreign assets purchased by domestic citizens equals exports plus domestic assets purchased by foreigners.
slide11
WSJ CURRENCY TRADING COLUMN

DATE OF

QUOTE

SPOT

RATES

FORWARD

RATES

WHOLESALE QUOTES:

TRADING AMONG BANKS

NAME OF COUNTRY’S

LEGAL TENDER

slide14
AT THIS POINT LET’S ADD A FOREIGN ASSET ( BOND ) TO THE PORTFOLIO DECISION FRAMEWORK.

PORTFOLIO

CASH ($)

DOMESTIC

BONDS

FOREIGN

BONDS

COMMON

STOCK

foreign exchange market
FOREIGN EXCHANGE MARKET
  • Look at the purchase of the bond in this simple sequence.

$

PORTFOLIO

CASH

DOMESTIC

BONDS

FOREIGN

BONDS

COMMON

STOCK

FOREIGN

EXCHANGE

MARKET

foreign exchange market16
FOREIGN EXCHANGE MARKET
  • AT THIS POINT LET’S ADD A FOREIGN ASSET ( BOND ) TO THE PORTFOLIO DECISION FRAMEWORK FROM CHAPTER 6 .

$

YEN

PORTFOLIO

CASH

DOMESTIC

BONDS

FOREIGN

BONDS

COMMON

STOCK

FOREIGN

EXCHANGE

MARKET

FOREIGN

BOND

MARKET

YEN DENOMINATED BONDS

slide18
IF YOU HAVE A CHOICE BETWEEN DOMESTIC AND FOREIGN BONDS THEN THIS IMPLIES THAT THEIR RATES OF RETURN ARE INTERRELATEDAND FURTHERMORE , FOREIGN EXCHANGE RATES MUST BE RELATED TO DOMESTIC INTEREST RATES.
slide20
THE PRICE OF ONE COUNTRY’S CURRENCY IN TERMS OF ANOTHER COUNTRY’S CURRENCY IS CALLED THE EXCHANGE RATE .
  • THE EXCHANGE RATE IS DETERMINED IN THE FOREIGN EXCHANGE MARKET.
  • THERE TWO KINDS OF EXCHANGE RATE TRANSACTIONS.

- SPOT TRANSACTIONS

- FORWARD TRANSACTIONS

slide22
SPOT TRANSACTIONSINVOLVE IMMEDIATE EXCHANGE OF CURRENCIES OR BANK DEPOSITS.
  • FORWARD TRANSACTIONS INVOLVE THE EXCHANGE OF CURRENCIES OR BANK DEPOSITS AT SOME FUTURE DATE . HOWEVER, THE CONTRACT TAKES PLACE TODAY.
how to convert foreign prices into dollars
How to Convert Foreign Prices into Dollars
  • Let the exchange rate be expressed in terms of dollars.
  • If the exchange rate is 100 yen, then the US dollar will purchase 100 yen.
  • Yen / Dollar or yen per Dollar
  • Dollar Price of Foreign Goods = Foreign Price / Exchange rate
  • Yen / (Yen / Dollar) = Dollar
  • If a watch cost 1000 yen and the exchange rate is 100 yen to the dollar, the dollar price is
  • 1000 / (100/1) = 1000 / 100 = $10
  • If the exchange rate goes to 110 to the dollar, the new dollar price would be 1000 / 110 = $9.09
how to convert dollar prices into foreign prices
How to Convert Dollar Prices into Foreign Prices
  • Foreign price = dollar price * exchange rate
  • From our previous example,
  • Foreign price = $10 * (100/1) = 1000 Yen
  • Foreign price = $9.09 * (110/1) =1000 Yen
problem
Problem
  • The exchange rate for the US dollar is 0.90 British pounds per dollar and 260 Yen per dollar.
    • How many dollars will it take to buy 1 pound? 1 Yen?
    • What will a $12,000 Chevrolet cost in Britain? In Japan?
    • What will a suit costing 200 pounds cost in the US? A 20,000 Yen suit?
answer
Answer
  • How many dollars will it take to buy 1 pound? 1 Yen?
    • Pounds / Dollar = 0.90 so Dollar / Pound = 1 / 0.90 = 1.11
    • Yen / Dollar = 260 so Dollar / Yen = 1 / 260 = 0.00385
  • What will a $12,000 Chevrolet cost in Britain? In Japan?
    • $12,000 *
    • $12,000 *
answer28
Answer
  • What will a suit costing 200 pounds cost in the US? A 20,000 Yen suit?
slide30
The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.
  • For example, if you go to your bank, you might see a posted exchange rate of 100 yen per dollar. The posted exchange rate is the nominal rate.
  • An exchange rate can always be expressed in two ways.
  • If the exchange rate is 100 yen per dollar, it is also 1/100 (.01) dollar per yen.
  • If a U.S. dollar will purchase 100 yen, a yen will purchase 1/100 of a U.S. dollar.
slide32
The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another country.
  • For example, suppose you go shopping and find a block of Dutch cheese is twice as expensive as a block of American cheese.
  • We would say that the real exchange rate is ½ block of Dutch cheese per block of American cheese.
  • It takes ½ a block of Dutch cheese to purchase a block of U.S. cheese
slide33
Like the nominal exchange rate, the real exchange rate is expressed in units of the foreign item per unit of the domestic item but in this case the item is a good rather than a currency.
  • Take another example. Suppose a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between the American and Japanese rice.
  • If the nominal exchange rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equivalent to 8,000 yen per bushel.
slide34
American rice is half as expensive as Japanese rice. The real exchange rate is ½ bushels of Japanese rice per bushel of American rice.
  • The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the domestic currencies.
slide38
The real exchange rate is a key determinant to a country’s balance of trade.
  • For example, if a domestic company is trying to decide where to purchase rice in our previous example , the real exchange rate is important.
  • The real exchange rate indicates where it is cheapest to purchase rice.
slide40
APPRECIATION :WHEN A CURRENCY INCREASES IN VALUE RELATIVE TO OTHER CURRENCIES IT IS SAID TO HAVE APPRECIATED.
  • DEPRECIATION : WHEN A CURRENCY’S VALUE FALLS RELATIVE TO OTHER CURRENCIES IT IS SAID TO HAVE DEPRECIATED.
slide42
EXPORTS TO

AMERICANS

  • ASSUME THAT THERE ARE TWO COUNTRIES : AMERICA AND FRANCE.
  • AND TWO CURRENCIES : DOLLARS AND EUROS.
  • FRENCH PERSONS MAY WANT TO HOLD (DEMAND) DOLLARS FOR THREE REASONS
    • TO BUY AMERICAN GOODS
    • TO BUY AMERICAN BONDS
    • TO SPECULATE
slide43
AMERICANS MAY WANT TO HOLD EUROS ( SUPPLY DOLLARS) FOR THREE REASONS:
    • TO BUY FRENCH GOODS
    • TO BUY FRENCH BONDS
    • TO SPECULATE
  • THE EXCHANGE RATE IS THE RELATIVE PRICE OF DOLLARS AND EUROS IN TERMS OF EACH OTHER.
  • EXCHANGE RATES ARE DETERMINED BY SUPPLY AND DEMAND IN COMPETITIVE MARKETS.

IMPORTS TO

AMERICANS

slide46
WHY DO THE SUPPLY AND DEMAND CURVES FOR FOREIGN EXCHANGE HAVE THE SHAPES THAT THEY DO ?
  • WHAT CAUSES THE SUPPLY AND DEMAND TO SHIFT ?
  • ASSUME NO BORROWING BETWEEN COUNTRIES IN THIS FIRST EXAMPLE. (ASSUME A LACK OF TRUST AMONG THE INHABITANTS OF THE COUNTIES.)
slide47
WHEN U.S. PRODUCERS SELL GOODS IN FRANCE THEY RECEIVE EUROS AND THEY WANT TO CONVERT THOSE EUROS INTO DOLLARS.
  • IF THEY DO NOT CONVERT THEM THEY WILL HAVE TO DEPOSIT THEM OR INVEST ( BUY BONDS) THEM IN FRANCE-- i.e., LEND THEM TO FRENCH PERSONS.
  • WHEN FRENCH PRODUCERS SELL IN THE U.S. THEY RECEIVE U.S. DOLLARS AND WANT TO CONVERT THEM TO EUROS.
  • THUS THERE IS AN EXCHANGE SITUATION.
slide48
EUROS/

DOLLARS

(E)

DDOLLARS

US Goods Expensive

More Euros per dollar

E2

E0

US Goods Cheap

Fewer Euros per dollar

E1

EXPORTS

U.S. DOLLARS

$1 $2 $3

slide49
HOW WOULD YOU EXPLAIN THE

UPWARD SLOPING SUPPLY FUNCTION ?

EUROS/

DOLLARS

(E)

SDOLLARS

IMPORTS

More Euros per dollar

E2

Foreign Goods Cheap

E0

Fewer Euros per dollar

E1

Foreign Goods Expensive

U.S. DOLLARS

$1 $2 $3

slide50
SDOLLARS

EUROS/

DOLLARS

( E )

DDOLLARS

IMPORT

E2

Exports = Imports

Balance of Payments Equilibrium

With no borrowing and lending

E0

E1

EXPORT

U.S. DOLLARS

$*

slide51
SUPPLY AND DEMAND FOR DOLLARS
  • EXCHANGE
  • RATE
  • EXCHANGE
  • RATE

FOREIGNERS’

DEMAND FOR

U.S. GOODS =

DEMAND FOR

DOLLARS

U.S. DEMAND

FOR IMPORTS =

SUPPLY OF

DOLLARS

D

S

S1

D1

U.S. IMPORTS

U.S. EXPORTS

slide52
CHANGES IN THE EXCHANGE RATE
  • FROM OUR PREVIOUS EXAMPLE , A FALL IN THE EXCHANGE RATE HAS ONE OF TWO CAUSES:
    • A REDUCTION IN THE DEMAND FOR U.S. EXPORTS AT ANY EXCHANGE WHICHTRANSLATES INTO A LEFTWARD SHIFT IN THE DEMAND CURVE FOR DOLLARS OR
    • AN INCREASED DEMAND FOR IMPORTS AT ANY EXCHANGE WHICH TRANSLATES INTO A RIGHTWARD SHIFT IN THE SUPPLY OF DOLLARS.
slide53
SDOLLARS

EUROS/

DOLLARS

(E)

S*DOLLARS

DDOLLARS

D*DOLLARS

U.S. DOLLARS

slide54
CHANGE IN THE SUPPLY AND DEMAND CURVE FOR DOLLARS : ANOTHER EXAMPLE
  • U.S. EXPORTS BECOME LESS POPULAR IN JAPAN:
    • U.S. EXPORTS BECOME LESS POPULAR.
    • DEMAND FOR DOLLARS DECREASES /LEFTWARD SHIFT OF THE DEMAND CURVE.
    • EQUILIBRIUM EXCHANGE RATE ( YEN PER DOLLAR ) FALLS.
    • SO WE SAY THE DOLLAR HAS DEPRECIATED.
slide55
U.S. CITIZENS ARE INFLUENCED TO “ BUY AMERICAN “ :
    • DEMAND FOR JAPANESE IMPORTS DECREASES.
    • U.S. CITIZEN SUPPLY FEWER DOLLARS TO THE FOREIGN CURRENCY MARKET.
    • THE SUPPLY CURVE FOR DOLLARS SHIFTS LEFTWARD
    • EQUILIBRIUM EXCHANGE RATE(YEN PER DOLLAR) RISES.
    • SO WE SAY THE DOLLAR HAS APPRECIATED.
slide57
BORROWING AND LENDING:

TRANSCTIONS IN FINANCIAL GOODS/

PORTFOLIO DECISIONS

slide58
INTERACTION BETWEEN THE GOODS

AND FINANCIAL MARKETS

slide59
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

e1

e0

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

$0

$1

slide60
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

Exports of goods

$0

$1

slide61
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

Exports of goods

$0

$1

slide62
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

Exports of goods

$0

$1

Imports of goods

slide63
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

Exports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

Exports of goods

$0

$1

Imports of goods

slide64
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

Exports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

D; demand without international

borrowing and lending

Imports of

financial

goods

Exports of goods

$0

$1

Imports of goods

slide65
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

Exports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

Financing of

balance of

payments deficit

D; demand without international

borrowing and lending

Imports of

financial

goods

Exports of goods

$0

$1

Imports of goods

slide66
S; supply without international

borrowing and lending

S; supply with international

borrowing and lending

S; supply with international

borrowing and lending –

Imports of financial goods

Exports of financial goods

e1

e0

D; demand with international

borrowing and lending

D; demand with international

borrowing and lending –

Exports of financial goods

Financing of

balance of

payments deficit

D; demand without international

borrowing and lending

Imports of

financial

goods

Exports of goods

$0

$1

Imports of goods

definitions
Definitions
  • Merchandise trade consists of all raw materials and manufactured goods bought, sold, or given away. Until mid-1993, this was the figure that was used when the "balance of trade" was reported in the media. Since then, the merchandise trade account has been combined with a second sub-account, services, to determine the total for the balance of trade.
  • Services include tourism, transportation, engineering, and business services, such as law, management consulting, and accounting. Fees from patents and copyrights on new technology, software, books, and movies also are recorded in the service category.
  • Investment income receipts include income derived from ownership of assets, such as dividends on holdings of stock and interest on securities.
  • Compensation of employees (paid). Income accruing to employees as remuneration for their work for domestic production. It is the sum of wage and salary accrual and of supplements to wages and salaries (pension benefits). It includes compensation paid to the rest of the world and excludes compensation received from the rest of the world.
  • Compensation of employees (received). Wage and salary disbursements and supplements to wages and salaries received by U.S. residents, including wages and salaries received from the rest of the world.
definitions71
Definitions
  • Unilateral transfers represent one-way transfers of assets, such as worker remittances from abroad and direct foreign aid.

The Capital Account

  • Capital transfers include debt forgiveness and migrants’ transfers (goods and financial assets accompanying migrants as they leave or enter the country). In addition, capital transfers include the transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets, and legacies.
  • Acquisition and disposal of non-produced, non-financial assets represent the sales and purchases of non-produced assets, such as the rights to natural resources, and the sales and purchases of intangible assets, such as patents, copyrights, trademarks, franchises, and leases.
definitions72
Definitions
  • The Financial AccountThe financial account records trade in assets such as business firms, bonds, stocks, and real estate, and it has two categories:
  • U.S.-owned assets abroad are divided into official reserve assets, government assets, and private assets. These assets include gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets, direct foreign investment, and U.S. claims reported by U.S. banks.
  • Foreign-owned assets in the United States are divided into foreign official assets and other foreign assets in the United States. These assets include U.S. government, agency, and corporate securities, direct investment, U.S. currency, and U.S. liabilities reported by U.S. banks.
definitions73
Definitions
  • Balance of Payments Deficit and Surplus

In theory, the current account should balance with the capital plus the financial accounts. The sum of the balance of payments statements should be zero. For example, when the United States buys more goods and services than it sells (a current account deficit), it must finance the difference by borrowing, or by selling more capital assets than it buys (a capital account surplus). A country with a persistent current account deficit is, therefore, effectively exchanging capital assets for goods and services. Large trade deficits mean that the country is borrowing from abroad. In the balance of payments, this appears as an inflow of foreign capital. In reality, the accounts do not exactly offset each other, because of statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions.

slide77
SUPPOSE AN AMERICAN INVESTOR IS GOING TO INVEST$1000 FOR ONE YEAR AND MUST DECIDE BETWEEN

-- INVESTING IN THE U.S. AT A RATE DENOTED AS rus = REAL RATE OF INTEREST.

-- INVESTING IN A FOREIGN COUNTRY AT rROW WHERE ROW = REST OF WORLD.

slide78
THE DECISION DEPENDS ON WHICH INVESTMENT PROVIDES THE LARGEST ACCUMULATED AMOUNT OF U.S. DOLLARS AFTER ONE YEAR OR STATED ALTERNATIVELY , WHICH INVESTMENT HAS THE HIGHEST EXPECTED RETURN IN U.S. DOLLARS .
  • IF THE INVESTMENT IS MADE IN U.S. BONDS , THE AMOUNT ACCUMULATED AFTER ONE YEAR IS

$ 1000 ( 1 + rUS )

slide79
IF THE INVESTMENT IS MADE ABROAD , THE AMOUNT ACCUMULATED -- IN U.S. DOLLARS -- AFTER ONE YEAR WILLBE

($ 1000 / E ) ( 1 + rROW) ( Ee )

