Ch19

Ch19

• 1.
  Chapter 19 The ForeignExchange Market © 2005 Pearson Education Canada Inc.
• 2.
  © 2005 PearsonEducation Canada Inc. 19-2 Foreign Exchange Rates
• 3.
  © 2005 PearsonEducation Canada Inc. 19-3 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.
  19-4 Law of OnePrice Example: Canadian steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are: Canadian Steel Japanese Steel In Canada $100 $200 In Japan 5000 yen 10,000 yen If E = 100 yen/$ then prices are: Canadian Steel Japanese Steel In Canada $100 $100 In Japan 10,000 yen 10,000 yen Law of one price ⇒ E = 100 yen/$ © 2005 Pearson Education Canada Inc.
• 5.
  © 2005 PearsonEducation Canada Inc. 19-5 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
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  © 2005 PearsonEducation Canada Inc. 19-6 PPP: Canada and U.S.
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  19-7 Factors Affecting Ein Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E ↑ © 2005 Pearson Education Canada Inc.
• 8.
  © 2005 PearsonEducation Canada Inc. 19-8 Expected Returns and Interest Parity Re for Francois Al $ Deposits iD + (Ee t+1 – Et)/Et iD Euro Deposits iF iF – (Ee t+1 – Et)/Et Relative Re iD – iF + (Ee t+1 – Et)/Et iD – iF + (Ee t+1 – Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes iD = iF – (Ee t+1 – Et)/Et Example: if iD = 10% and expected appreciation of $, (Ee t+1– Et)/Et, = 5% ⇒ iF = 15%
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  © 2005 PearsonEducation Canada Inc. 19-9 Deriving RF Curve Assume iF = 10%, Ee t+1 = 1 euro/$ 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 $, Et ↑
• 10.
  © 2005 PearsonEducation Canada Inc. 19-10 Deriving RETF Curve Assume iF = 10%, Ee t+1 = 1 euro/$ 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 ↑
• 11.
  © 2005 PearsonEducation Canada Inc. 19-11 Equilibrium in the Foreign Exchange Market
• 12.
  19-12 Shifts in RF RFcurve shifts right when 1. iF ↑: because RF ↑ at each Et 2. Ee t+1 ↓: because expected appreciation of F ↑ at each Et and RF ↑ Occurs Ee t+1 ↓ iF: 1) Domestic P ↑, 2) Trade Barriers ↓ 3) Imports ↑, 4) Exports ↓, 5) Productivity ↓ © 2005 Pearson Education Canada Inc.
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  © 2005 PearsonEducation Canada Inc. 19-13 Shifts in RD RD shifts right when 1. iD ↑; because RD ↑ at each Et Assumes that domestic πe unchanged, so domestic real rate ↑
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  © 2005 PearsonEducation Canada Inc. 19-14 Factors that Shift RF and RD
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  19-15 Response to i↑ Because πe ↑ 1. πe ↑, Ee t+1 ↓, expected appreciation of F ↑, RF shifts out to right 2. iD ↑, RD shifts to right However because πe ↑ > iD ↑, real rate ↓, Ee t+1 ↓ more than iD ↑ ⇒ RF out > RD out and Et ↓ © 2005 Pearson Education Canada Inc.
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  19-16 Response to Ms ↑ 1.Ms ↑, P ↑, Ee t+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 © 2005 Pearson Education Canada Inc.
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  © 2005 PearsonEducation Canada Inc. 19-17 Why Exchange Rate Volatility? 1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting