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
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 has to 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)
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.
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.