ACTUAL

EXCHANGE

RATE:SPOT

RATE

EXPECTED

EXCHANGE

RATE:FORWARD

RATE

BASED ON ALL INFORMATION

CURRENTLY AVAILABLE:

OPTIMAL FORECAST / BEST GUESS

slide81
AN AMERICAN INVESTOR HAS $1000 TO INVEST FOR ONE YEAR .

rUS = 10%

rROW = 8%

E = $ .20 PER EUROS

Ee = $ .25 PER EUROS

slide82
AMOUNT ACCUMULATED FROM U.S. BOND

( $ 1000 ) ( 1 + rUS ) = $ 1000 ( 1.10 ) = $ 1100

  • AMOUNT ACCUMULATED FROM FRENCH

BOND

-- EUROS INVESTED

( $ 1000 / E ) = ( $ 1000 / .20 )

= 5000 EUROS

-- AMOUNT ACCUMULATED IN EUROS

5000 ( 1 + rROW) = 5000 ( 1.08 )

= 5400 EUROS

slide83
-- CONVERT EUROS TO DOLLARS

5000 EUROS ( 1 + rROW) ( Ee ) = 5400(.25)

= $ 1350

  • THE DECISION WHETHER TO INVEST IN THE U.S. OR IN FRANCE IS MADE BY COMPARING THE $ AMOUNTS THAT ARE EXPECTED TO BE ACCUMULATED OVER THE YEAR.
slide85
IRP = [ $1000(1+rUS)/($1000/E)(1+rROW)(Ee)]
  • = ( 1+ rUS/ 1+ rROW ) ( E / Ee)
  • WHEN IRP > 1
  • WHEN IRP = 1
  • WHEN IRP < 1

INVESTORS PURCHASE,

DOLLAR DENOMINATED

BONDS

INVESTORS ARE

INDIFFERENT

INVESTORS PURCHASE

FOREIGN DENOMINATED

BONDS

from our previous example
FROM OUR PREVIOUS EXAMPLE
  • IRP = ( 1.10 / 1.08 ) ( .20 / .25 )

= 1.01852 * 0.8 = .815 < 1

THE DECISION IS TO PURCHASE THE FRENCH BOND.

INTEREST

RATE

RATIO

EXCHANGE

RATE

RATIO

definitions from the previous example
DEFINITIONS FROM THE PREVIOUS EXAMPLE
  • INTEREST RATE RATIO: INDICATES THAT THE U.S. INVESTMENT IS FAVORED WHEN THE U.S. INTEREST RATE -- rUS-- IS HIGH RELATIVE TO THE FOREIGN RATE --rROW.
  • EXCHANGE RATE RATIO: INDICATES THAT THE U.S. INVESTMENT IS FAVORED WHEN THE DOLLAR IS EXPECTED TO APPRECIATE IN VALUE.
exchange determination
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

EUROS/ $

E

C

10.5

  • *

Our Characterization

of the Foreign

Exchange Market

10.0

B

A

D

9.5

Start at

9.5 Euros

to the Dollar

4.8%

10%

14.8%

EXPECTED RETURN

IN $

slide90
EXPECTED OR FORWARD RATE OF EXCHANGE

RETURN IN DOLLARS( RETF)

RET$ ON FOREIGN BOND

rUS rROW - ( E * - E ) / E

CURRENT OR

SPOT RATE

OF EXCHANGE

FROM U.S.

FINANCIAL

INSTRUMENT

slide91
IF E* > E , THEN THE DOLLAR IS EXPECTED TO APPRECIATE ( OR FOREIGN CURRENCY IS EXPECTED TO DEPRECIATE) . IF THE FOREIGN CURRENCY DEPRECIATES , THEN IT WILL BUY FEWER DOLLARSAFTER THE FOREIGN BOND MATURES , REDUCING THE TOTAL RETURN ON THE FOREIGN INVESTMENT ( i.e., MEASURED IN DOLLARS )
slide92
AT POINT A: RETF = 10% - ( 10 - 9.5)/9.5

