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ECN 160B Lecture 8 International Macroeconomics Galina A. Schwartz Department of Economics University of CA, Davis Brief on Money (next lecture) Currencies = Monies Money as a store of value, KO, p. 334 this is one of the functions of money Demand for Currency ~ Demand for Money

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ecn 160b lecture 8 international macroeconomics

ECN 160B Lecture 8International Macroeconomics

Galina A. Schwartz

Department of Economics

University of CA, Davis

Lecture 8 ECN160B

brief on money next lecture
Brief on Money (next lecture)
  • Currencies = Monies
  • Money as a store of value, KO, p. 334

this is one of the functions of money

  • Demand for Currency ~ Demand for Money
  • Demand for Currency – two components
    • Demand by domestic residents
    • Demand by foreign residents
  • Supply of Currency (next lecture & next chapter)

Lecture 8 ECN160B

value of currency
Value of Currency
  • Currency is an asset
  • How to determine asset returns?

(Or in which asset should one invest?)

All else equal, one should invest into the asset with the highest real rate of return

  • As we have mentioned, asset value depends on

● Liquidity & ● Risk

Lecture 8 ECN160B

forex market characteristics
ForEX Market Characteristics
  • Rate of Return (+ we will relate this to arguments about Interest Rate Parity(IRP))
    • Expected ???
    • Real ? What does this mean?
  • All else equal, in equilibrium, real returns on all assets should be equal, but
  • Risk (variability of returns)
  • Liquidity (cost (ease) & speed of selling the asset)
    • What affects liquidity? Ex. Market volume

Lecture 8 ECN160B

interest rates asset returns
Interest Rates & Asset Returns

●Rate of Return & ● Liquidity & ● Risk

Rate of Return depends on two factors:

  • I. Interest rate that the currency offers (examples: R€ and R$)
    • Interest rate is ?
  • II. Expected currency exchange rate against other currencies (ex. Ee$/€)

Lecture 8 ECN160B

interest rate parity irp
Interest Rate Parity (IRP)
  • IRP: return on $ deposits in terms of €:

R€ +[(Ee$/ € - E$/€ )/E$/€ ] = R$

has to be equal to R$ (otherwise profits can be made via arbitrage) KO, 13-2

  • Therate of depreciationof thedollar against the euro is

(E1$/ € - E$/€ )/E$/€

E1$/ € dollar/euro rate in one year

Ee$/ € expected dollar/euro rate in one year

Lecture 8 ECN160B

forex market equilibrium
FOREX Market Equilibrium
  • Equilibrium Determination:
  • Assumptions

R€ , R$ and Ee$/€

are given (i.e., fixed)

  • Main conclusion:

FOREX markets adjust to make deposits of all currencies offer the same expected rate of return

  • I.e., in equilibrium, IRP holds (KO, 13-2)

Lecture 8 ECN160B

forex market equilibrium8

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)

ForEx Market Equilibrium

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

Lecture 8 ECN160B

interest rates expectations equilibrium effect of a rise in r on e

Exchange rate, E$/€

Dollar return

1

1'

E1$/€

E2$/€

2

Expected

euro return

R1$

R2$

Rates of return

(in dollar terms)

Interest Rates, Expectations & Equilibrium Effect of a Rise in R$ on E$/€

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

Lecture 8 ECN160B

interest rates expectations equilibrium effect of a rise in r on e10

Exchange rate, E$/€

Dollar return

Rise in euro

interest rate

2

E2$/€

E1$/€

1

Expected

euro return

R$

Rates of return

(in dollar terms)

Interest Rates, Expectations & Equilibrium: Effect of a rise in R€ on E$/€

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

Lecture 8 ECN160B

non covered versus covered interest rate parity
Non-covered versus Covered Interest Rate Parity
  • Non-covered interest rate parity – the parity involves the expected future spot exchange rate
  • Covered interest rate parity – involves parity condition based on forward exchange rate (not on the expected future spot exchange rate)

Lecture 8 ECN160B

next lecture
Next Lecture
  • Money
    • Long run
    • Short run
    • Equilibrium
    • Connection with interest rates
  • Exchange Rates Overshooting (time permitting)
    • covered
    • uncovered
  • Your preparation: KO Ch. 14

Lecture 8 ECN160B

summary of today
Summary of Today
  • Rate of return
  • Rate of depreciation / appreciation
  • Interest parity condition aka

Interest Rate Parity (IRP)

  • FOREX market equilibrium; How equilibrium changes with R or E
    • 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.
  • Have a Nice Day

Lecture 8 ECN160B