chapter 7 the foreign exchange market. copyright © 2002 pearson education canada inc. 7- 2 foreign...

chapter 7

The Foreign Exchange Market

Copyright © 2002 Pearson Education Canada Inc. 7- 2

Foreign Exchange Rates


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


Law of One Price

Example: Canadian steel $100 per ton, Japanese steel 10,000 yen per tonIf E = 50 yen/$ then prices are:

Canadian Steel Japanese Steel

In Canada $100 $200In Japan 5000 yen 10,000 yen

If E = 100 yen/$ then prices are:

Canadian Steel Japanese Steel

In Canada $100 $100In Japan 10,000 yen 10,000 yen

Law of one price E = 100 yen/$


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


PPP: Canada and U.S.


Factors Affecting E in Long Run

Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E


Expected Returns and Interest Parity

RETe for

Francois Al

$ Deposits iD + (Eet+1 – Et)/Et iD

F Deposits iF iF – (Eet+1 – Et)/Et

Relative RETe iD – iF + (Eet+1 – Et)/Et iD – iF + (Ee

t+1 – Et)/Et

Interest Parity Condition:

$ and F deposits perfect substitutes

iD = iF – (Eet+1 – Et)/Et

Example: if iD = 10% and expected appreciation of $, (Ee

t+1– Et)/Et, = 5% iF = 15%


Deriving RETF Curve

Assume iF = 10%, Eet+1 = 1 euro/$

Point

A: Et = 0.95 RETF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%

B: Et = 1.00 RETF = .10 – (1 – 1.0)/1.0 = .100 =10.0%

C: Et = 1.05 RETF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%

RETF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RETF

Deriving RETD Curve

Points B, D, E, RETD = 10%: so curve is vertical

Equilibrium

RETD = RETF at E*

If Et > E*, RETF > RETD, sell $, Et

If Et < E*, RETF < RETD, buy $, Et


Equilibrium in the Foreign Exchange Market


Shifts in RETF

RETF curve shifts right when

1. iF : because RETF at each Et

2. Eet+1 : because

expected appreciation of F at each Et and RETF Occurs:

1) Domestic P ,

2) Tariffs and quotas 3) Imports , 4) Exports , 5) Productivity

Figure 7-4


Shifts in RETD

RETD shifts right when

1. iD ; because RETD at each Et

Assumes that domestic e unchanged, so domestic real rate

Figure 7-5


Factors that Shift RETF and RETD


Response to i Because e

1. e , Eet+1 , expected

appreciation of F ,

RETF shifts out to

right

2. iD , RETD shifts to

right

However because e > iD , real rate , Ee

t+1 more than iD RETF out > RETD out and Et

Figure 7-6


Response to Ms

1. Ms , P , Eet+1

expected appreciation

of F , RETF shifts

right

2. Ms , iD , RETD shifts

left

Go to point 2 and Et

3. In the long run, iD

returns to old level,

RETD shifts back, go

to point 3 and get

Exchange Rate

Overshooting

Figure 7-7


Why Exchange Rate Volatility?

1. Expectations of Eet+1 fluctuate

2. Exchange rate overshooting

chapter 7 the foreign exchange market. copyright © 2002 pearson education canada inc. 7- 2 foreign...

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