FRENCH

INTEREST

RATE

CURRENCY

MOVEMENT

FACTOR

= .10 - .052 = .048 OR 4.8%

slide93
IF E* < E , THEN THE DOLLAR IS EXPECTED TO DEPRECIATE ( OR THE FOREIGN CURRENCY TO APPRECIATE ) . IF THE FOREIGN CURRENCY APPRECIATES , THEN IT WILL BUY MORE DOLLARS AFTER THE FOREIGN BOND MATURES , INCREASING THE TOTAL RETURN ON THE FOREIGN INVESTMENT ( i.e., MEASURED IN DOLLARS) .
slide95
EXCHANGE DETERMINATION
  • *

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

exchange determination96
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

exchange determination97
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

14.8%

10%

EXPECTED RETURN

IN $

exchange determination98
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

exchange determination99
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

exchange determination100
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

exchange determination101
EXCHANGE DETERMINATION

RET$

RETF

EXCHANGE

RATE

Euros/ $

E

C

10.5

  • *

10.0

B

A

D

9.5

4.8%

10%

14.8%

EXPECTED RETURN

IN $

suppose the expected exchange rate e e e rises103
SUPPOSE THE EXPECTED EXCHANGE RATE (Ee = E*) RISES

RET2F

RET$

RET1F

Euros/$

11

E**=

10.5

E*=10

14.5%

10%

19.1%

5%

calculations for the diagram
CALCULATIONS FOR THE DIAGRAM
  • AT THE OLD MARKET CLEARING POINT:

RETF = .10 - (10.5 -10)/10

= .10 - .05 =.05 or 5%

NEW EXPECTED

EXCHANGE RATE

E**

OLD EXCHANGE

RATE

RETURN ON THE

FOREIGN BOND AT

THE NEW EXPECTED

EXCHANGE RATE

slide105
SUPPOSE THE EXPECTED

e

EXCHANGE RATE (E

= E*) RISES

  • TRY AN EXCHANGE RATE OF 11 EUROS TO THE DOLLAR

RETF = .10 - (10.5 - 11 ) / 11

= .10 - ( -.045 )

= .145 or 14.5%

RETURN ON THE

FOREIGN BOND

AT THE NEW EXPECTED

EXCHANGE RATE

change in the domestic real rate of interest
CHANGE IN THE DOMESTIC REAL RATE OF INTEREST

RET1$

RET1F

  • Exchange

Rate (e/$)

10

10%

change in the domestic real rate of interest107
CHANGE IN THE DOMESTIC REAL RATE OF INTEREST

RET1$

RET2$

RET1F

  • Exchange

Rate (e/$)

9.5

10%

12%

change in the domestic real rate of interest108
CHANGE IN THE DOMESTIC REAL RATE OF INTEREST

RET2$

RET1$

RET1F

  • Exchange

Rate (e/$)

10

EXCESS DEMAND

FOR DOLLARS

The Exchange Rate Rises

9.5

12%

10%

increase in domestic nominal rate due to an increase in inflation
INCREASE IN DOMESTIC NOMINAL RATE DUE TO AN INCREASE IN INFLATION

RET1F

RET1$

  • Exchange

Rate (e/$)

increase in domestic nominal rate due to an increase in inflation110
INCREASE IN DOMESTIC NOMINAL RATE DUE TO AN INCREASE IN INFLATION

RET1F

RET1$

RET2$

  • Exchange

Rate (e/$)

E1

1

10%

12%

increase in domestic nominal rate due to an increase in inflation111
INCREASE IN DOMESTIC NOMINAL RATE DUE TO AN INCREASE IN INFLATION

RET1F

RET1$

RET2$

  • Exchange

Rate (e/$)

RET2F

E1

1

2

E2

The Exchange Rate

Falls

10%

12%

increase in the domestic money supply
INCREASE IN THE DOMESTIC MONEY SUPPLY

RET1F

RET1$

  • Exchange

Rate (e/$)

E1

10%

increase in the domestic money supply113
INCREASE IN THE DOMESTIC MONEY SUPPLY

RET1F

RET1$

RET2$

  • Exchange

Rate (e/$)

E1

8%

10%

LIQUIDITY

EFFECT

increase in the domestic money supply114
INCREASE IN THE DOMESTIC MONEY SUPPLY

RET1F

RET1$

RET2$

  • Exchange

Rate (e/$)

INCOME

EFFECT

E1

8%

10%

LIQUIDITY

EFFECT

increase in the domestic money supply115
INCREASE IN THE DOMESTIC MONEY SUPPLY

RET1F

RET1$

RET2$

RET2F

  • Exchange

Rate (e/$)

E1

1

E2

PRICE

EXPECTATIONS

EFFECT

3

2

8%

10%

LIQUIDITY

EFFECT

increase in the domestic money supply116
INCREASE IN THE DOMESTIC MONEY SUPPLY

RET1F

RET1$

RET2$

RET2F

  • Exchange

Rate (e/$)

INCOME

EFFECT

E1

1

E2

PRICE

EXPECTATIONS

EFFECT

3

2

8%

10%

LIQUIDITY

EFFECT

the nominal exchange rate is
The nominal exchange rate is

the difference between the interest rate in one country and the interest rate in another country.

the rate at which a bond may be exchanged for currency.

the rate at which a stock may be exchanged for currency.

the price of one country’s currency in terms of another’s.

incorrect
INCORRECT!!!

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CORRECT

Next Question

slide120
If a British automobile sells for £20,000 and the British pound is worth $1.50, then the dollar price of the automobile is

$11,600.

$12,500.

$30,000.

$40,000

incorrect121
INCORRECT!!!

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slide122
CORRECT

Next Question

a change in the dollar value of the british pound from 1 60 to 1 50 represents
A change in the dollar value of the British pound from $1.60 to $1.50 represents

an increase in the pound price of British goods.

an appreciation of the dollar relative to the pound.

an appreciation of the pound relative to the dollar.

an increase in the dollar price of British goods.

incorrect124
INCORRECT!!!

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slide125
CORRECT

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if the japanese yen appreciates against the u s dollar
If the Japanese yen appreciates against the U.S. dollar,

Japanese businesses gain by a decrease in the dollar price of exports to the United States.

Japanese consumers gain by a decrease in the yen price of U.S. exports to Japan.

Japanese consumers lose by an increase in the yen price of U.S. exports to Japan.

U.S. consumers gain by a decrease in the dollar price of Japanese exports to the United States.

incorrect127
INCORRECT!!!

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slide128
CORRECT

Next Question

slide129
The relation between the nominal and real exchange rates is given by which of the following equations?

EX = (EXrP)/Pf

EX = (EXrPf)/P

EXr = (EXPf)/P

EXr = (EXP)/Pf

incorrect130
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slide131
CORRECT

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slide132
The relation between changes in the nominal and real exchange rates is given by which of the following equations?

DEXr/EXr = DEXr/EXr+ p – pf.

DEX/EX = DEXr/EXr +p – p f.

DEX/EX =DEXr/EXr +pf +p.

DEXr/EXr = DEX/EX + pf – p.

incorrect133
INCORRECT!!!

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slide134
CORRECT

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in the spot foreign exchange market
In the spot foreign exchange market

only dollars, yen, and pounds may be traded.

only dollars and yen may be traded.

currencies or bank deposits are exchanged immediately

currencies or bank deposits are exchanged at a fixed date (or spot) in the future.

incorrect136
INCORRECT!!!

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slide137
CORRECT

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in forward transactions
In forward transactions

the exchange takes place at the same exchange rate as in the spot market.

currencies are exchanged at a set date in the future.

currencies may only be exchanged at rates set by governments well in advance.

currency is bought and sold for delivery later that same day.

incorrect139
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slide140
CORRECT

Next Question

slide141
Suppose that you expect during the next year the dollar will appreciate against the pound from 0.5 pound to the dollar to 0.75 pound to the dollar. How much will you expect to make on an investment of $10,000 in British government securities that will mature in one year and pay interest of 8%?

–59.5%

–28%

8%

28%

incorrect142
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slide143
CORRECT

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an increase in the expected inflation rate in the united states will
An increase in the expected inflation rate in the United States will

reduce the nominal interest rate in the United States.

cause the U.S. exchange rate to appreciate.

increase the budget deficit in the United States relative to the budget deficits of foreign governments.

cause the U.S. exchange rate to depreciate.

incorrect145
INCORRECT!!!

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CORRECT

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