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The Foreign Exchange Market

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  1. The Foreign Exchange Market

  2. Asian Currencies vs. U.S. Dollar

  3. The Foreign Exchange Market Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation Currency appreciates, country’s goods prices  abroad and foreign goods prices  in that country 1. Makes domestic businesses less competitive 2. Benefits domestic consumers FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies

  4. The Foreign Exchange Market D S Exchange rate Peso/$ Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos Foreign exchange (dollars)

  5. Currency Depreciation and Appreciation • Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange • Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange

  6. Changes in the Equilibrium Exchange Rate Supply of Dollars by people who want pesos D Exchange rate Peso/$ S S’ $ -depreciation Peso- appreciation Demand for Dollars by people who have pesos Foreign exchange (dollars)

  7. Exchange Rate Regimes • Flexible (Floating) exchange rates. • Fixed exchange rates. • Currency Board • Monetary Union • Managed Float (Dirty Float) exchange rates.

  8. The Central Bank Can Intervene to Maintain Exchange Rates D’’ Exchange rate $/pound S D’ Foreign exchange (pounds)

  9. China

  10. Currency Crisis D’ Exchange rate Baht/$ D S 52 25 Foreign exchange ($)

  11. Asian Currencies vs. U.S. Dollar

  12. Law of One Price Example: American steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are: American Steel Japanese Steel In U.S. $100 $200 In Japan 5000 yen 10,000 yen If E = 100 yen/$ then prices are: American Steel Japanese Steel In U.S. $100 $100 In Japan 10,000 yen 10,000 yen Law of one price E = 100 yen/$

  13. Purchasing Power Parity (PPP) PPP  Domestic price level  10%, domestic currency  10% 1. Application of law of one price to price levels 2. Works in long run, not short run Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy 2. Many goods and services are not traded: e.g. haircuts

  14. Big Mac Index

  15. PPP: U.S. and U.K

  16. Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E Factors Affecting E in Long Run

  17. Exchange Rates in the Short Run • An exchange rate is the price of domestic assets in terms of foreign assets • Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other

  18. Expected Returns and Interest Parity Re for Francois Al $ Deposits iD + (Eet+1 – Et)/EtiD Euro Deposits iFiF – (Eet+1 – Et)/Et Relative ReiD – iF + (Eet+1 – Et)/EtiD – iF + (Eet+1 – Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes iD = iF – (Eet+1 – Et)/Et Example:if iD = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5% iF = 15%

  19. Deriving RF Curve Assume iF = 10%, Eet+1 = 1 euro/$ Point A: Et = 0.95, RF = .10 – (1 – 0.95)/0.95 = .048 = 4.8% B: Et = 1.00, RF = .10 – (1 – 1.0)/1.0 = .100 =10.0% C: Et = 1.05, RF = .10 – (1 – 1.05)/1.05 = .148 = 14.8% RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF Deriving RD Curve Points B, D, E, RD = 10%: so curve is vertical Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et

  20. Equilibrium in the Foreign Exchange Market

  21. Shifts in RF RF curve shifts right when 1. iF: because RF at each Et 2. Eet+1: because expected appreciation of F at each Et and RF Occurs Eet+1 iF: 1) Domestic P, 2) Trade Barriers  3) Imports , 4) Exports , 5) Productivity 

  22. Shifts in RD RD shifts right when 1. iD; because RD at each Et Assumes that domestic e unchanged, so domestic real rate 

  23. Foreign Exchange I • Exchange rate—price of one currency in terms of another • Foreign exchange market—the financial market where exchange rates are determined • Spot transaction—immediate (two-day) exchange of bank deposits • Spot exchange rate • Forward transaction—the exchange of bank deposits at some specified future date • Forward exchange rate

  24. Foreign Exchange II • Appreciation—a currency rises in value relative to another currency • Depreciation—a currency falls in value relative to another currency • When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa • Over-the-counter market mainly banks

  25. Exchange Rates in the Long Run • Law of one price • Theory of Purchasing Power Parity • Assumes all goods are identical in both countries • Trade barriers and transportation costs are low • Many goods and services are not traded across borders

  26. Factors that Affect Exchange Rates in the Long Run • Relative price levels • Trade barriers • Preferences for domestic versus foreign goods • Productivity

  27. Factors that Shift RF and RD

  28. 1. e, Eet+1, expected appreciation of F, RF shifts out to right 2. iD, RD shifts to right However because e > iD, real rate , Eet+1 more than iDRF out > RD out and Et Response to i Because e

  29. Response to Ms  1. Ms, P , Eet+1 expected appreciation of F, RF shifts right 2. Ms, iD, RD shifts left Go to point 2 and Et 3. In the long run, iD returns to old level, RD shifts back, go to point 3 and get Exchange Rate Overshooting

  30. Why Exchange Rate Volatility? 1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting

  31. 1. Value of $ and real rates rise and fall together, as theory predicts 2. No association between $ and nominal rates: $ falls in late 70s as nominal rate rises The Dollar and Interest Rates

  32. Chapter 18 The International Financial System

  33. Unsterilized Foreign Exchange Intervention • A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base • A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base

  34. Unsterilized Intervention • An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

  35. Sterilized Foreign Exchange Intervention • To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation • There is no effect on the monetary base and no effect on the exchange rate

  36. Current Account International transactions that involve currently produced goods and services Trade Balance Capital Account Net receipts from capital transactions Sum of these two is the official reserve transactions balance Balance of Payments

  37. Monetary Policy Strategy: The International Experience

  38. Role of a Nominal Anchor Ties Down  Expectations Helps Avoid Time-Consistency Problem 1. Arises from pursuit of short-term goals which lead to bad long-term outcomes 2. Time-consistency resides more in political process 3. Nominal anchor limits political pressure for time-consistency

  39. Exchange-Rate Targeting Advantages 1. Fixes  for internationally traded goods 2. Anchors  expectations 3. Automatic rule, avoids time-consistency 4. Easy to understand: “sound currency” as rallying cry 5. Helps economic integration 6. Successful in reducing  France, UK, Mexico

  40. Exchange-Rate Targeting Disadvantages 1. Loss of independent monetary policy Problems after German reunification: UK, French monetary policy too tight 2. Open to speculative attacks Europe, Sept. 1992; Mexico: 1994; Asia: 1997 3. Successful speculative attack disastrous for emerging market countries because it leads to financial crisis 4. Weakened accountability: lose exchange-rate signal

  41. Currency Boards vs. Dollarization Currency Boards 1. Domestic currency exchanged at fixed rate for foreign currency automatically 2. Fixed exchange rate with very strong commitment mechanism and no discretion 3. Usual disadvantages of fixed exchange rate 4. Still subject to speculative attack 5. Lose ability to have lender of last resort Dollarization 1. Even stronger commitment mechanism 2. No possibility of speculative attack 3. Usual disadvantages of fixed exchange rtae 4. Lose seignorage

  42. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies

  43. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies